CAI0058

Written evidence submitted Bitso

This brief Call for Evidence is provided as reference information only for UK Parliament exclusively use, reflects information available as of the date hereof or as of such other date indicated herein and is subject to change. None of Bitso, subsidiaries, affiliates, employees and/or contractors (i) makes (or shall be deemed to have made) any representation, warranty or guarantee as to the accuracy, completeness, utility or relevance of any information contained herein; (ii) has (or shall be deemed to have) any obligation to update any information contained herein; or (iii) shall be responsible or liable (or be deemed to be responsible or liable) for any kind of accuracy, utility, completeness or relevance of, or any interpretations of or conclusions drawn from, any information contained herein. Accordingly, any person or entity (i) shall assume full responsibility for the use of any information contained herein; and (ii) shall not be entitled to rely, and shall be deemed not to have relied, on any information contained herein.

Table of Contents

First Question - Impacts of Crypto-Assets on Social Inclusion

Second Question - Regulatory Benchmarking

Third Question - Benefits of Regulation

Summary of Conclusion. Social inclusion shall be the main driver to foster the regulation of crypto-assets. As the biggest fintech in Latin America, by being the main crypto player, with more than 5 million users, Bitso's experience has shown that crypto-powered solutions can enable efficient, faster, and cost efficient cross-border payments than traditional processes and provide other types of financial services. Regarding regulatory models, crypto legislation can adopt two approaches: authorization and licensing. We demonstrate that an equilibrium between the two models should be prioritised because it would ensure the compliance with anti-money laundering rules, market integrity and a safe and sound financial environment at the same time guaranteeing the flexibility to enable products that foster technological development through crypto and blockchain. Lastly, we emphasise the importance of regulation to enhance consumer protection and education.

First Question - Impacts of Crypto-Assets on Social Inclusion

1. What impact could the use of crypto-assets have on social inclusion?

Summary of the First Question

According to Bitso’s experience, the use-cases of crypto technology to bridge Latam’s financial inclusion gap may serve as a good benchmark by the UK Parliament. Crypto could leverage on the mobile-first landscape of Latam to foster several functionalities, including payments, remittances and other financial products. In addition, crypto-assets can enhance the efficiency of regular banking products, such as lending. Not only through decentralised finance (DeFi) mechanisms, but also using crypto as collateral for credit services. 

1.1.Banking the unbanked

Crypto-assets are not only assets that have a value proposition but also payment systems on themselves that allow quick transactions. They offer several advantages over traditional forms of money, such as instant global reach and decreased reliance on intermediaries. This has led to increased interest in the use of digital currencies in developing countries that are often home to large unbanked populations. Developing countries in Latin America have seen significant growth in the number of digital wallet users and a growing number of small businesses have begun accepting digital currencies as payment. This has fueled significant discussion about the potential benefits of using digital currencies as a way to increase financial inclusion in these communities[1]

During 2021, cash accounted for 36% of all transactions in Latin America[2]. Crypto-assets offer an alternative to cash payments that may be more reliable than paper money because of the possibility of indefinite storage and transmission across the globe without loss. This makes them ideal for use in areas of the world where access to traditional financial services is limited or unreliable.

Crypto-assets can be used for peer-to-peer transactions without the need for a third-party intermediary. This reduces the number of transactions, including costs of transferring funds, but also increases the security of transactions. Hence, transaction fees for digital cross borders transactions are much lower compared to conventional wire transfers. This makes it easier to send smaller amounts of money across long distances and reduce the costs of maintaining a bank account. For example, in the case of United States - Mexico remittances the fees are lowered by more than fifty percent and are three times faster when done through Bitso,.

The flexibility granted by crypto-assets allows for the offer of novel financial products such as savings in crypto, the access to other stable fiat currencies or crypto as a hedge against rampant inflation in countries such as Argentina or Venezuela or crypto backed mortgages.

Therefore, crypto can provide cheaper and faster alternatives, opening a new door to the banking system rigidity and reticence to cater for small accounts and transactions. It fosters cheap and easy access to new financial services and products that can improve the financial status and day to day lives of financially marginalised persons by letting them integrate the formal economy and save or access much needed credit. Crypto-assets and the technologies they entail avoid the need for brick and mortar banks, unnecessary requisites and large bureaucracies, making them more accessible to the unbanked or underbanked.

