Why traditional finance should finally accept crypto

Introduction

With virtual assets becoming an increasingly desired asset class and service providers more heavily regulated, the environment is ripe for traditional financial (TradFi) service providers to exploit opportunities in this space and at reduced risks.

Financial service providers are heavily regulated. While regulation is necessary to protect customers from scams and bad actors and stop service providers from taking excessive risks with other people’s money, it also plays an important role in ensuring the orderly operation and resilience of a system on which we have come to depend.

Regulation of TradFi has evolved over many years as the industry has grown and adapted. However, it tends to play catch up, and new rules are developed to address the risks that led to previous financial crises or failures.

In 2008, we witnessed a global financial crisis spurred by excessive risk-taking, which led to the collapse of some large institutions, requiring governments to intervene to save banks that were considered “too big to fail”. This highlighted how interconnected the financial world was and its fragile state.

The crisis also incentivised the creation and publication of the Bitcoin whitepaper, the blueprint for an alternative payment system that allowed for peer-to-peer transactions without needing a trusted intermediary.

Ironically, despite being built to disintermediate financial services, Bitcoin and its underlining technology paved the way for a new wave of centralised service providers, virtual asset service providers (VASPs).

Current regulatory environment

During the early years, VASPs operated in a regulatory vacuum. This allowed the industry to develop and grow quickly, but it also created high levels of uncertainty and created opportunities for fraudsters, money launders and other criminal organisations. Dealing in virtual assets was highly risky and led to many users losing significant sums of money.

Drawn by the economic incentive of attracting business to their shores, some countries, like Gibraltar, Bermuda and Malta, created bespoke regulatory regimes for VASPs.

In 2018, the Financial Action Task Force (FATF) broadened its Recommendation 16 and included virtual assets (VAs) and VASPs, meaning that all countries that wanted to continue complying with FATF’s anti-money laundering and counter-terrorism financing (AML/CFT) standards must either register or authorise VASPs and subject them to AML/CFT laws.

More recently, following the collapse of key VASPs in the past few years, countries are now drawing their attention to applying laws aimed at protecting customers. These new regulatory measures are bringing VASPs more in line with TradFi.

There’s no escaping crypto!

Historically, most TradFi firms have stayed clear of virtual assets due to their unregulated nature and the risks they pose. Many policymakers, governments and influential players in finance have opted to bury their heads in the sand in the hope that crypto would implode. But crypto is here to stay and choosing to ignore it is a dangerous approach.

Crypto is becoming increasingly intertwined with TradFi. The approval by the US Securities and Exchange Commission (SEC) of the spot Bitcoin exchange-traded funds (ETFs) early this year is a prime example. The impact it has had on the markets indicates the appetite from non-crypto natives for this relatively new, fast-evolving asset type.  

Indirect risk exposure to virtual assets is becoming inevitable, and any prudent compliance professional in TradFi should invest time in learning about crypto, its risks and how to manage them effectively.

Opportunities

Servicing VASPs

VASPs need access to banks and other financial services. Securing such services is no small feat. Most traditional service providers have chosen not to service the industry, whether driven by a lack of understanding of the risks, a lack of risk appetite at the board level, or, in some cases, a fear of losing their correspondent banking relationships. Although less common, some regulators have banned financial service providers from servicing VASPs.    

However, as VASPs become increasingly regulated, with better-developed and more mature compliance frameworks, the risk of dealing with VASPs is significantly reduced.

This creates opportunities for TradFi to diversify its client base and address the needs of a heavily underserved but growing market. With a better appreciation of the risks virtual assets and VASPs present and the tools available to help manage these risks, TradFi firms can make well-informed decisions on how to capitalise on these opportunities and do it safely.

Becoming VASPs

Opportunities also exist for TradFi to directly provide virtual asset related services such as the exchange, transfer and storage of virtual assets. TradFi is accustomed to operating under heavily regulated conditions. They have the client base and volumes to remain profitable whilst meeting high compliance obligations, creating an advantage and opportunity to enter the market and leverage the trust they have gained within their target markets.  

In some countries, the regulatory frameworks being created for virtual assets favour TradFi, creating notable advantages. In the European Union, under the Markets in Crypto-Assets (MiCA) regulation, certain authorised TradFi firms are only required to notify their regulators that they intend to provide virtual asset services, as opposed to getting authorised. This could result in securing authorisation under the incoming MiCA regime faster, thereby gaining the ability to passport services across the 30 countries that make up the European Economic Area (EEA).

Using blockchain technology to enhance product offerings

One area in which TradFi has always shown meaningful interest is in the potential of virtual asset’s underlying technology. Distributed ledger technology (DLT), an incorruptible record of transactions without the involvement of any third-party financial institution, can improve efficiency and transparency and reduce costs in traditional financial services. The tokenisation of securities and real work assets (RWA) is a huge area of focus and interest, with many firms trying to capitalise on the existing opportunities by transferring these assets to the blockchain. BlackRock, one of the largest investment management firms, has reportedly filed an application with the SEC, which is suspected to be related to the issuance of tokenised RWAs.

Conclusion

Virtual assets and, more broadly, the use of DLT are growing rapidly and will undoubtedly play a significant role in financial services in the future. TradFi firms that fail to act and embrace change will fall behind and miss out on the opportunities this represents.

Not acting is not a viable strategy, as exposure to crypto in one way, shape, or form is now inevitable.

Recent failings and losses incurred have left many in the retail space apprehensive about entering the market and trusting centralised virtual asset service providers, paving the way for TradFi to take advantage.

As VASPs become more regulated, it provides opportunities for TradFi firms accustomed to operating in heavily regulated markets to benefit from economies of scale and expand their product offering to include virtual asset-related services.

Although there are barriers to overcome, many such barriers centre around a lack of understanding. Education at the board level, senior management and for compliance professionals is key for any TradFi firm wishing to safely enter the market and capitalise on the opportunities virtual assets and DLT present.

There’s no time like the present for TradFi players to act, take advantage of the current landscape and enter the market.

XReg Consulting is a public policy and regulatory affairs consultancy specialising in crypto. We help governments formulate sound policy, regulators supervise effectively, public authorities build capacity, and crypto businesses thrive and follow the rules. If you would like to gain further insights into the current opportunities for TradFi and how to capitalise on such opportunities, contact Nicky Gomez at nicky@xreg.consulting.

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