How should we regulate virtual assets? This is a question on the mind of almost every financial services regulator in the world. Many have adopted a very cautious and in some cases a prohibitory approach. However, the Abu Dhabi Global Market’s (ADGM) Financial Services Regulatory Authority (FSRA) has taken a more innovative and pragmatic approach by being one of the first international regulators to publish regulations on virtual assets.

The FSRA has now taken a further step by releasing a set of guiding principles about its approach to virtual asset regulation and supervision. Although these principles are not binding, the FSRA intends that they will complement its virtual asset framework, which has been in place since 2019. A reoccurring theme of these principles is the need to balance a risk averse or risk sensitive approach with the need to foster confidence and innovation in the ADGM.

We set out below a summary of the FSRA’s guiding principles along with our views on the potential implications of these guiding principles.

Principle 1 – A robust and transparent risk-based regulatory framework

The FSRA believes that bringing definable virtual asset activities within its supervision will ensure greater oversight and mitigate inherent risks in the sector. However, in doing so, it wants to ensure investor protection, market integrity and a level of future proofing against financial stability risks.

Principle 1 provides a sensible starting point for virtual assets supervision but it must be genuinely risk-based. For example, the supervisory approach of the FSRA must be adapted to the nature of a virtual assets firm’s customers, with the most sophisticated customers being provided the least protections.  We note that the FSRA has stated its commitment to be agile in respect of new trends and terminology. We can therefore expect that the FSRA’s virtual asset framework will evolve over time in response to changes in the virtual asset industry.

Principle 2 – High standards for authorisation

The FSRA intends to continue to impose a very high bar for authorisation as a virtual asset firms in the ADGM. It intends to only admit those that can meet its high standards. By having a seemingly low risk appetite, it is likely that the FSRA wants the ADGM to be a venue for ‘gold standard’ virtual asset firms. In essence, not every virtual asset firm wanting to operate in the ADGM will be permitted to do so by the FSRA, unless they can meet its exacting standards.

There is no doubt that Principle 2 is a key pillar in the FSRA’s regulation of the virtual assets sector. However, the bar should not be set so high as to stifle innovation or create barriers to entry. The benefits of financial decentralisation should not be diluted by regulatory complexity, particularly in the non-retail space.

Principle 3 – Preventing money laundering and other financial crime

The ability for users of crypto assets to maintain anonymity means that these assets have a deservedly poor reputation when it comes to money laundering and financial crime. However, service providers in the crypto industry are keen to dispel this view and are increasingly seeking to operate under the umbrella of a regulatory regime.

In this regard, the FSRA expects that any virtual asset firm within its remit follow AML/CFT rules as well as the UAE federal AML/CFT rules. The FSRA also expects virtual asset firms to comply fully with relevant FATF guidance and recommendations, and to avoid virtual asset transactions where a counterparty is unknown. This approach is welcomed. However, to be effective, the FSRA should encourage a risk-based approach and should at all costs avoid promoting, or adopting, a tick-box approach.

Principle 4 – Risk sensitive supervision

The FSRA will not only adopt a risk based approach in respect of its framework and licensing, but will also extend this approach to ongoing supervision. In doing so, the FSRA will set a risk rating for firms and undertake a continuous risk assessment cycle.

The FSRA has outlined four risk drivers:

(1) custody of virtual assets;

(2) technology and governance controls;

(3) exchange type operations; and

(4) investor protection.

These risk drivers will receive heightened supervisory focus from the FSRA. To achieve this, the FSRA has recruited a supervisory team with experience in the virtual asset industry. As such, FSRA-regulated firms can expect that its supervisors will have a good understanding of the virtual assets industry, including having an understanding of the nuances of the sector and its risks.

Principle 5 – Commitment to enforce on regulatory breaches

The FSRA has stated its commitment to enforce any breach of its regulatory rules and regulations that it administers. Under this principle, the FSRA has made it clear that it will not hesitate to use the full breadth of its enforcement powers where necessary.

Firms in the traditional financial services industry are all too familiar with enforcement actions by regulators. However, for those in the virtual asset industry, this is unfamiliar territory. It remains to be seen how these players will react to enforcement action by the FSRA, and the effect this may have on the ADGM’s nascent virtual asset industry. While enforcement action should be used in appropriate circumstances, such as when a firm commits deliberate breaches of regulations, such actions should only be used where it is proportionate to do so. Regulation is relatively new to the virtual assets sector and, as innovators, many firms will be natural risk-takers. Regulators should work with the virtual assets sector while it adapts to the new world of regulation.

Principle 6 – International cooperation

A commitment to international cooperation is hardly surprising for any reputable financial services regulator. Cooperating with other international regulators and entering into Memoranda of Understanding to support the exchange of information is to be expected.

However, the FSRA is keen to capitalise on being one of the first regulators to publish a comprehensive regulatory framework to govern virtual assets. With Principle 6, as well as committing to international cooperation, the FSRA states that it supports the development of international minimum standards, and has expressed its willingness to contribute to the design of principles by international bodies such as IOSCO, FATF and the Basel Consultative Group.

Given the FSRA’s leadership role in the virtual assets space, we would not be surprised to see its principles, regulations and guidelines adopted by other international regulators and by international standard setters.

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