E is for Environmental: is it just about the energy usage, or could crypto enable us to ‘build back better’?

When one thinks of crypto, the most famous example that springs to mind is the cryptocurrency Bitcoin. In ESG terms, one commonly hears that bitcoin mining - the process of adding transaction records to Bitcoin's public ledger of past transactions or blockchain - uses more energy than a given entire country, for example Argentina and uses energy which is derived from coal. The proof of work consensus used by Bitcoin is particularly energy intensive. Other cryptocurrencies use different consensus mechanisms which are less energy intensive, for example proof of stake or even proof of authority. In addition to using a less energy-intensive consensus mechanism, other ways of reducing the impact of energy usage that are being adopted include offsetting greenhouse gas emissions and using renewable and clean energy sources.

Signatories to the Crypto Climate Accord (CCA)[1], inspired by the Paris Climate Agreement, are crypto market participants that make a public commitment to achieve net-zero emissions from electricity consumption associated with all of their respective crypto-related operations by 2030 and to report progress toward this net-zero emissions target using the best industry practices. CCA also counts UN FCCC Climate Champions amongst its supporters.

It is also worth recalling the distinction between cryptocurrency as an asset, and the distributed ledger technology (DLT – of which blockchain is but one example) by which transactions are recorded and assets transferred. DLT has a wide number of potential use cases in financial services that may be deployed in ways not relying on complex consensus mechanisms. It may be that the technology underlying cryptocurrency is ultimately more effective in achieving ESG outcomes.

S is for Social: is crypto only an investment trap for the unwary consumer, and a vehicle for financial crime, or can it facilitate positive societal benefits?

There is currently widespread publicity around the downsides of crypto, but perhaps the evolution of regulatory frameworks, structures and technology involved will enable crypto to realise its potential as a means for facilitating social improvement through financial inclusion

Volatility

Cryptoassets, particularly those that are unregulated and not asset-backed, are often highly volatile and present a high risk of loss. The FCA banned with effect from January 2021 the sale of derivatives and exchange traded notes that reference certain types of cryptoassets to retail consumers, and in its current consultation on bringing qualifying cryptoassets within the financial promotion regime the FCA plans to introduce enhanced risk warning and positive frictions to dissuade consumers from investing in cryptoassets.

Illicit activity

The FCA was assigned the role of cryptoasset supervisor for AML/CTF purposes as part of the transposition of the EU Fifth Money Laundering Directive, and it has serious concerns around the use of crypto to facilitate financial crime. This can be seen from the large number of businesses that withdrew their FCA registration applications due to failing to meet the standards required by the FCA under the Money Laundering Regulations. The FCA will only register firms where it is confident that processes are in place to identify and prevent the transfer and disguise of funds from criminal activity, or funding of terrorist groups.

Potential for increased financial inclusion

The starkest example of belief in the ability of crypto to facilitate financial inclusion is that of El Salvador, where Bitcoin became legal tender in September 2021 in an effort to promote “financial inclusion”, investment and economic development. It was hoped the move would make it easier for Salvadorans living abroad to send remittances home (potentially due to cheaper cross-border transaction costs, quicker timescales, and accessibility to those unserviced by the traditional banking sector) which in 2019 amounted to a fifth of the country’s GDP. Critics have pointed out that few Salvadorans would have the technical capacity to access bitcoins, and that converting to and from local currencies is a complex process and prices are volatile. The IMF has recently urged El Salvador to drop bitcoin as legal tender given the large risks entailed for financial and market integrity, financial stability, and consumer protection. The IMF has also expressed concerns over the risks associated with bitcoin-backed bonds, which the Salvadoran government plans to issue in March 2022. The IMF did agree that boosting financial inclusion was important, and that digital means of payment - such as the Chivo e-wallet (the country’s official digital wallet) – could facilitate this but emphasised the need for strict regulation and oversight of the new ecosystem of Chivo and bitcoin.

It was the recognition of the problem of volatility of cryptocurrencies and the potential for crypto to facilitate financial inclusion that led to the development of stablecoins, the most well-known being Diem (formerly known as Libra) proposed by Meta (formerly Facebook). The potential for such a stablecoin to become a globally systemic form of private money was a key driver for many nations in exploring the possibilities of central bank digital currencies and caused the G7’s global stablecoin working group report to state that ‘no global stablecoin project should begin operation until the legal, regulatory and oversight challenges and risks… are adequately addressed, through appropriate designs and by adhering to regulation that is clear and proportionate to the risks.’

At the time of writing, the response to HM Treasury’s consultation on the UK regulatory approach to cryptoassets and stablecoins is still awaited.

G is for Governance: can the crypto governance conundrum be resolved to realise its potential social and environmental benefits?

A key governance issue in relation to crypto is whether there is a centralised entity within the operating structure that can carry out governance and be held accountable. The decentralised nature of some crypto structures, with no one person who is responsible or who can be held accountable, presents a key challenge to the ESG credentials of such crypto. Common ESG governance considerations might include whether:

• the management body takes into account sustainability issues in the course of business;
• the firm operates with tax transparency;
• financial crime, bribery and corruption risk is adequately managed;
• and whether the firm addresses diversity and inclusion.

Typically these considerations are addressed by a management body of identifiable responsible persons, or by a corporate entity that can be held accountable. It remains to be seen how these requirements will be applied and evaluated in the context of governance by code and software developers.

Further challenges may arise in the context of crypto structures that involve a loose network of unrelated corporate entities only held together by common policies, standards and agreements about respective roles but without being part of the same group. Specifically in the context of global stablecoins, the Financial Stability Board has set out recommendations which include governance requirements.

In a regulatory environment that is increasingly hostile towards crypto, those involved in the crypto ecosystem are really going to have to go the extra mile to show that crypto can deliver against stringent ESG criteria to become a legitimate asset class.

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