Financial regulation in the metaverse

08.11.2022

While the metaverse is seen by some as the ungovernable Wild West when it comes to regulation, efforts are currently underway to ensure that appropriate safeguards are in place to protect those transacting and operating within this undefined virtual space. From the likes of Paris Hilton to JP Morgan, consumers and businesses alike are thronging to buy their virtual plots in virtual reality (VR) worlds such as Decentraland and Roblox, with digital currencies such as MANA and Robux. Regulators, meanwhile, are under pressure to create a financial regulatory framework to govern and protect consumers in these VR spaces, which are poised to become the new commercial hubs.

In the fourteenth article in our series, we examine the current and incoming financial regulations that will impact the metaverse.

Particular attention is being paid to understanding and regulating the two key components which underpin the infrastructure of the metaverse: digital currencies, which are used to purchase digital content, and non-fungible tokens (NFTs), which are used to record digital ownership and rights. Both NFTs and digital currencies use distributed ledger technology (DLT) to record transactions on the blockchain, thereby eliminating the need for a financial intermediary such as a bank. This poses a significant risk to financial regulation enforcement since it is these intermediaries which enforce financial regulatory checks and have obligations which prevent money laundering, terrorist financing and other forms of financial crime.

Regulating Digital Currencies

A key challenge in regulating digital currencies is the speed and ingenuity with which new ones are developed. It is an ever-changing landscape, from cryptocurrencies, such as Bitcoin, to lesser-known stablecoins, such as Tether, which are tied to fiat currencies like the dollar. The Financial Conduct Authority (FCA), in its Guidance on CryptoAssets (July 2019) has responded to this challenge by clearly defining which “crypto-assets” fall within its jurisdiction. For example, “exchange tokens” such as Bitcoin, Ether and XRP, and “utility tokens” are outside the FCAs remit, while “e-money tokens” and “security tokens” are regulated. New digital currencies, such as stablecoins, remain undefined and could fall into any of the categories above.

It is likely, however, that some of these unregulated crypto-assets may become regulated in the near-future. The FCA has already considered granting a new regulatory category for stablecoins, whereby market participants such as those issuing the tokens, validating and executing transactions and providing access to them, will face complying with certain requirements. The FCA gives the following examples of the sorts of requirements which could be imposed on market participants:

  • being authorised prior to operating
  • having specified capital and liquidity requirements
  • maintaining a reserve of assets
  • record keeping
  • implementing anti-money laundering rules, and
  • implementing cybersecurity requirements.

Although this regime is not currently applicable to other digital currencies like Bitcoin, it gives a glimpse of where the FCA could head in the UK.

While the UK’s future strategy is nebulous, the EU has provided far more guidance on its intended treatment of digital currencies through the European Commission’s draft regulation Markets in Crypto-Assets (MiCAR) which is due to be implemented in 2024. This regulation aims to clearly define the regulatory treatment of all crypto-assets that are not covered by existing financial services legislation and to instil appropriate levels of consumer and investor protection in the EU.

Similar to the FCA’s Guidance, MiCAR also sets out a range of obligations which will apply to “any person whose occupation or business is the provision of one or more crypto-asset services to third parties on a professional basis”. So called Crypto-Asset Service Providers (CASPs) are broadly defined and include, for example, those who are involved in:

  • the custody and administration of crypto-assets on behalf of third parties
  • the operation of a trading platform for crypto-assets
  • the exchange of crypto-assets for fiat currency that is legal tender
  • the exchange of crypto-assets for other crypto-assets
  • the execution of orders for crypto-assets on behalf of third parties
  • the placing of crypto-assets
  • the reception and transmission of orders for crypto-assets on behalf of third parties, and
  • providing advice on crypto-assets.

While not all obligations apply to all CASPs, it is important for those operating in this space to pay careful attention to see what additional requirements will need to be complied with. For example, some CASPs and issuers of crypto-assets will need to receive prior authorisation from a competent Member State government before they can operate in the EU, as well as ensuring they comply with robust cybersecurity requirements and certain consumer protections. Furthermore, issuers of crypto-assets will be required to publish a white paper (similar to those issuing a prospectus in order to sell securities) containing core information on the characteristics of their crypto-assets.

As MiCAR illustrates, caution should be advised for those eager market entrants who see the metaverse as a place where DLT, crypto and NFTs are king and where regulation has no place. Regulators are grappling with the emergence of these new technologies and setting the foundations for a regulated metaverse.

Regulating NFTs

While regulators have already set robust foundations for the financial regulation of crypto-assets, the regulation of the increasingly popular NFT market remains unclear. NFTs do not currently fall within the remit or definitions set out in MiCAR or the FCA’s Guidance on Crypto-Assets. The need for clarification has been recognised by the Financial Action Task Force (FATF), an intergovernmental body which sets international standards for the prevention of money laundering and terrorist financing globally. In its Guidance on Virtual Assets and Virtual Asset Providers, FATF recommends that certain NFTs should be categorised as “virtual assets” (VAs) and regulated accordingly:

“Some NFTs that on their face do not appear to constitute VAs may fall under the VA definition if they are to be used for payment or investment purposes in practice. […] Countries should therefore consider the application of the FATF Standards to NFTs on a case-by-case basis.” (p.24)

If certain NFTs fit the definition of a VA, service providers which are involved in their exchange, transfer, sale and/or administration could fall within the definition of a virtual asset service provider (VASP) and become financially regulated entities. Compliance obligations on NFT service providers could include requirements to have “know your client” checks, robust verifications for the products being sold, record-keeping, and other anti-money laundering requirements similar to those set out in MiCAR.

The prevalence of fraudulent practices in the NFT market, such as tokenisation, wash trading, insider trading and sleep minting, heightens the pressure to create a financial regulatory framework for their exchange. Governments have also become aware of the increasing risk of tax evasion with NFTs and crypto-assets, which provide anonymity as their ownership is not linked to a legal person, but a digital wallet. With the NFT market surpassing $40 billion in 2021, financial regulators are unlikely to leave this space untouched for much longer.

Closing comments

The metaverse is unlikely to ever become the unregulated Wild West of the new digital era which some fear and others hope it will become. There are already some financial regulations which affect virtual digital trades, and the trajectory is towards more rather than less regulation. Globally, regulators are setting up the foundations and the legal infrastructure to regulate this virtual space. Legal and regulatory obligations are shifting from financial intermediaries to virtual asset sellers, marketplaces, and administrators. While it is currently a patchwork of interacting regulations and standards (often still in draft form), financial regulations are coming, and market participants should lay the groundwork for compliance so as to be prepared when they do come.

Still have questions? Be sure to read our metaverse articles below:

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