Regulating crypto can be like nailing jello to the ceiling. But while regulation of the emerging cryptocurrency technologies is necessary to protect consumers, it needs to be sufficiently flexible to allow companies to raise capital effectively and financial services business to bring new products to market smoothly, says Jeremy Muir, a partner at MinterEllisonRuddWatts.
It’s a difficult balancing act because those two goals can work against each other. “Things you wish to do to protect consumers might make it harder to bring products to market, which might otherwise be useful,” Muir says. Many jurisdictions, including New Zealand, have begun developing regulation but most are looking to see what happens in the United States, says Lane Neave partner James Cochrane.
In September 2022, the White House published a whole-of-government approach with a framework on what crypto regulation should look like. In particular, US regulators the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission have been asked to address six points: consumer and investor protection; promoting financial stability; countering illicit finance; US leadership in the global financial system and economic competitiveness; financial inclusion; and responsible innovation.
Nothing has yet been mandated and the reality on the ground in the US is regulation by enforcement, not guidance, says Cochrane. The SEC has been publicly targeting high-profile scalps to send messages to the industry. Those scalps include influencer Kim Kardashian, for allegedly breaching securities law with misleading statements and inadequate disclosures. She settled with the SEC.
And there were charges against crypto lender Genesis and crypto exchange Gemini for allegedly offering and selling unregistered securities in relation to Gemini’s Earn product – something similar to a bank term deposit where the depositors receive a return for “staking” their crypto. The SEC has also gone after high-profile crypto players such as Bitcoin and crypto exchange Kraken, which agreed to a US$30 million settlement in relation to its service to retail customers.
According to The New York Times, regulators have for years failed to get to grips with the crypto industry but have faced intense public pressure since the overnight collapse of the FTX crypto exchange in November last year. Once valued at US$32 billion, the company has lost an estimated US$8b of investors’ funds and its founder, Sam Bankman-Fried, has been charged with orchestrating a years-long fraud.
The enforcement measures are often based on the Howey Test, which helps determine whether a transaction qualifies as an investment contract. “All of these, at least as far as crypto markets are concerned, appear calculated to achieve maximum impact,” Cochrane says. Yet other players offering similar services have not been targeted directly. “All guns blazing” isn’t the only way to regulate crypto. The European Union and United Kingdom are taking a more co-operative approach, Cochrane says – one that he would like New Zealand to follow.
The European Parliament has taken an innovation-friendly direction that still includes measures for consumer protection and safeguards against market manipulation and financial crime. Key provisions in the regulation cover transparency, disclosure, authorisation and supervision of transactions for businesses issuing and trading crypto assets. That will ensure consumers are better informed about risks, costs and charges. The framework also regulates public offers of crypto assets and is designed to support market integrity and financial stability. The EU-wide regulation includes measures against money laundering, terrorist financing and other crimes.
Like other countries, the UK wants to rein in reckless business practices, consistent with its approach to traditional finance. Its approach is more technology than the US, says Muir. “The [UK] Law Commission has published papers on how to treat crypto or digital assets as property. Their regulators are trying to come up with a unified approach, encouraging business. That ties in with the wider European approach.”
Closer to home, Australia is a few steps ahead of New Zealand in that it published a roadmap about 18 months ago, Muir says. “That seems to have survived the election.” In early February, the Australian Treasury released a consultation paper on token mapping, which is the process of identifying the key activities and functions of products in the crypto ecosystem and mapping them against existing regulatory frameworks. “It’s quite a technical exercise, seeing what the gaps are in the regulatory system and how they fit,” Muir says.
Like other countries, New Zealand’s lawmakers and regulators are scrambling to find appropriate responses to regulating the crypto industry. There is no silver bullet. The government acknowledges that it needs to do more. The inquiry into crypto currencies by Parliament’s Finance and Expenditure Select Committee has been considering a range of questions since 2021 and is due to present its findings shortly.
Crypto is not by any means unregulated here. As with other countries, New Zealand already has laws designed for traditional finance, consumer protection and taxes which crypto businesses need to comply with. “While crypto might not be legal tender, or physical currency, there is comprehensive regulation,” Cochrane says. For example, the Financial Markets Conduct Act, the Anti-Money Laundering and Countering Financing of Terrorism Act 2009 and the Financial Service Providers (Registration and Dispute Resolution) Act 2008 all apply to initial coin offerings (ICOs).
Anyone offering financial advice to consumers must comply with FSLAA (the Financial Services Legislation Amendment Act) and CoFI (the Financial Markets (Conduct of Institutions) Act). From March 15, they will also need to be fully licensed by the Financial Markets Authority. Those who profit from crypto businesses or investing fall under the Income Tax Act 2007; and the Goods and Services Tax Act 1985.
Consumers have protection under the Fair Trading Act 1986 and the Credit Contracts and Consumer Finance Act 2003 (the CCCFA). Other relevant laws include the Crimes Act 1961, Companies Act 1993, Overseas Investment Act 2005 and Trusts Act 2019. Muir, along with Alexandra Sims of the University of Auckland, is a special advisor to the parliamentary inquiry and filed a report towards the end of last year for the committee to consider.
