Digital Asset Regulation Needs to More Strongly Reflect TradFi Standards for Market Structure to Capture Institutional M

Traditional financial institutions are already major contributors to the digital asset ecosystem, injecting liquidity into the economy and offering customers the ability to hold, trade, and in some cases, stake digital assets. The US Securities and Exchange Commission’s approval of a spot Bitcoin ETF will only further bolster the participation of such institutions.

The coming influx of value into digital assets is a further clarion call to regulators to provide clear directions as to how digital asset players can achieve regulatory compliance.

Many jurisdictions around the globe are adopting a regulatory approach to digital assets that mirrors the standards that have been in place for traditional finance (TradFi) for decades. Putting these basic, well-tested protections in place is a big step toward creating safer digital asset markets. However, these regulatory frameworks could benefit from setting clearer expectations regarding custody and market structure; TradFi offers very useful principles in this regard that can be applied to the digital asset industry.

What the digital asset industry should learn from TradFi

In TradFi, the trading value chain has been intentionally parceled out such that the exchange, brokers, clearing house and custodians are all separate parties. This market structure automatically creates a system of checks and balances and removes any single point of failure. The digital asset industry has an interesting nuance in that digital asset exchanges are often vertically integrated and perform most, if not all of the above functions, particularly providing both an exchange for trading and also custody for the traded assets.

Regulators are contemplating whether to replicate aspects of the TradFi market structure for the digital asset industry, but the question is how far do they need to go? In particular, should they require digital asset exchanges to use third-party independent custodians unrelated to the exchange?

Having the custodian separate from the exchange would help prevent cases of fraud and misuse of customer funds, though thus far, no regulator appears to have mandated that digital asset exchanges use third-party independent custodians. In Singapore, proposed rules appear to allow exchanges the option of either providing custody themselves through an operationally independent unit, or using a third-party independent custodian. In Hong Kong, however, licensed digital asset exchanges (“virtual asset trading platforms”) are not allowed to use independent custodians and are instead required to provide their clients custody through a subsidiary company of the exchange.

Whatever the custody arrangement used by exchanges, what is critical is that these nuanced arrangements are clearly disclosed to customers to allow them to make informed decisions. Customers should know how their assets are being held and safeguarded at the exchanges and other trading platforms they use. More risk-averse customers may gravitate towards trading on exchanges and platforms that use independent custodians wholly or at least in part to hold their assets.

“Custody” as absolute, unilateral control of a digital asset wallet

That “custody” should refer to such absolute, unilateral control of a wallet is an important nuance that regulations should take into account. The Malaysian Securities Commission has actually given very useful guidance on this in its Guidelines on Digital Assets, saying that a person is not considered a custodian if they do not have full control over the digital assets, with “full control” defined as the ability to unilaterally transfer them from a wallet.

However, in other countries that regulate digital assets, the rules are not always so clear as to which wallets are considered custodial and should be regulated. Wallet service providers which hold none of the keys or shares of a multisig or MPC wallet, or an insufficient number of them to unilaterally withdraw digital assets from a wallet, are really just providing non-custodial wallets which should not fall within the regulatory perimeter.

End customers should be keenly aware of whether their digital assets are being held in custodial or non-custodial wallets. Should a customer sign up for a non-custodial wallet, they must recognize that they themselves are responsible for the safety and security of their digital assets. Alternatively, they can consider using custodial wallets provided by trusted, reputable and regulated wallet service providers.

What’s next?

The digital assets industry has many similarities to TradFi, so it is possible to apply many of the same time-tested TradFi principles to regulate the digital assets space, yet still factoring in the unique nuances that digital assets present which may require more fine-tuned regulations.

It is in the best interests of the digital asset industry to work proactively and closely with regulators to share knowledge, industry practices and operational challenges. The more regulators understand the underlying nuances of digital assets, the more likely it is that we will arrive at rules for the digital asset industry that offer strong protections to customers yet are risk-proportionate and practicable enough for digital asset firms to comply with.

HB Lim is Managing Director of APAC for BitGo, a digital asset wallet and custody provider.

This article is sourced from the internet: Digital Asset Regulation Needs to More Strongly Reflect TradFi Standards for Market Structure to Capture Institutional Market Share

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