How Regtech is shaping the future of crypto compliance
Digital asset regulation
As cryptocurrencies edge closer to mainstream adoption, they face significant regulatory challenges. Initially attractive for their decentralisation and lack of government control, cryptocurrencies require greater structure, organisation, and regulation to fully integrate into the financial ecosystem. Effective regulation is critical to sustaining growth in the digital asset space, balancing innovation with investor protection while encouraging broader participation from retail and institutional investors.
Regtech is poised to play a pivotal role in this transformation, becoming an essential ally in shaping the future of digital assets. Current Regtech systems can adapt to digital asset platforms as regulatory frameworks emerge; however, this will require stakeholder collaboration. On a fundamental level, will full acceptance require potential compromises to the original anonymous and decentralised nature of these assets?
The evolution of digital asset regulation
Whether regulators were too slow to react or dismissive of the growing interest in digital assets, mainly cryptocurrencies, they are well behind the development curve. While the UK and European Union authorities now have several key legislative frameworks, work still needs to be done.
In the UK, there are several acts which now cover digital assets, including:
- Financial Services and Markets Act 2000 (FSMA)
- Economic Crime and Corporate Transparency of 2023
Then we have the Financial Services and Markets Bill, which is currently being debated in Parliament and seeks to establish a comprehensive regulatory framework for stablecoins and other crypto assets.
In the European Union, digital asset regulations include:
- Market in Crypto Regulation (MiCA)
- Anti-Money-Laundering Directive (AMLD5)
The US authorities have a broader regulatory landscape that involves federal and state regulations. Looking at the federal scenario, digital assets are now part of the legislative outreach of:
- The Securities and Exchange Commission
- Commodity Futures Trading Commission
- Financial Crimes Enforcement Network
- Internal Revenue Service
Recently, several financial institutions received authorisation to trade Bitcoin ETFs even though the broader regulations for digital assets have not yet been completed. Does this suggest that the SEC has accepted digital assets as an integral part of the future financial ecosystem?
On a global basis, we have the introduction of the OECD’s:
- Crypto Asset Reporting Framework (CARF) / DAC8
The UK, EU, and SEC have taken an aggressive stance regarding the trading and regulation of digital assets such as cryptocurrencies. Alternatively, if we look towards the East, regulators in Hong Kong and Singapore have taken a different approach, more receptive to digital assets as they look to become global hubs of the future.
Currently, the regulatory scene is a patchwork of rules and guidance with different timescales and approaches to the growing popularity of digital assets.
Key drivers of regulation
Looking forward, there are many prominent and not-so-obvious drivers when it comes to regulations, which include:
- Investor protection
- Financial stability
- Anti-money-laundering
- Counterterrorist financing
- Tax compliance
- Market integrity
- Investor/institutional access
- Technological innovation
- Digital sovereignty
Ironically, many central banks seek to create their own digital currencies while regulators are not as appreciative of their potential. There is no doubt that tighter regulations are on the way, with formal structures and more significant legal burdens sure to fall on digital asset platforms. However, these developments don’t come without their unique challenges.
Regulatory challenges unique to cryptocurrencies
The relatively unique nature of cryptocurrencies has prompted several challenges for regulators. It will be interesting to see how they address these, as this will determine the level of control in the future.
Identifying individuals
Anonymity and pseudonymity are, to a certain extent, ingrained in the culture of digital assets and the trading process. Blockchains work on public ledgers linked to specific wallet addresses rather than particular individuals. This issue has been addressed by insisting that trading platforms and those creating digital wallets request Know Your Customer and Anti-Money Laundering documentation.
Cross-border transactions
It is fair to say that cryptocurrencies transcend national borders, enabling seamless global transactions. As mentioned above, the current patchwork of international regulations makes it difficult, if not impossible, to trace the illicit flow of digital assets. Eventually, this will require coordinated enforcement actions and regulators working together to create a global regulatory structure that protects participants while not overly restricting innovation.
Technological complexity
While cryptocurrencies are currently the primary target for regulators, technological advancements now facilitate the likes of decentralised finance (DeFi), smart contracts and multi-chain ecosystems. Consequently, the next few years will be a steep learning curve for regulators, especially with DeFi, where transactions are undertaken directly between the buyer and the facilitator, cutting out the traditional central third party. Does this make current enforcement mechanisms ineffective?
National and global regulators face fundamental challenges regarding the way digital assets are currently traded. A more structured approach could reduce the appeal for some investors and potentially stifle innovation. In contrast, some investors and institutions won’t be able to consider digital assets without formal structure and protection.
The power of RegTech in transforming crypto oversight
While those trading digital assets may enjoy a degree of anonymity, RegTech can dictate the route to regulation. This will require cooperation between all stakeholders, but when it comes to RegTech, some of the areas to consider include:-
- Blockchain analytics
- Smart contract verification
- Risk intelligence
- Streamlined reporting
- Combining advanced algorithms with human oversight
The ability to detect illegal activity across blockchains or audit smart contracts before deployment is a powerful tool. The key to long-term regulation and a more formal structure is the compliance of trading platforms with global standards.
