The Metaverse Within Finance And Its Growing Regulation

The metaverse is a digital world created through a combination of hardware, software, and AI technology to blend the real world with the virtual world through the expansion of the latter. Metaverse already operates virtual digital financial trades such as NFTs, however, there is a complete lack of regulation in this area. By 2030, the Metaverse is expected to reach 7-11 trillion pounds in total revenue. Efforts are currently underway to ensure that appropriate safeguards are in place to protect consumers operating in this virtual space

The Use of Metaverse in the Financial Sector

Recently, banks and financial companies have started to notice the potential of the Metaverse. They are moving to develop ‘financial Metaverse platforms’ which use Metaverse real-world financial products and services (sales, brokerage, advisory packages, etc.). Based on its current trajectory, it is anticipated that the Metaverse will be used as an innovative sales channel to become a new digital financial ecosystem.

Of course, as financial platforms on the Metaverse are still in their infancy, the focus of regulation today is the management and development of tokens which finance and make up the Metaverse (NFTs being a common source and name). The finance touched upon here consists of traditional currencies and emerging digital-specific crypto assets, stable currencies, and central bank digital currencies which all coexist as new forms of money thanks to blockchain technologies. Commercial hubs, such as JP Morgan, are seeking to buy plots in virtual reality through these digital currencies. This newfound technological advancement is aligned with financial strategies of targeting Millennials and Generation Z consumers who are familiar with the use of smartphones, AI, and VR, becoming key consumers of the sector.

With consideration of these possible developments, this article will focus on the regulation of two prominent areas today which underpin the infrastructure of the Metaverse: digital currencies (in a general form) and Non-Fungible tokens (NFTs). These two components operate using the Distributed Ledger Technology (DLT) in the Metaverse, which records transactions on the blockchain without needing a financial intermediary such as a bank. This poses a significant risk to financial regulation enforcement as it is these intermediaries which enforce financial regulatory checks and have obligations to prevent financial crimes such as money laundering, terrorist financing, and more.

Regulation of the Metaverse and Digital Currencies

The challenge for regulating digital currencies is the ingenuity of and speed at which new ones are developed as this is an ever-changing and growing area of finance. In 2019, the Financial Conduct Authority (FCA) published its Guidance on Crypto Assets in July as a response to defining relevant crypto assets and the jurisdictions in which they lie. However, newer coins remain undefined and could fall into any of the categories mentioned in the publication. This has resulted in harsh consequences such as the FTX Scandal which showcase the importance of regulation within this area of finance and technology.

The FCA has given examples of the requirements which could be imposed on market participants, which indicate a potential future approach in the UK. These include:

Authorisation before operation
Capital and liquidity requirements
Maintaining a reserve of assets
Record keeping
Anti-money laundering rules
Cybersecurity requirements

The EU has also provided 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 seeks to clearly define the regulatory treatment of all crypto-assets that are not covered by existing financial service legislation and to instil appropriate levels of consumer and investor protection in the EU. MiCAR sets out a range of obligations which 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’. In its current state, MiCAR will be an advisory for those who are seeking to enter the Metaverse in the financial sector - setting up these foundations has proven to be more crucial than ever to keep up with the developmental potential of these cryptocurrencies.

Regulation of NFTs

Though regulators have already set up foundations for the financial regulation of crypto assets, the regulation of NFTs within the Metaverse remains unclear. NFTs are assets that have been tokenized via a blockchain by using a unique identification code which distinguishes them from other tokens. NFTs can be traded and exchanged for money, cryptocurrencies, or other NFTs depending on the value the market owners have placed on them. For example, The Merge currently holds the title of the most expensive NFT sold at $91,800,000 due to the value placed on it by the creator. The critical difference between NFTs and cryptocurrencies is that two cryptocurrencies from the same blockchain are interchangeable (fungible) however two NFTs from the same blockchain can look identical, but they are not.

In 2021, the NFT market surpassed 40 billion pounds, and hence requires immediate attention for regulation. The prevalence of fraudulent practices in the NFT market (tokenization, wash trading, insider trading, etc.) heightens the pressure and importance of a regulatory framework. NFTs do not fall into the definitions set out in MiCAR or the FCA’s Guidance on Crypto-Assets. The need for its clarification has been recognized by the Financial Action Task Force (FATF), an intergovernmental body which sets international standards for the prevention of money laundering and terrorist financing. The FATF in their Guidance on Virtual Assets and Virtual Asset Providers (GVAVAP) recommends that certain NFTs should be categorized as ‘virtual assets’ (VAs) and regulated accordingly. Implementation of this may include client checks, verifications for the products, record keeping, and other similar requirements to those in the MiCAR.

“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 of GVAVAP)

Legal and regulatory obligations for the Metaverse no longer concern financial intermediaries but are now of virtual asset sellers, marketplaces, and administrators. Though there is still no regulation on some of the recognized future potential of the Metaverse such as the virtual bank branches which provide financial services, these new regulations are no less vital to the future development of financial assets in the virtual world. Though still in draft form, financial regulations are coming, and market participants will lay the groundwork for future regulation in this fast-advancing technological world. The question which remains now is whether these regulations can keep up with the rapid development of the new world.

By

Esther Zhang