1.2. Making crypto useful: from financial speculation to financial infrastructure providers.

Crypto-assets are generally considered speculative investments, with the potential for huge returns. However, their use as a financial tool can go beyond speculation or investment. The most important value proposition that crypto has to offer for financial inclusion lies in the use of the technology to rethink and improve traditional financial services or products. People at large do not know how crypto works and are not interested in knowing. However, crypto can be used as the basic infrastructure to construct a frictionless payments system and new financial products. We must think of crypto as the natural back end of digital financial services.

The success of crypto as a tool for financial inclusion will be measured by the tangible benefits it can provide for low income or marginalised people by reducing fees and how well it integrates with the traditional financial system to reduce transaction costs.

Smartphone connections in Latin America reached 500 million at the beginning of 2022, an adoption rate of 74%. The next four years will see almost 100 million additional connections in the region, taking adoption above 80% (see more information here). The use of smartphones and digital financial services based on crypto architecture and infrastructure could be the fastest way for Latam to have a financial leapfrog and integrate the whole population.

The rapid growth of the Latin American markets demonstrates that virtual currencies have the potential to make a substantial contribution to economic growth in developing countries if they are adopted by a broader base of consumers and become more widely accepted not only as a store of value or means of payment but as a technological proposal that can rehaul the traditional financial system and make it accessible to everyone by just clicking an app that can be rapidly downloaded.

1.3. Conclusion

The benefits of a crypto backed economy for the inclusion of low income or marginalised persons are clear. Crypto-assets provide faster and reliable products that can be a tool to promote financial inclusion and enable banking the population, especially in a mobile-first continent. This calls for clear regulation that allows for financial innovation and fosters mass adoption of crypto networks by enhancing the access of crypto alternatives.

Crypto-assets can increase the efficiency of existing banking products, such as lending. As a store of value, crypto can be used as a collateral for innovative credit products, which is desirable in a banking environment generally controlled by few financial institutions.  In short, crypto-assets can also help the traditional financial industry to provide better services.

Second Question - Regulatory Benchmarking

2. How are Governments and regulators in other countries approaching crypto-assets, and what lessons can the UK learn from overseas?

Summary of the Second Question

Although many jurisdictions have enacted comprehensive crypto regulations, some of them share common characteristics. In general, there are four models of financial regulation: institutional, functional, integrated or "twin peaks", but it seems that the functional approach has become prominent in the crypto landscape. The objective of this question is to explore two approaches towards crypto regulation (namely, authorization and licensing) and examples of jurisdictions that have adopted each one of them. The conclusion is that a middle ground between the two approaches are desirable, ensuring the compliance with the AML/CFT rules, prudential legislation (e.g., segregation of funds) and entry requirements, but guaranteeing that the regulated company has the flexibility to launch new products without the need to request additional authorizations. This approach can be described as ‘flexible licensing’.

2.1. Authorization Model

The authorization model aims to leverage the flexibility of the technology to provide better services to the clients. The objective is not to regulate the way to provide Distributed Ledger Technology ("DLT") or how this technology should be (e.g., technological agnostic), but to ensure that certain Anti-Money Laundering/Combating the Financing of Terrorism ("AML/CFT") rules are met. According to this approach, at the same time crypto-asset service providers (“CASP”) are the gatekeepers between the traditional and crypto finance, the regulators should not impose many requirements on how to provide these services, except for the AML/CFT obligations.

Generally, regulations where this approach are being considered or in place are heavily aligned with the Financial Action Task Force ("FATF") guidelines, but instead of having a robust and comprehensive type of licensing process, the authority just want to ensure that all mesures to prevent money laundering and terrorism financing are in place. As the CASPs are gateways to crypto products, they become the main ally for the regulators by screening and monitoring their clients that want to interact with crypto. In general, this model can be characterised as a form of authorization and registration with a regulator, which will focus on monitoring and ensure the right application of AML/CFT rules.

As for the activities in which the entity is able to render, there are no explicit limitations, which does not mean that the authority cannot notify or request for more information regarding the activities performed by the CASP. In this framework, as long as CASP is in compliance with the AML/CFT rules and with the general regulations of the country (e.g., general consumer protection law), they are able to serve individuals and companies freely.

Portugal is a good example where this approach is currently in force. The Aviso do Banco de Portugal nº 3/2021 establishes the rules to register entities that will provide services with virtual assets, but it has not enacted laws defining the legal nature of virtual assets. The Central Bank of Portugal states that the registration obligation is for AML/CFT purposes only, which is aligned to the rationale above-mentioned. Despite Law No 83/2017 states that activities related to virtual assets include exchange between virtual assets with fiat money, exchange between virtual assets, transfer of virtual assets and custody - there are no specific requirements related to entry requirements, governance rules, prudential requirements, and resolution methods for CASPs.