As we have seen in recent months, regulators and governments worldwide have various tools at their disposal. In the UK, for example, the FCA instructed banks to effectively ban transactions with digital asset platforms. This relatively blunt tool has given the authorities more time to consider their approach to more formal regulation without nullifying the benefits of digital assets.
RegTech solutions in action
Due to the nature of the RegTech industry, it is essential to consider real-life situations when creating tools to monitor trades and apply regulations. We have put together some real-life examples that demonstrate the challenges and results.
Mitigating fraud on NFT marketplaces
Even though cryptocurrencies currently dominate the digital assets scene, it’s important to recognise other tradable assets. Non-Fungible Tokens (NFTs) have increased in popularity in recent years, attracting the interest of both bona fide traders and criminal gangs. RegTech tools can now monitor platform trades and identify potential fraudulent activity (for example, in areas such as fine art) and their origins. These measures enhance transparency and trust, which are critical to any financial market.
Ensuring compliance on decentralised exchanges
The introduction of cutting-edge RegTech solutions now facilitates the monitoring of decentralised exchanges in relation to illegal activity, which is often focused on anti-money-laundering compliance. These tools can analyse blockchain transactions, alerting platforms and regulators to suspicious activity while still being unable to access or identify specific accounts. Maintaining the core principles and the need for regulatory compliance is vital for the integrity and trust in decentralised exchanges.
Cross jurisdiction reporting
The introduction of the OECD’s Crypto Asset Reporting Framework (CARF) is an important stepping stone to global regulations. RegTech tools that can connect with this system benefit from centralised data collection, the chance to map to specific jurisdictions, and the ability to ensure compliance with local laws. A central hub, this framework reduces administration for exchanges and issuers, enabling seamless adherence to evolving global standards.
The future of RegTech in crypto compliance
The ability to regulate and control a digital asset would be challenging in a traditional environment, but removing central third parties makes this activity even more difficult. Looking ahead, there are numerous ways in which RegTech solutions can assist with digital asset compliance, such as:-
- Proactive compliance tools can use predictive analytics to project regulatory shifts in crypto markets.
- Decentralised identity solutions will use blockchain technology to incorporate and streamline KYC processes.
- RegTech companies can bridge the gap between digital assets, trading platforms, and regulators, eventually leading to unified regulations.
- The ongoing integration of AI into RegTech and the broader regulatory framework creates a dynamic element to compliance and monitoring.
It’s important to remember that technological advancements in areas such as digital assets can often be integrated into RegTech and broader compliance. While these are just some of the ways in which RegTech solutions are expected to maintain a proactive role going forward, we are just scratching the surface of AI and ML technologies.
eflow’s crypto compliance solutions
While regulators may have ignored cryptocurrencies in the early days, it is the role (or is that responsibility?) of RegTech solution providers to address the obvious regulatory and compliance issues. Our technology is flexible and can adapt to the diverse and evolving needs of the digital asset industry. This is best reflected in our announcement in June 2024, which saw Frankfurt-based FinTech 21X sign up for our award-winning digital compliance tools.
21X implemented our trade surveillance, best execution and transaction reporting to support its mission to build Europe’s first fully regulated distributed ledger technology (DLT) exchange. The exchange will facilitate security token and crypto asset trading within stringent regulatory controls. As a regulated financial institution, 21X needed to demonstrate the same level of regulatory adherence when developing its cutting-edge exchange.
We work closely with clients to create a personalised RegTech solution which addresses all of their issues while ensuring there is scope for scalability going forward. The fact that we can accommodate what is a relatively complex market - that of digital assets - demonstrates our forward-thinking proactive approach. As the spotlight continues to fall on digital assets, we are well positioned to benefit from the need for regulatory surveillance, assisting with:
- Building trust in digital asset markets
- Operational efficiencies
- Long-term market stability
These regulatory solutions don’t just fall into place; they often take years to plan and test before they are launched to the market.
Conclusion
Digital assets, particularly cryptocurrencies, present numerous challenges for regulators and those operating in this space. While the market has increased exponentially in recent years, there is still limited trust and concerns regarding market stability, which are crucial if it is to go mainstream.
Consequently, we urge crypto firms to embrace our RegTech solution so that they can proactively navigate the evolving regulatory landscape. Due to regulators’ relatively unique challenges with digital assets, our proactive and flexible approach is essential in bridging the gap between trading platforms and regulations.
If you are currently operating a digital asset exchange or plan to incorporate digital assets into your broader offerings, we would welcome the chance to discuss future compliance and regulations. Our forward-thinking approach is paying dividends for our clients, allowing us to provide help and guidance in this complex space.
