Technology is transforming every aspect of the world, including financial markets. Considering the rapid developments around Financial and Regulatory Technology that span from cloud computing and digital identification, to big data analytics and artificial intelligence, it is not an exaggeration to say that we might be witnessing the beginning of a new revolution in the financial markets.
Distributed Ledger Technologies (DTL) such as Blockchain and their applications are at the forefront of this revolution and they therefore fall under the Cyprus Securities and Exchange Commission’s (CySEC) remit. DLT became widely known because of its application of cryptoassets, which is a challenging area for regulators due to their novelty and the new risks that arise for end investors.
Risks associated with cryptoassets
Bitcoin, the very first project that introduced this underlying technology, was underpinned by a rebellious philosophy of creating an ecosystem independent of central authorities, while fostering decentralisation and disintermediation. This philosophy unavoidably raised eyebrows amongst the regulators’ community, as it is a well-known fact that the orderly functioning of the financial system is a product of regulation and supervision. The cryptoassets’ projects that were developed later onshared a similar philosophy and therefore similar risks.
An analysis by CySEC found that the cryptoassets market was highly volatile and highly unpredictable. Certain cryptoassets experience high levels of intraday volatility and in some cases, high levels of intra-hour or even intra-minute volatility, leading to price gaps. Furthermore, cryptoassets are bearer instruments and when they are used as a form of payment, there is an increased risk of money-laundering and terrorist financing. This is exacerbated by the fact that in contrast to cash transactions, they do not require the physical presence of the person who executes the transaction.
The emergence of Initial Token Offerings and Asset Tokenisation creates additional challenges, as several tokens that were issued appeared to share substantially similar characteristics with financial instruments.
Benefits for the financial markets
Without prejudice to the risks involved, Distributed Ledger Technology per se, is a significant achievement. Creating distributed, immutable and time-stamped records could bring a number of benefits to several sectors. Particularly in the case of the securities markets, DLT could contribute to cost reduction and may create more efficient post-trade processes and enhance reporting and data management.
Initial Token Offerings could provide alternative less complex and costly fundraising opportunities for start-ups and alternative yet riskier investment opportunities for small investors. Asset Tokenisation could enhance the liquidity of certain illiquid assets and make transfer of ownership easier and faster, through the automated execution of contractual terms by means of smart contracts. This could also reduce the involvement of intermediaries and the costs entailed.
In an effort to further explore the risks and benefits of the technological developments and to enhance the regulatory and supervisory treatment of new, innovative financial activities, CySEC launched an Innovation Hub in late 2018.
In the context of its operations, CySEC engaged and consulted with several entities innovating in the financial sector, including in the area of cryptoassets and DLT. The majority of DLT projects reviewed, appeared to be at a premature stage and interested parties did not manage to demonstrate that they were able to scale up the technology in full compliance with the regulatory perimeter we have in place to protect investors.
The work undertaken by the CySEC Innovation Hub underlined the need for further guidance and additional safeguards in the case of cryptoassets that do not fall under the existing regulatory framework.
CySEC is fully committed to exploring the benefits and risks of financial technology in the context of process optimisation, cost reduction and investor protection, and is actively involved in helping materialise recent National and EU initiatives so that we can manage the risks associated with new financial innovation, without stifling the very benefits that they are intended to provide. In this respect, CySEC is currently contemplating the launch of a Regulatory Sandbox.
*Vice-Chairman of the Cyprus Securities and Exchange Commission.