In addition, note that Ireland also falls into the same category. Although it doesn't have a specific crypto regulation, it does have a set of rules created for the registration of VASPs, definition of virtual assets and AML/CFT rules (for a summary, see here). Even if the Central Bank of Ireland requires the proper registrations of VASPs with the authority, it is more focused on ensuring the implementation of AML/CFT procedures than governance, corporate capital, and legal structure requirements.

Therefore, while authorization does not mean absence of entry requirements, they are indeed highly focused on AML/CFT requirements, positioning the CASP as an anti-money laundering gatekeeper between traditional finance and the crypto industry.

2.2. Licensing Model

              Besides the AML/CFT rules, the licensing model takes into consideration a variety of forms similar to bank and capital markets regulation, especially four in particular: entry requirements, governance rules, prudential requirements, and resolution methods. More specifically, these requirements also include a comprehensive business plan, making sure that the CASP, once it has received the licence, doesn't expand its services beyond what the business plan has addressed, which could result in a limitation of the technological development provided by crypto services and blockchain.

              Entry requirements relate to the structural features of entities at the time that they apply for a licence, meaning they have to demonstrate that they have appropriate personnel in charge, and that they are 'proper and fit' for the functions that they perform. In a nutshell, the entry requirements aim to analyse if the directors are qualified for the functions that they perform and to have training and experience.

              Prudential rules are related to the obligation of holding adequate levels of capital and liquidity. Usually, by monitoring the loans and activities of the regulated entity, there are different capital requirements. For a similar reason, these types of regulations generally rely on a special 'resolution' procedure to minimise the cost of the possible failures of the regulated entity, trying to avoid the bail-out alternative.

Lastly, the licensing model usually imposes governance rules, which focus on processes (and structures) that are fit for the entity, such as operating systems, effective screening and monitoring and a well structured risk management team.

One of the main examples of the licensing model is Bahrain, which establishes that applicants for a licence must submit a duly completed application, that includes (i) in-depth information regarding the corporate control structure of the entity, (ii) a comprehensive business plan, (iii) documentation of the board of the company, (iv) letter of non-objection and copies of the audited financial statements of the holding, if the applicant is part of a economic group, (v) memorandum and article of association, (vi) minimum corporate capital, and, also, the authority may impose, at its discretion, additional capital.

In accordance with Article L. 54-10-3 of the French Monetary and Financial Code, France has also imposed high standards for CASPs. The licencing requirements includes, but is not limited to: (i) a detailed description of activities to have a exact knowledge of the business model carried out by the applicant, (ii) a list and nature of the digital assets and other assets on which the activities are based, (iii) the geographical distributions of its activities, specifying the nature of the customer base and the number of clients per geographical area, (iv) diagram of flows, (v) identity of senior manager, (vi) information relating to the good repute of the senior manager (eg, criminal record for the chairman), (vii) information relating to knowledge and skills of the senior manager, (viii) shareholders' information, such as identification, criminal records and other declarations.

2.3. Final remarks: towards a 'flexible licencing'

As demonstrated, the licensing model may impose a heavy regulatory burden not only on the CASPs, but also on the technological experimentation and development. As the industry is still growing it is desirable that additional products and services are easily introduced in the market. Nonetheless,  it is also important to protect and maintain a safe and sound financial environment, that is why some elements of the licensing model may be useful towards such goals.

One of the crucial elements in the crypto environment is the capability of enhancing the efficiency of many products and services available in the traditional market by adding crypto to it, not to mention the several use cases of blockchain beyond the financial space. In a nutshell, the crypto industry has shown that virtual assets are not only speculative assets, being used not only as payment but also collateral in lending products. Therefore, it is extremely important that no regulation blocks or creates limitations for technological development, which does not mean that the industry should not have prudential rules.

In conclusion, we believe that a middle ground between the authorization and the licensing model is feasible and desirable. In this approach, the applicant would have to comply with the AML/CFT rules, some entry requirements and minimum corporate capital. In addition, the regulation would ideally establish a non-exhaustive list of activities in which the CASP would be able to render, ensuring a perfect balance between flexibility to develop and deploy new products in the crypto space with the AML/CFT and prudential mechanisms in place.

