VIRTUAL CURRENCIES—IOSCO report sizes up issues, risks surrounding crypto-asset trading platforms - 19 February 2020

Report does not mandate regulatory action, but suggests tools regulators might use in addressing the issues that crypto-assets present.

A new report prepared by the International Organization of Securities Commissions (IOSCO) offers assistance to global regulators that are wrestling with how to handle crypto-assets trading platforms (CTPs) within their existing regulatory frameworks. The report, which includes tools that regulators could consider using, addresses issues such as access to CTPs, safeguarding participant assets, conflicts of interest, operations of CTPs, and price discovery.

To prepare the report, IOSCO issued a consultation paper in May 2019 seeking public feedback based on the regulatory approaches to CTPs that member jurisdictions are currently applying or considering. IOSCO received 28 comment letters, the contents of which are incorporated into the report.

IOSCO believes that many of the issues related to the regulation of CTPs are common to traditional securities trading venues, but may be heightened by the business models used by CTPs. IOSCO said in a news release that when a regulator has determined that a crypto-asset is a security and falls within its remit, the basic principles or objectives of securities regulation should apply. It also acknowledged that the crypto-asset market is rapidly evolving, which is why it opted not to suggest any particular regulatory action or requirement in the report.

For purposes of the report, crypto-assets are defined as a type of private asset that depends primarily on cryptography and distributed ledger or similar technology as part of its perceived or inherent value. A crypto-asset can represent an asset such as a currency, commodity, or security or be a derivative on a commodity or security.

Based on a survey of its members, IOSCO found that the approaches to the regulation of CTPs differ among jurisdictions. Most regulators apply their existing regulatory frameworks to CTPs when the crypto-assets traded qualify as securities or other financial instruments. However, a number of jurisdictions have established a specific framework for CTPs that offer trading of crypto-assets that fall within their regulatory remit, IOSCO found.

Some jurisdictions are creating a new regulatory scheme or adapting their existing one by tailoring requirements and/or exemptions. IOSCO said that some members indicated that the existing regulatory framework does not apply to CTPs, primarily because crypto-assets are not financial instruments as defined in existing rules, while in other jurisdictions, the trading of crypto-assets is banned.

Access to CTPs. IOSCO noted that a key consideration for regulatory authorities is how access is provided to CTPs. If CTPs provide non-intermediated access to investors, another consideration is who is responsible for the on-boarding process and how it is being performed, IOSCO added.

Currently, access criteria differ between CTPs, IOSCO said. Some CTPs restrict trading access to regulated intermediaries, while others provide non-intermediated access to institutions. IOSCO noted that some CTPs provide non-intermediated access to retail investors, which is a novel approach since trading venues that provide non-intermediated access rarely provide access to retail investors.

The report states that if a regulatory authority is considering the issues and risks relating to participant access to CTPs and the on-boarding process, its assessment may include a review of the CTPs’ policies and procedures regarding access criteria, consideration of allowing only intermediated access to CTPs, and a review of the assessments made by CTPs of their participants for "appropriateness" from the perspective of anti-money laundering issues, and product suitability. Regulators also might consider whether CTPs should provide risk disclosure and, if so, assessing the adequacy of such disclosure, IOSCO stated.

Safeguarding participant assets. The report addresses safeguarding of assets, noting that when a CTP holds participant assets, a key consideration for regulators is how the assets are held and safeguarded. This includes consideration of what arrangements are in place in the event of a loss, including a loss due to theft from, or the bankruptcy of, the CTP.

IOSCO found that CTPs currently use three common models of custody for crypto-assets: 1) the CTP offers custody services and may hold crypto-assets in hot or cold storage; 2) custody services are provided by a third party; or 3) participants self-custody their crypto-assets in their own wallets, and control the private keys.

IOSCO said that when the CTP offers custody, the risks that could arise include operational failure; co-mingling of assets; and theft, loss, or inaccessibility of private keys. Additional risks include inaccurate record-keeping and not maintaining sufficient assets to meet liabilities.

Issues for regulators to consider in this area, according to the report, are the types of crypto-assets of which the CTP has custody, who has access to the private keys for all CTP wallets and what back-up arrangement are in place to avoid a single point of access, and what ownership rights and claims an investor has to their assets and how they are evidenced. IOSCO also suggests that regulators consider the lifecycle and audit trail of the movement of funds and crypto-assets between the participant, the CTP, and any third parties and within the CTP, including in whose name the assets are stored, and whether they are stored online or offline.

Conflicts of interest. The IOSCO report indicates that another key consideration for regulators is the extent to which conflicts of interest exist due to the internal structure and organization of a CTP and, if so, how they are managed. IOSCO recommends that regulators do an evaluation of the policies and procedures of a CTP that are established to mitigate and manage the conflicts of interest. When a CTP or related parties or the operator, employees, officers and/or directors of the CTP or its related parties, are permitted to engage in proprietary trading and/or market making on the platform, IOSCO suggests a review of several issues such as the disclosure of relevant trading activities, the separation of market making activities from trading activities or services provided to participants, and the transparency of policies and procedures that address participant priority, the fair pricing of trades with participants, and/or favorable execution of trades with participants.

CTP operations. Due to the prevalence of non-intermediated access to CTPs, IOSCO recommends that regulators consider the extent to which information about how CTPs operate is available to their participants. IOSCO said that a regulator’s assessment of the transparency of CTP operations to participants may include order types and interaction, price discovery, and transparency of orders and trades on the CTP, including trading volumes and turnover, fees charged by the CTP, rules relating to the prevention of market abuse, and the technology used by the CTP.

Price discovery. The report indicates that a key consideration for regulators is how efficient price discovery is supported on CTPs. According to IOSCO, a regulator should consider whether and what pre- and/or post-trade information is made available to participants and/or the public and on what basis, and the overall potential impact of pre- and post-trade transparency on order execution quality for participants and market quality generally. IOSCO also suggests that regulators evaluate the market microstructure of the CTP, as well as the crypto-assets traded, including the liquidity of the crypto-assets and their characteristics.