By Michael Huertas, a Frankfurt-based partner at law firm Dentons.
Cryptocurrency and digital asset valuations derive their input from a number of contributing factors. As with their non-distributed ledger technology (DLT) based cousins, crypto and digital assets’ perceived worth to investors may also largely be shaped by their perception of limited supply. The (perceived) level of asset scarcity and the (perceived) level of an asset’s valuation dictates, in part, the higher prices that an investor is willing to pay to obtain such asset or the price it is willing to part with that asset.
Market economics has a role to play in the digital disruption and many stakeholders have begun to take measures to borrow or abridge concepts from traditional financial markets to generate greater liquidity in these comparably more illiquid, opaque and non-intermediated DLT markets.
Policymakers are likely to continue to focus their immediate pressures on strengthening oversight and conduct of business rules in respect of cryptocurrency points of exchange as well as certain clearing houses clearing digital and cryptocurrency options. However, there is possibly a far greater priority at play, namely financing and monetisation of holdings of cryptocurrencies and digital assets.
The rise in cryptocurrency and digital asset valuations has prompted greater interest from those looking to finance new positions and/or monetise existing holdings and do so efficiently and safely. At present, financing options are limited by perceived lack of trust in the resilience of those offering financing, the susceptibility of the assets, and those willing to lend against them, to fraud and financial crime and/or the lack of knowledge of what is available and where or how to access those willing to lend.
Supervisors are rightfully concerned on ensuring digital asset markets are safe and sustainable and that the financing options available to investors, notably retail clients looking to pile into these markets, often for fear of missing out, are equally safe and sustainable. This is particularly the case as the cases of, and risks associated with, retail clients using credit leverage or facilities that are not designed to cover these asset classes continues to grow.
As a second, yet perhaps, over the longer term, more pressing priority, comes the fact that there are no uniform standards as of yet in how to document these types of ‘digital asset loans’ or how to adjudicate disputes. A number of law firms are looking to change that and arbitration as well as certain specialist dispute resolution venues are beginning to provide first steps in having jurisdiction and relevant bench strength.
In order to ensure that cryptocurrency and digital assets can become a more established cornerstone of financial markets rather than a risk-generating exotic cousin, market participants and stakeholders will want, to be part of that debate, be it in existing industry associations or new ones, and work with specialist legal and regulatory advisers to help set standards. Given the risks, making margin lending fit for DLT offers the market and supervisors a potential win-win.
The emergence of margin lending to monetise digital asset and cryptocurrency holdings
At present, participants engaged in lending against digital assets and cryptocurrency held by borrowers/investors are mostly specialised lenders. The majority of these are located in the United States and the United Kingdom. In contrast, EU-27 domiciled institutions have only recently begun to enter this emerging market for financing.
Where lending against cryptocurrency and digital assets is taking place, the actual activity may still fall outside the supervisory perimeter for a number of reasons, mostly due to the fact that the lending component or the taking of security, including over digital assets and cryptocurrency (i.e. “fiat to crypto lending”) may not be licensable in a range of jurisdictions.
And those specialist lenders engaging in “crypto to crypto lending” may be outside most of the regulatory perimeter as the digital assets themselves may (currently) not qualify as financial instruments or instruments that require a licence. However, that regulatory uncertainty may also hamper the ability of those willing to lend inasmuch as it may deter those willing to borrow. This is before one gets to the issues around how to custody crypto and digital assets – even if solutions are emerging.
Brexit throws in a further concern for market participants, in particular for those conducting lending activity into the EU-27 both in terms of being able to extend financing from the UK, but also be repaid, once it becomes, viewed through the EU regulatory lens, a ‘third country’ upon the UK’s exit on 29 March 2019.
Where lending is occurring, financing channels have mainly focused on loans being made in fiat currency like GBP, USD, EUR and extended in favour of financial collateral in the form of cryptocurrencies, possibly with some other financial instruments (equities, commodities, funds etc.).
Going forward, lending demand and offer is also moving towards a market of lending one cryptocurrency or digital asset token against another cryptocurrency. This calls for greater volumes of more stable collateralisation and this is where tokenization, tethering and stable margin lending will likely play an important role.
This absence of a stable market for financing and/or monetisation of means that borrowers may be tempted to obtaining financing from traditional lenders and may use non-digital assets, including real economy assets, such as homes as security or draw maximum amounts of unsecured funds so as to invest into digital assets.
In the absence of restrictions of where such borrowed funds flow into, many of those traditional lenders may even be unaware of what they are really financing. That poses a risk propagation channel from the digital economy into the financial sector but also the real economy.
That type of behaviour is not new but rather a component of many crises past. For those firms looking to offer the very financing that is needed and which would improve liquidity, this means getting serious about margin lending, liquidity and effectively tackling tokenisation.
Tokenization and tethering how to strengthen trust in values
Any sustainable supervisory approach to improving the status quo may also need to focus on also improving documentation but equally uniform standards of tokenization. Tokenization, in the broadest sense, is the process of converting rights to actual or future real assets into a token that can be used in a DLT based setting.