***

Third Question - Benefits of Regulation

3. Could regulation benefit crypto-asset start-ups by improving consumer trust and resilience?

Summary of the Third Question

CASP start-ups that operate within a bespoke comprehensive regulatory framework can benefit from enhanced consumer trust and resilience as they set themselves apart from those start-ups or more established companies in the crypto-asset industry that are unregulated or have obtained registrations for AML/CFT supervision purposes only. However, there are many types of consumers with varying levels of knowledge of and experience in relation to crypto-assets and increased consumer trust and resilience can only be achieved if consumers are able to understand the benefits of using a regulated CASP. Therefore, implementation of a regulatory framework alone is not sufficient. Education of consumers is a key element that should not be overlooked as it could undermine the potential success of a well structured regulatory framework.

3.1. Definitions

Firstly, ‘regulation’ can take many forms. A regulatory framework can be robust or light-touch, it can be principle-based or prescriptive, it can entail a comprehensive analysis of a company’s internal systems, controls and operations by the relevant regulator or it can focus on one element of the company’s operations, it can entail frequent monitoring of the company’s operations by the supervisory authority or voluntary notifications by the company to the supervisory authority on an infrequent basis. A regulatory framework could be a combination of any of these approaches. Therefore, it should be acknowledged that in answering this question the type of regulatory framework developed to regulate CASP start-ups will have an important impact on whether being ‘regulated’ improves consumer trust and resilience in relation to CASP start-ups. For the purpose of the response to this question, we have assumed that the UK will be developing a comprehensive regulatory framework for CASPs that regulates many elements of a CASPs’ operations, such as the ‘flexible licensing’ model discussed earlier in this document.

Secondly, the term ‘start-up’ is defined in the Oxford Dictionary as “a company that is just beginning to operate”. The definition is simple however, crypto-asset start-ups can be created by a range of persons with different expertise, experience and financial backing, from one individual that has experience in developing crypto-asset related products or services (i.e. a developer) to established global financial services institutions that have developed and operated traditional financial products and services but wish to expand their offering to crypto-assets. Therefore, it should be acknowledged that not all start-ups are created equal and this will also impact whether being ‘regulated’ improves consumer trust and resilience in relation to CASP start-ups.

Thirdly, the term ‘consumer’ is defined in the Oxford Dictionary as “a person who buys goods or uses services”. Both the term ‘consumer’ and its definition are broad and it is therefore important to acknowledge that there are many types of consumers with differing levels of knowledge, experience and financing, and varying expectations and aspirations. It is important to consider the various types of consumers as the importance and the impact of a CASP start-up being regulated may differ for each type of consumer.

              If we consider who a consumer could be, we must first acknowledge that a ‘person’ who buys goods or uses services can either be an individual or a legal entity. If we focus on individuals in the first instance, it is difficult to categorise individuals without conducting a comprehensive survey as they have differing levels of knowledge, experience, financial stability, expectations and aspirations. However, for the purposes of providing a response to this question to stimulate further discussion, we will categorise individuals into three high-level categories to demonstrate how the answer to this question may change depending on the perspective of an individual:

●        Experienced Crypto User: an individual who has a good understanding of the underlying technology and has experienced trading crypto-assets and/or using crypto-asset products and services, including interacting directly with decentralised finance (“DeFi”), including decentralised applications (“dApps”).

●        Competent Crypto User: an individual who has some understanding of the underlying technology and occasionally buys and sells crypto-assets and/or uses crypto-asset products and services. This individual would have only interacted with crypto-assets through a CASP, they would never have interacted with DeFi protocols or dApps. 

●        Novice Crypto User: an individual who has no experience in buying and selling crypto-assets or using crypto-asset products and services. They may have heard of crypto-assets and certain CASPs but would never have interacted with any.

Institutions can also be categorised into two high-level categories: (i) Financial Services Institution – a company that is regulated and has experience in operating within a regulated framework for traditional financial services, (ii) Non-Financial Services Entity – a company that is not regulated under a financial services regulatory framework such as retail shops, traders of goods and service providers.

3.2. Analysis

For much of the last decade the crypto-asset industry has been seen as a scam or only used to carry on or fund illicit activities. This view is still shared among many traditional media outlets, commentators and financial experts. The discussion, development and introduction of bespoke crypto-asset regulatory frameworks legitimises the industry and the efforts of those individuals and companies working to develop, offer and provide products, services and solutions based on DLT. Crypto-asset regulation demonstrates that legislators recognise the growing prevalence of products, services and solutions being developed on DLT and the potential impact it can have on the future of the economy and peoples’ lives. It is also an acknowledgement as to the risks associated with such products, services and solutions, not only for the financial system but also for consumers. However, the fact that many jurisdictions are seeking to regulate the DLT industry rather than simply ban it shows that the risks associated with the industry do not outweigh the potential benefits. This recognition is key in order for the industry to continue to grow and also to demonstrate to consumers that they can trust the offerings of companies, including start-ups, utilising this technology and the resilience of the technology itself. The key for consumers is to recognise which companies in the industry they can trust.

