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Rather than set ground rules for crypto, central banks and regulators have been mired in philosophical debates about how to best classify this fast-growing sector.Kin Cheung/The Canadian Press

Bitcoin was just the beginning, and with each passing week the murky world of cryptocurrencies has continued to explode in popularity. For many investors, the fear of missing out is now very visceral.

In the past month alone, two of Canada’s largest pension funds have announced investments in crypto businesses; a Canadian money manager has started marketing crypto investments for retirement savings accounts; and Mastercard announced a partnership that will allow merchants and banks to trade and process payments in crypto assets across its global network.

More than US$2 trillion is now invested in crypto assets globally, more than the total amount managed by Canadian mutual funds and exchange-traded funds. In late October, bitcoin and its sister asset, ethereum, both set record prices, capping off rebounds from their sharp sell-offs this spring.

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For all the progress, guardians of the global financial system have barely seemed to notice. Rather than set ground rules for this fast-growing sector, central banks and regulators have been mired in philosophical debates about how to best classify crypto – as a security, a currency or a commodity.

Because they can’t decide, very little has been enforced. Meanwhile, the industry is only growing more tentacles. Crypto ETFs have made the sector more palatable to retail investors, and mass marketing campaigns are broadening its appeal. Crypto.com, an exchange, is now a lead sponsor of Formula 1 racing, and FTX, another exchange, has purchased an ad to air during the next Super Bowl. What used to be a sideshow is on the cusp of becoming a more legitimate asset class.

Sensing the proliferation, some securities regulators have started sounding the alarm about the sector’s dark side. Gary Gensler, a crypto expert who now runs the U.S. Securities and Exchange Commission, launched a media campaign late this summer to warn investors that the industry is “rife with fraud, scams and abuse.”

Yet the sirens have done little to stanch the flow of money into crypto assets. The more that is invested, the better the chances the industry will achieve its evangelists’ ultimate goal: building a parallel financial system under the banner of decentralized finance, or DeFi. The dream is to free people from the tyranny of financial intermediaries. One of DeFi’s main assets, stablecoins, has the potential to siphon power from central banks – which is why they are the focus of a new report from the U.S. President’s working group on financial markets that was released Monday and called for them to be regulated in a similar fashion to banks.

To this end, Coinbase, a major U.S. hub, has already attempted to launch a platform that uses crypto assets to make loans. Its plans were rebuffed by the SEC for now, but if watchdogs aren’t careful, the crypto sector could soon start looking like a shadow banking system – which is precisely what regulators warned would pose the next significant systemic risk after they got the 2008 global financial crisis under control.

So far, central banks have downplayed crypto’s potential. In May, the Bank of Canada was generally dismissive of any threat to the global financial order. “Despite their growing popularity, these markets are not of systemic importance in Canada, neither as an asset class nor as a payment instrument,” the BoC wrote in its annual financial system review. “While these investments have received much attention from the media, their footprint remains small relative to the size of the financial market.”

Yet the crypto sector has rebounded sharply since, and the longer watchdogs wait to impose rules, the greater the chance of discomfort when they finally do.

To this end, Canada has some experience. Ottawa neglected income trusts for years, and investors fell in love with them because trusts paid out most of their cash flows directly to unitholders – a loophole that let them skirt corporate taxes.

By 2006 income trusts had become so popular that some of Canada’s largest companies, including Telus Corp., were considering turning into trusts. With the situation getting out of hand, the late federal finance minister Jim Flaherty was forced to deliver his infamous Halloween surprise that outlawed most trusts, sending their values plunging on the Toronto Stock Exchange.

With crypto, China has already taken extreme action by banning the trading of these assets altogether. But in most other places, central banks and watchdogs are treading lightly. “It’s just not yet clear what crypto is and how it should be regulated,” said Lori Stein, a partner at Osler, Hoskin & Harcourt LLP who specializes in digital assets and blockchain. “That’s been a challenge for crypto all over the world.”

Crypto has also emerged as a global network, which means regulation requires international collaboration.

There are also territorial issues within individual countries. In Canada, the central bank, the Office of the Superintendent of Financial Institutions (OSFI) and provincial securities regulators all have a say in different aspects of regulation. Of these, the Ontario Securities Commission is the only one to take a strong stand so far by requiring cryptoexchanges to register with the regulator or get shut down.

“At a certain point in time, we saw this tremendous retail interest that really exploded,” OSC chair and chief executive Grant Vingoe said in an interview. “We felt as an investor protection-oriented regulator, and also bearing in mind our responsibility to help foster sensible innovation, that we needed to step in.”

The OSC devised a novel solution to the never-ending debate about the nature of crypto assets. Instead of focusing on the underlying asset, the OSC determined that the relationship between a crypto platform and an investor can be considered a “crypto contract” and therefore regulated as a security. Because of this workaround, the OSC felt comfortable approving the world’s first bitcoin ETF this year.

The goal, Mr. Vingoe said, was to be realistic. Investors were already using mysterious exchanges, such as Quadriga, to buy and sell crypto assets. The OSC wanted to corral them into safer spaces. “Clients are better off 100 per cent on regulated platforms,” he said.

Yet he also believes that more needs to be done to combat the endless promotion of crypto as the ultimate investment. “It is frankly everywhere,” he said. “It’s really hard to get to the root of that as a securities regulator.” He also acknowledged that regulation is a double-edged sword because crypto companies now market their compliance with OSC rules, making the industry seem more legitimate to the average investor.

OSFI, Canada’s banking regulator, declined to comment for this story, but newly appointed superintendent Peter Routledge gave a speech in September that noted the organization is leveraging the Bank of Canada’s analysis to adapt “how we might evaluate the soundness of the financial institutions as and if digital money proliferates.”

At the moment the sky is not falling, and Canadian financial watchdogs have proven over the past 15 years that they can keep the system safe.

But showing some urgency is also necessary. Financial markets have a history of letting innovation run its course, then spending years cleaning up the mess after something backfires – as was the case with over-the-counter derivatives during the 2008 crisis.

The infrastructure underlying the crypto market, blockchain, will fundamentally alter the financial system. And much like the social-media revolution over the past decade, new players will promise innovation and a better way of doing things – but they cannot be given too long a leash.

Facebook once promised to bring communities together. Today it is playing a major role in tearing them apart. The same can’t happen to the financial system that touches every aspect of our lives.

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