Whilst tokenization is welcome and achieves financialisation across less established markets, if done purely for purposes of driving up prices and inflating (repackaged) assets rather than in a prudent manner, it may run more risk than reward for specific investors but equally across a range of exposures. This has led to the establishment of a concept of ‘tethered-tokens’ i.e. tokens that are backed by actual assets and are supposed to be ‘safer’ and thus create instruments that digitise traditional collateral assets.
This prompts some very real interest in terms of how to mobilise collateral assets more efficiently, including across borders, where certain holding chains or interoperability may not exist and the use of DLT, as a bridge to beam say New Zealand uncertificated bonds to stand as security in a North American domiciled financing can work using DLT. Nevertheless, this new technology comes with risks of their own. Even some of the leading ‘tetherers’ have reported that their “Asset-Backed Tokens” have been stolen, and for some this may seem quite unsurprising given the corner out of which this some of this technology has come from.
For policymakers it marks another example of a need to strengthen supervision and thus deliver resilience for markets and participants. Nevertheless, the proposition and the arguments for strong standards for tokenization and tethering to facilitate more efficient collateral asset creation and mobilisation goes hand in hand with the benefits it can bring to market and funding liquidity.
So why has this strengthening not happened as of yet? In the absence of common global, EU and national level interpretations and/or standards, the financial regulatory oversight of FinTech, and thus a host of cryptocurrencies and a host of digital assets remains fragmented to the extent it is even regulated.
So, how could one change the status quo?
Some proponents argue that the existing regulatory ecosystem is not capable of being expanded to capture cryptocurrency, DLT and the range of FinTech activity. Instead, a lex specialis that would operate as a lex systematis (law of the system) ought to be engineered from the ground up to govern DLT assets. This would have the benefit of not upsetting the existing lex specialis and the lex generalis governing non-DLT assets.
However, with the pace of “disruption” at which FinTech and DLT are becoming more prevalent, policymakers may be out of time to reinvent and must instead rather focus on rolling out the existing regulatory perimeter and supervisory tools further and in a workable manner. The EU’s FinTech Action Plan takes a middle ground but does not do much in looking at transaction types and/or how to make existing concepts and cornerstones of say securities financing transactions, including margin lending and the relevant stakeholders and financial market infrastructure providers more fit in terms of DLT based assets.
The fallout of past financial crises prompted regulatory and supervisory action in relation to retail clients being able to mortgage ‘real economy’ property or buy on margin. In the US, American style margin lending is subject to strict ratios. In the EU, conduct of business and transparency obligations have been strengthened as part of implementing global standards.
The pressure is certainly on EU policymakers to finalise a regulatory and supervisory environment for FinTech, cryptocurrency, DLT and ICOs. Some national authorities, notably in smaller and offshore jurisdictions have begun their own work on that. ESMA has issued, like many others, supervisory warnings on ICOs. Those supervisory warnings are gathering pace as the rate of ICO failures or cyber-crime incidents increase. As argued above, not all avenues of change can or should come from supervisors.
In conclusion, if the idea is to reduce risk-propagation in FinTech activity whilst ensuring financing does good as opposed to harm, then supervisory policymakers need to apply and adapt some existing standards and balance pragmatic solutions on how to nurture new developments and entrants. That also means shifting away between the policy focus on drawing borders between what is considered “good” and “bad” FinTech activity but instead ensuring common standards create a safe, sustainable, liquid and sufficiently transparent market and margin lending is likely to play a role in achieving a leading role in that change.
In order to advance change in a sensible manner, policymakers, working together with industry associations, ought to create flexible conduct of business rules that are interoperable with the cornerstones of the existing regulatory perimeter. This requires a proportionate approach as to how much regulation is needed if suitably well-crafted standardised documentation and dispute resolution standards can first help standardise market behaviour, create norms and improve conduct as well as attract greater options in those willing to lend and/or borrow, thus contributing to more sustainable and liquid DLT related markets.
Expanding the scope of say, the EU’s Securities Financing Transaction Regulation (SFTR), without thought to DLT specifics risks falling into the category of overregulation and would be counterproductive.
As an example, the Global Master Securities Lending Agreement created standard practice among a breadth of market participants well prior to the advent of sector specific regulation, irrespective of the perceived need for that regulatory response. As a result, a documentation suite of, industry-led yet policymaker-endorsed, set of master agreements and a pragmatic client reporting framework along with robust dispute resolution standards, crafted by specialist legal and regulatory lawyers would make for a much more sustainable and compelling way of achieving the overarching supervisory goal of safer financing of participants as well as their DLT activity.
Michael Huertas is a partner at Dentons. He is based in Frankfurt and is a member of the firm's Financial Regulation and Funds practice as well as its Banking and Finance practice. His structured finance practice focuses on derivatives, securities financing transactions and securitizations.