With that in mind, we must acknowledge that regulation differs from jurisdiction to jurisdiction and many jurisdictions have not yet developed regulatory frameworks specifically for crypto-asset businesses and of those that have, many focus solely on compliance with AML/CFT legislation. Furthermore, there are few bespoke regulatory frameworks for CASPs that are more than just light-touch regulation and involve the supervisory authority carrying out a comprehensive analysis of a company’s internal systems, controls and operations.

Therefore, start-ups that are regulated under a bespoke comprehensive crypto-asset regulatory frameworks set themselves apart from those start-ups or more established companies in the crypto-asset industry that are not regulated and those that have obtained registrations for AML/CFT supervision purposes only, as we have seen in a number of EU Member States in recent months. Therefore, consumers may take more confidence and thereby trust a start-up more if the consumer is aware that the start-up has successfully completed a thorough application process with a respected supervisory authority before being allowed to provide products and services to consumers. However, whether a consumer will be aware of and understand the differences between a company that is regulated under a comprehensive regulatory framework, a company that has registered with a supervisory authority for AML/CFT purposes and a company that is unregulated may depend on the type of consumer in question:

●                    Experienced Crypto Users are likely to understand the differences between various forms of regulatory oversight however, they have the knowledge and experience to interact directly with DeFi and will therefore prefer to interact directly with dApps rather than use an intermediary such as a CASP. A CASP may provide Experienced Crypto Users with added comfort if they were to use CeFi, however they are likely to bypass or actively avoid CASPs, trusting DeFi (i.e. the code) rather than intermediaries which, as we have seen recently, can be vulnerable if they do not have good risk management practices.

●                    Competent Crypto Users are also likely to understand the differences between various forms of regulatory oversight and are more likely to use a CASP than an Experienced Crypto User. Perhaps they have the knowledge to use DeFi but prefer to use CASPs in order to trade and use the available crypto services and products as they do not want the responsibility of using un-hosted wallets and safeguarding private keys and seed phrases.

●                    Novice Crypto Users are unlikely to understand the differences between various forms of regulatory oversight but are most likely to use a CASP. The majority of people will fall into this category[3].

●                    Financial Services Institutions will understand the differences between various forms of regulatory oversight as they operate within highly-regulated environments. It is likely that Financial Services Institutions will only use CASPs that operate within a comprehensive regulatory framework, as they are monitored by supervisory authorities and have to be selective with the third parties that they use.

●                    Non-Financial Services Entity may, depending on the type of business in question, understand the differences between various forms of regulatory oversight however, they are less likely to understand the differences in comparison to Financial Services Institutions.

The above distinction is important because financial services regulatory frameworks are developed to protect consumers, particularly those persons that are less likely to have in-depth knowledge of and experience in using the products and services that are being regulated. It follows that the target of the UK crypto-asset regulatory framework is likely to be Novice Crypto Users and Non-Financial Services Entities which will consist of the majority of the persons trying to access crypto-asset products and services through CASPs. Yet the persons in these two broad consumer categories are the least likely to understand the differences between various forms of regulatory oversight.

So while such persons should take most comfort in using regulated start-up CASPs that operate at high standards to ensure consumer protection, the risk is that due to the number of CASPs that a person can currently choose from such persons may easily open an account with a CASP that is either unregulated or is subject to light-touch regulation and does not afford its users the same levels of protection as a regulated CASP. 

3.3. Final remarks: consumer protection and education are key elements

Therefore, not only is it important to create a robust regulatory framework that is effective in ensuring that CASPs are properly managed, have sufficient resources, have the necessary systems and controls internally to support their operations, safeguard consumers funds and ultimately protect the interests of consumers that use the products and services of these companies, but also to educate consumers in tandem. Without education, many consumers may not be sufficiently empowered and informed to make a distinction between those CASPs that are unregulated, registered or regulated and what this means for the products and services that they want to use.

To conclude, regulation can benefit CASP start-ups by improving consumer trust and resilience but the implementation of a regulatory framework alone is not sufficient. Education of consumers is a key element that should not be overlooked as it could undermine the potential success of a well-structured regulatory framework.

September 2022

10