What actions can drive responsible innovation in digital assets?

Effective risk management and the use of proven regulatory frameworks can help bring order to recent volatility in the digital assets market.

The crypto asset market is experiencing alarming volatility. The global market value rose to US $3 trillion at the end of 2021 and has plunged to less than US$1 trillion in recent months. This crash in value – coupled with the collapse of Luna/Terra tokens, the hedge fund Three Arrows and a range of crypto investment firms – is fueling concerns about the risks that digital assets pose to consumers, investors and financial systems.

Policymakers cannot ignore this kind of disruption. Just last month, the US Federal Reserve issued guidance for banks, which can be viewed as an important step in creating a supervisory process for banks engaging in activities involving digital assets. The Financial Stability Board, a group of national financial authorities and international standard-setting bodies, is also expected to publish a report in October 2022 for the G20 on regulatory and supervisory approaches to stablecoins and other crypto-assets.

What proactive steps should traditional finance firms and crypto natives take to get ahead of upcoming digital asset regulation? In our report, “Managing the digital assets environment: Key considerations for traditional finance firms, crypto natives and policymakers,” we argue that there is no need to reinvent the wheel: proven risk management and regulatory approaches can be applied to the digital assets’ universe.

Perspectives on responsible innovation

Digital assets range from tokens that may or may not mimic securities, to stablecoins and Central Bank Digital Currencies (CDBCs). Stakeholders in the digital asset market will have different views and needs, depending on their role within the ecosystem, organizational history, management experience and the broader applications they have used. The views of traditional finance firms with well-established governance processes differ from those of crypto-native companies that are strong on technology but can lack risk management experience. Policymakers have a different take, seeking to mitigate risks to investors and markets, while at the same time contemplating their own digital assets.

In the current uncertain environment, each of these three key ecosystem participants – traditional finance firms, crypto natives and policymakers – can benefit from leveraging proven frameworks and approaches. Together, this can help to foster responsible digital asset innovation.

Traditional finance firms: Proactive risk mitigation is key

Some traditional finance firms are implementing targeted digital asset strategies due to increased customer interest but are doing so cautiously. Areas of concern include the lack of familiarity with digital assets and the related technology, how digital assets align with existing service offerings and increasing regulatory scrutiny.

To navigate the opportunities and risks effectively, traditional finance firms need to leverage their experience with risk management and embed digital asset activities into their overall risk and compliance frameworks. Developing an overarching digital assets strategy is a critical first step for mitigating potential liquidity, credit, market, compliance and operational risks. This requires investing in people, processes and technology that align with their firm’s risk appetite.

Understanding the expectations of regulators is only part of the equation. Another top priority should be to provide services that target and safeguard consumers and enable them to make informed decisions.

Policymakers: search for effective regulatory outcomes while contemplating national digital currencies

“Regulatory clarity is often a journey, not a destination – and typically a slow one that evolves with changes in innovation and market environment,” says Katie Kummer, Global Deputy Vice Chair for Public Policy.

Policymakers are sensitive to regulation – over-regulating tends to hamper innovation, while under-regulating leads to market instability and leaves customers unprotected. Understanding the unique ecosystem of crypto and digital, as well as the risks, opportunities and tradeoffs, could foster more effective regulatory outcomes.

For policymakers, there are close analogies already available to drive regulation of digital assets with some modifications to support the digital nature of these ecosystems. We’re already seeing this emerge with fiat-backed stablecoins. There is growing consensus that such stablecoins have clear parallels with money market funds, provided they are backed by reserves in real-world currencies.

Private-public company collaboration is another way to achieve better harmony in regulating digital assets. Regulatory sandboxes are a proven example of how regulators can work with innovators to build consumer protection safeguards into their products and services before they are mass marketed. This approach only works if there is transparency and clarity on requirements and expectations.

Aside from regulation, some policymakers want to create their own digital currencies. The emergence of CBDCs is consistent with historical innovations in money that have reduced both holding and transaction costs over time, such as the introduction of the euro.

In developing CBDCs, policymakers need to be able to articulate the opportunities and risks for the crypto-asset market and the overall economy. Aligning technical requirements with policy objectives necessitates careful consideration of public policy implications, expectations and tradeoffs. Clear expectations are needed between the public sector and private sector as they relate to “know your customer” and data security and privacy.

Key actions for traditional finance firms and crypto natives

With more regulations on the horizon, traditional finance firms will need to decide soon why and how to engage prudently in a manner consistent with their risk and compliance frameworks. The big issue for crypto natives will be how to adapt their operating models to address risks that are top of mind for policymakers.

Key actions that can be taken now include:

1. For traditional finance firms

• Ensure that senior management plays a leadership role in evaluating the inherent risks and effectiveness of business models and internal controls
• Verify risks bespoke to digital assets are identified and assessed comprehensively and embedded in the internal control environment
• Provide informative, digestible and actionable internal reporting for senior management and the board regarding the inherent risks and effectiveness of internal controls as they relate to digital assets
• Evaluate whether marketing and communications strategies allow customers and users to make informed choices
• Provide services such as safeguarding customer digital assets, trade execution and settlement in a manner consistent with industry practices observed in more regulated markets

2. For crypto natives

• Establish product approval processes and controls to help mitigate potential risks posed by these products to the public and investors
• Monitor trends on the blockchain to help identify and mitigate risks such as fraud and anti-money laundering (AML)
• Develop extensive cyber controls and testing, particularly around smart contracts
• Evaluate third party validation of the entity’s exposure to vulnerabilities in smart contracts
• Assess the relevance and reliability of blockchain information evidencing the existence of digital assets held

The volatility in the digital assets market cannot be ignored by policymakers. Proactive risk management and governance by traditional finance firms and crypto natives can help drive responsible innovation and adaptability to new regulations.