They would like to see New Zealand become a fast-follower in regulation, rather than trying to lead the world with a complicated and bespoke regime for a diverse series of technologies at a very early stage of their development. “We think New Zealand should be agile and flexible [in its regulation of crypto],” Muir says. “Both of us are quite deeply involved in the community, know a lot of the New Zealand players and understand some of the benefits of the industry to New Zealand as well as some of the risks.”
The report itself is still confidential, Muir says. “Broadly speaking, we take the approach that New Zealand should take a technologically neutral approach to regulation, which both encourages, and does not put unnecessary barriers in the way of, people doing interesting things with the technology. Equally, [it] gives the regulators the tools to look after consumers.”
Muir and Sims would like to see relevant parties working together to understand developments in crypto as they emerge. “We have also made a few specific recommendations around legal tweaks.” It’s up to Parliament to decide how the recommendations are enacted.
Legislative change is a question that Cochrane has been weighing up. He says the more he considers regulation in New Zealand, the more he likes the idea of one omnibus, specific crypto Act that market participants, businesses and individuals alike can refer to, supported by comprehensive guidance from regulators. “Even if the crypto Act specified where and how other Acts apply – e.g., Fair Trading Act, Financial Markets Conduct Act – that would be good.”
Replacing a hotchpotch of various rules with a one-stop-shop would make it simpler for all market participants because they have to look in only one place, he says. “I think this would really benefit the SME market which New Zealand commerce is based on. The greater clarity would hopefully encourage investment in tech innovation businesses.
Likewise, if there are known adverse consequences for misleading market participants, this protects consumers and reduces market fragility. “If regulation is too harsh or unclear, it drives entrepreneurship offshore to more welcoming jurisdictions and all the jobs and tax revenue that brings, and investment, from institutional and retail customers alike. Either because they are less regulated and compliance cost is less or the law is certain so risks can be better managed and priced. If regulation is too light, it welcomes bad actors and increases risk for investors.
Cochrane would like to see regulators engaging more with market participants to give them guidance, rather than threaten them with a big stick. “The penalties that the Financial Markets Conduct Act can levy on you [for non-compliance] are massive. That’s some of the big challenges that clients face. “Many of them aren’t institutional. Not everyone is a Kiwibank and can afford to go through all the hurdles that might be involved in [launching], for example, a managed investment scheme.”
“They’re SME-sized companies. It’s just cost prohibitive for them to spend enormous amounts on accountants and lawyers to navigate the financial markets laws.” They need help managing the complexity of securities laws, he says. “Regulators and politicians that embrace education, understanding and a willingness to work collaboratively with market participants are essential.”
New Zealand has a steadily growing number of crypto start-ups and even a web-focused venture capital fund. One of the better-known names is Easy Crypto, a New Zealand-based exchange founded in 2018 by siblings Janine and Alan Grainger.
Janine Grainger travels the world attending conferences and has kept abreast of regulatory developments. She worries, however, that the FTX debacle and other scams and failures will push governments to take a draconian approach to regulation and stymy innovation.
“FTX was straight-out fraud. Very similar to Bernie Madoff’s fraud,” she says. “It wasn’t a failure of the existing regulation being applied. [FTX] was licensed in multiple jurisdictions. They were probably one of the most licensed crypto companies out there at that time. It ticked all the regulatory boxes.”
There is work to be done, however, to rein in some elements of the industry. She cites the work the Financial Stability Board [FSB], an international body that monitors and makes recommendations about the global financial system, is doing. It released a framework for the international regulation of crypto-asset activities in October 2022.
The FSB noted that the turmoil in crypto markets last year highlighted several structural vulnerabilities in those markets and exposed inappropriate business models, significant liquidity and maturity mismatches, the extensive use of leverage and other vulnerabilities that were amplified by a lack of transparency and disclosures, flawed governance, inadequate consumer and investor protections, and weaknesses in risk management.
The FSB is also considering prudential regulation such as better checks on directors and ensuring companies are audited. That’s the area where regulation is possibly too light internationally, Grainger says. “The failure of FTX could have been prevented potentially with better checks.”
But Grainger is concerned that the FSB’s approach of “same activity, same risk, same regulation” is not appropriate for crypto assets. “We need a little bit more nuanced than that. ‘Same risk, same regulation’ risks shutting down innovation and stopping these new financial systems from evolving and becoming better than the old ones, where you force them to look exactly like the old ones.”
One of Grainger’s issues with heavy regulation is that good players will comply with regulation, opening opportunities for bad actors to go about their business. “That’s where, at an international level, there’s a lot of opportunity for a joined-up approach,” she says.
Getting the balance right will be very beneficial. “That whole pace of the digitisation of financial products and services is speeding up. It definitely opens up new opportunities and lets us do things differently.” ■