Crypto crisis begs the question in the UK: brave new world, same old problems?

2022 has been a challenging year in the cryptoasset industry, marked by ongoing instability and the collapse of several well-known players. As cryptoassets become more widely used and their potential impact on financial stability grows, there is an increased recognition by policymakers of the risks posed to investors. 

From inception, cryptocurrencies in particular aimed to circumvent many of the problems associated with traditional banking institutions and systems. Proponents emphasised the benefits of a decentralised, transparent monetary system, which is outside the control of governments and central authorities. However, recent events have demonstrated that participants in the cryptoassets space can be vulnerable to many of the same issues that have plagued traditional financial institutions.

What has happened?

Following the dramatic unravelling of crypto projects such as Terra and Celsius earlier in 2022, it has been the recent downfall of FTX, one of the largest cryptoexchanges in the market, that has made headlines. Details continue to emerge, but some of the problems which brought down the FTX group – which was regarded as "untouchable" by many within the industry – appear startlingly reminiscent of the 2007-2008 financial crisis. 

Media reports suggest that opaque accounting practices, a failure to segregate customer assets, complex interdependent relationships between group entities, and overleveraging beyond risk limits are all potentially involved in FTX's failure. The final sequence of events – a crisis of confidence, customers rushing to withdraw assets, and a terminal liquidity crunch – is likewise familiar from the last days of Northern Rock and others. 

However, there are crucial differences between the banking and crypto sectors during their respective crises. Traditional financial institutions are heavily regulated, with well-established risk management and consumer protections in place. Sweeping post-crisis reforms have since driven higher regulatory capital requirements, strengthened risk management practices, and made senior management more accountable. 

On the other hand, the regulation of cryptoassets remains in its infancy, even as links between the crypto and traditional financial systems increase and the potential risk to financial stability grows. At present, the regulation of cryptoassets is primarily focused on anti-money laundering requirements and does not consider potential financial stability risks. 

A decade ago, major banks received government bail-outs during the credit crunch, with financial guarantees made to investors to restore public confidence, and consumers of regulated businesses having a level of protection through national compensation schemes. However, no taxpayer-funded help is generally on the cards for firms in difficulty in the crypto space, even for those might be regarded as "too big to fail". Indeed, in September 2022 the Financial Conduct Authority published a warning to customers of FTX that they would be unlikely to get their funds back if things went wrong.

Osborne Clarke comment

In the UK, moves are already underway to bring cryptoassets within the regulatory perimeter, which will increase consumer confidence in investing in cryptoassets, deliver some degree of stability, and boost growth in the industry. However, no firm time lines have been established as to when regulation can be expected. The passage of proposed legislation to regulated cryptoassets in the EU has also been delayed, owing in part to the length and complexity of the proposals.

Despite this, firms in this space should be expecting an uplift in their compliance obligations, some of which may come from customer demand. While potentially adding operational cost, some in the market may welcome a greater focus on risk management and compliance after a year marked by crashes and crises.  

This Insight was written with the assistance of Sarah Denny, Trainee Solicitor at Osborne Clarke.

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