FSCA DRAFT DECLARATION – Passing the Regulatory Buck to Crypto Exchanges
As cryptocurrency fever rages across mainstream headlines the world over, retail investors are looking to the asset class for a promise of quick returns. The South African consumer base has been warned by the Financial Sector Conduct Authority (‘FSCA’) to refrain from parting with their money, and scandals such as Mirror Trading International are used as cautionary tales. One cannot go far in this space without hearing stories about early adopters becoming overnight millionaires, their stories are no doubt inspiring and unacquainted new entrants become easy targets for online scammers.
As South African crypto enthusiasts and industry participants anxiously await the release of the FSCA’s final declaration, Global regulators are burning through countless pages of lawmaking to legislate an idea captured within 8-pages of a whitepaper written by Bitcoin’s anonymous founder, a mysterious cryptographer using the pseudonym Satoshi Nakamoto. Since the release of Nakamoto’s whitepaper in 2008, the industry has evolved ten-fold and Bitcoin is now accompanied by a cacophony of new technologies spanning from Stable-coins to Decentralised Finance (‘DeFi’) Protocols which allow for crypto-based loans, insurance and interest-bearing products, to name but a few.
While the FSCA suggests that it is regulating the industry to protect consumers, we must question whether this goal can be achieved within the framework of existing legislation. Furthermore, are these protection mechanisms enforced to the detriment of local crypto entrepreneurs and market participants?
Lastly, if the FSCA is looking to protect consumers, are there remedies within the FAIS Act to recover lost funds? If not, how will the Regulator be amending the powers and jurisdiction of the FAIS Ombudsmen to adjudicate upon civil claims against licensed participants? These are some of the practical questions which will need to be addressed in the FSCA’s final Declaration.
The FSCA has looked to protect consumers by regulating the entry points which includes crypto exchanges and wallet providers. The draft Declaration published on 20 November 2020 marks the FSCA’s first attempt at regulating the industry in a meaningful way. Industry participants will face increased costs as global authorities such as the Financial Action Task Force (‘FATF’) begin to impose increasing compliance recommendations to the G20, of which South Africa is a signatory. The FATF recommendations underpin the approach taken by the 2020 Intergovernmental Fintech Working Group (‘IFWG’) Position Paper.
The FSCA concedes in their 20 November 2020 Declaration that the draft serves as an interim solution to address some of the immediate consumer risks, and rather than having cryptocurrency designated as a financial service in terms of the Financial Services Regulation Act, a decision was taken to expeditiously define it within the auspicious of the Financial Advisory and Intermediary Services Act (‘FAIS’). This action is in line with FATF recommendation 15. Recommendation 15 states that member countries should mitigate risks emerging from cryptocurrencies and cryptocurrency providers by ensuring that providers are regulated for AML purposes, licensed or registered.
Interestingly, the FSCA states that the proposed Declaration is intentionally limited in scope as to only capture advice and intermediary services in respect of crypto assets. The intention behind the Declaration is to immediately capture intermediaries that advise on or sell crypto assets to consumers so as to provide adequate protection for consumers that are advised to purchase these products. The first licensing requirements will no doubt lay the foundation for the FSCA to gather data on the crypto asset environment to consider whether there is a need for further regulatory interventions.
Practically, the Regulator would need to appreciate that the intermediaries which will need to be licensed will largely be comprised of Centralised Exchanges. Thus, they play a critical role in the proposed implementation of consumer protection mechanisms. These exchanges have a single known point of control where client funds are held in a custodial manner through a combination of hot and cold storage wallets. This differs from Decentralised Exchanges where clients connect to trading protocols directly through their self-hosted wallets.
The current proposed efforts to collate information in accordance with the Financial Intelligence Centre Act (‘FICA’) will become a redundant and costly exercise where intermediaries will be expected to gather and store client FICA details, client trading data and transactional records. Thus, licensed intermediaries will be tasked with a burdensome administrative task which ought to be done by the Regulator. As a simple thought experiment, what would happen if centralised exchanges elected to close their businesses due to increased compliance costs? One might think that the industry would cease to exist, however thanks to decentralised exchanges, this will not be the case. The next question becomes who will then be responsible for collating the required repository of data? The government will not be equipped to take on this role if cryptocurrency intermediaries no longer find it viable to do business in South Africa.
The move to decentralised exchanges is already underway as meme culture protocols such as UniSwap and 1inchExchange are already responsible for trading volumes in excess of $ 20 billion a day.
Ironically, the repository of required data already exists on the block-chain. Every transaction between hosted and self-hosted wallets are mathematically encrypted in the innovated distributed ledger underpinning each Crypto Asset. However, meeting the Know-Your-Client ‘KYC’ regulatory prescripts will prove challenging as wallet holders in the decentralised are largely anonymous. The United States Financial Enforcement Crime Network (‘FinCen’) have already identified this problem and have released a rule-making proposal that places identification requirements and amount restrictions for transactions involving self-hosted crypto wallets.
Global regulators are certainly empowered to enact legislation to govern self-hosted wallets, however enforcement mechanisms become ill-suited when any person is able to create a thousand self-hosted wallets in less than 10 seconds without the need of an internet connection. CEOs of the world’s largest exchanges have already criticised the rule claiming that it would throttle innovation and place onerous requirements on their business.
Decentralised distributed ledger technology will go down as one of the most innovative endeavours of the modern information age. An ideological battle between cryptocurrency fanatics and traditional finance is brewing and regulatory authorities are encouraged to catch up. Comments on the FSCA’s draft declaration are due on 28 January 2021 and market stakeholders are asked to voice their views and concerns during this consultative process.