FSPs under close regulatory scrutiny

Love them or hate them, crypto assets are here to stay. As we enter 2024, the experts estimate that more than 5.8 million South Africans already have some exposure to crypto assets, with this number forecast to grow to 26.4 million by 2030. And with Bitcoin once again testing the USD40 000,00 per ‘coin’ level, and lifting a wide basket of cryptocurrencies with it, you can expect renewed interest in the asset class entering 2024.

Significant risk to financial services customers

In this context, few will be surprised by the Financial Sector Conduct Authority (FSCA) decision to hasten bringing crypto assets and crypto asset financial service providers (FPSs) into the regulatory fold. “After declaring crypto assets as financial products we are still of the view that crypto asset related activities pose a significant risk to financial customers,” said Awelani Rahulani, Head of Department: Fintech at the FSCA, during the media launch of the regulator’s Crypto Asset Market Study. He noted that while South Africa had an extensive financial services legal framework in place, it was not yet “tailored” for crypto asset FSPs. 

To their credit, South Africa’s financial sector regulators have adopted a proactive approach to the emerging asset class. As far back as 2014, the Financial Intelligence Centre (FIC), FSCA, South African Reserve Bank (SARB) and South African Revenue Services (SARS) issued a public statement on crypto assets, warning consumers of the risks associated with ‘dabbling’ or speculating in unregulated financial products. Also in 2014, the SARB published a position paper on crypto assets in which it noted the lack of a regulatory and legal framework and highlighted anti-money laundering and combatting the financing of terrorism (AML-CFT) as key risks. 

In the years since, the Intergovernmental Fintech Working Group (IFWG), through the Crypto Assets Regulatory Working Group (CAR WG), has published a number of papers to inform the regulatory approach. This included the CAR WG crypto assets consultation paper in 2019; draft position paper in 2020; and final position paper in 2021. The FSCA, meanwhile, published its draft and final ‘Declaration of Crypto Assets as a Financial Product’ in 2020 and 2022 respectively. Rahulani reminded his audience that the IFWG’s final position paper had proposed the FSCA to licence, supervise and investigate crypto assets FSPs, a task the regulator has taken in its stride. 

Informing the supervisory approach

Turning to the matter at hand, the FSCA said the Crypto Assets Market Study offered useful insights into current crypto asset activities; would assist in identifying risks in such activities; and guide the supervisory response through licensing and necessary amendments to the existing legal framework. “This survey supports the work that is currently taking place within our licencing, framework and supervisory departments; and we also believe that the insights that emanate from this study will assist some of our regulatory partners,” said. Rahulani, before handing over to Keith Sabilika, Senior Fintech Specialist at the FSCA, to discuss the survey findings. 

They survey took place in October 2022 through an FSCA information request to crypto asset FSPs to explain their crypto asset activities; share the supply-side factors driving their businesses; and describe their business models and outsourcing arrangements, among others. “The majority of crypto asset FSPs provide financial services by making use of un-backed crypto assets such as Bitcoin and Ethereum (60%); followed by stable coins such as USD Coin and Binance Coin (26%),” Sabilika said, adding that this was consistent with international developments. Un-backed crypto assets are “the oldest and most widely-recognised digital assets, primarily used for speculative purposes rather than to serve as a means of exchange”. 

Cape Town leads the way in head office location with the largest number of crypto asset FSPs having established their headquarters in that city (46%) followed by Johannesburg (33%) and Pretoria (7%). Around 10% of businesses had offshore head offices. “The strong local presence amongst crypto asset FSPs is quite important to us as regulators, as it makes it easier for us to do our regulatory and supervisory work,” Sabilika said. In what this writer found to be quite a surprising statistic, the FSCA then revealed that 38% of the crypto asset FSPs generated less than R1 million in crypto activity related revenues annually. One can only hope these businesses have significant non-crypto activities to cover their looming crypto asset compliance costs.

 The lowdown on financial services outsourcing

The survey highlighted a range of outsource functions sourced by crypto asset FSPs including KYC-AML; exchange platform, custody, cyber security, information technology services, and blockchain monitoring services. “It is important to note that the outsourcing of activities does not relieve crypto asset FSPs from their responsibility to ensure fair treatment of customers, and they therefore have to comply with the outsourcing arrangements that are required for financial institutions,” Sabilika said. Financial services activities can only be outsourced by entities that are licenced / regulated under the Financial Advisory and Intermediary Services (FAIS) framework. 

Given the ongoing song-and-dance about RDR, adviser remuneration and financial advice practice remuneration models, it was fascinating to unpack the survey’s findings re crypto asset FSPs. Under the ‘business model’ section, the FSCA revealed that 38% of crypto asset FSPs were operating as crypto exchanges; 19 were operating in the advice space; and 15% as crypto brokerages. “In most instances, the business models mirror traditional financial activities such as operating an exchange or providing advice; the main difference that we picked up was with businesses applying cryptographic techniques or using distributed ledge technology (DLT) on the back end,” Sabilika explained. 

Businesses generated remuneration from trading fees (38%); administration fees (25%) and advice fees (20%) with bid-ask spreads; profit share; performance fees; referral fees; and rebates all coming in at 5% or less. Returning to the tried-and-tested treating customers fairly (TCF) paradigm, the FSCA said that consideration had to be given to how fees were disclosed to consumers, and the extent of said fees. Another potential regulatory ‘red flag’ arose in the field of cross-border monitoring. “Effective cross border monitoring mitigates the risk of money laundering and financing of terrorism and is essential in protecting the integrity of the domestic and global financial markets,” Sabilika said. 

Tough to track-and-trace in the murky crypto world

This writer has some sympathy for regulators as they attempt to shine light into the dark corners of the crypto asset universe, and would almost certainly take any ‘size-of-market’ estimates with the proverbial pinch of salt. During its presentation, the FSCA estimated the average monthly trade in crypto assets at R520 million per month in 2020, which activity will no doubt have increased significantly since. The regulator said it would closely monitor trading patterns for any changes that might flag conduct risk concerns. 

The Crypto Assets Market Survey showed that 94% of distribution and marketing of crypto-related financial products was via digital channels. According to Sabilika, the imminent Conduct of Financial Institutions (COFI) Bill would therefore provide for “a targeted regulatory framework for retail consumers”. The survey also highlighted a future challenge in managing dormant crypto assets accounts, with a growing number of zero-balance or inactive accounts. Some crypto asset FSPs have started reaching out to clients to understand account dormancy, in some cases insisting that clients sign a ‘new’ mandate annually. 

Innovative, inclusive and sustainable

“The FSCA aims to promote the development of an innovative, inclusive and sustainable financial system in South Africa [and] any research undertaken in support of this objective allows us to better understand technology and other related innovations taking place in the financial services space,” concluded Sabilika. Reading between the lines, the industry can expect a raft of crypto asset focused licensing, regulatory framework and supervisory regulations in the coming years. 

Writer’s thoughts:

The regulator reckons one-in-10 South Africans has some exposure to crypto assets. Do you think this is a fair observation, or do your client interactions hint at far greater crypto asset penetration? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.