Cryptocurrencies and ESG Considerations

As the cryptocurrency industry rises in prominence (with Bitcoin and increasingly, Ethereum being 2 of the most popular cryptocurrencies by market value), many Financial Institutions (“FIs”) worldwide have shown interest in virtual assets, as well as their related service providers as asset classes for trading and investment purposes.

ESG (Environmental, Social and Governance) considerations and their associated risks have played a part in the decision making process of FIs when it comes to management of their own portfolios. In order to meet their ESG agendas or the criterion or requirements of their investors or other stakeholders, FIs have their own due diligence processes and compliance procedures.

The following article considers, in light of increasing interest in the cryptocurrency landscape by FIs, some of the ESG related issues and challenges associated with such virtual assets and their industry players. It sets out, where applicable, some measures for FIs to consider in meeting such challenges. Lastly, the article also covers measures taken by Singapore, both regulatory or otherwise, in dealing with such challenges. 

On the environmental front, the main issue has been the amount of energy consumed when cryptocurrencies are mined and related blockchain operations. Bitcoin, the most widely used and popular cryptocurrency, relies mostly if not entirely on mining operations.

Traditional mining operations use large amounts of computing space and power. Most of the time, the blockchain technology used to authenticate, or verify the cryptocurrency transactions are Proof of Work (POW) transactions. Countries such as China and Inner Mongolia, which use coal as the main power source and support crypto mining activities on a large scale, are banning such mining activities altogether (crypto mining, not traditional mining).

Such nations resort to these measures to meet their own commitments to carbon emission reduction or carbon neutrality targets.

While this results in an exodus of cryptocurrency mining operations and related industries to other nations, the fact remains that the underlying virtual assets themselves will be at odds with the environmental considerations of FIs that place importance on ESG considerations in their agenda.

Given the governmental, regulatory, international and increasingly, investor and stakeholder- driven attention to and requirement that FIs place increasing importance on environmental issues, as well as their related risks and challenges, some FIs have already adopted, or are looking into cryptocurrency alternatives that use environmentally- compatible, if not friendly alternatives (hydroelectric power, solar power and other renewable energy sources).

With regard to blockchain operations, some quarters have switched to using Proof of Stake (POS) instead of POW. It is believed that one of the advantages of using POS is that it is far more energy efficient, as the way in which the blockchain transactions are initiated and processed are entirely different.

In the case of Ethereum, use of the Energy Web Chain to build renewable energy applications on the blockchain serves as a much more environmentally friendly option.

In Singapore,  locally- based Cyberdyne Tech Exchange’s intended introduction of a platform for the trading of green assets in tokenised form uses its “environmentally friendly” or “green” platform as an incentive to attract FIs and investors / stakeholders for whom ESG considerations are critical.

In addition, the Monetary Authority of Singapore has commenced, or provided widespread support for FIs that it regulates or licenses to adopt, or comply with ESG values and considerations in their operations.

One such measure from the MAS was its issuance of Guidelines on Environment Risk Management for Banks, Insurers and Asset Managers (“Guidelines”) in December 2020. The Guidelines set out to improve the resilience of FIs to environmental risks by setting out sound practices to be followed. However, the Guidelines do recognise that this is a relatively nascent and evolving landscape and thus, provide for flexibility in compliance and disclosure requirements (one of which is an 18-month transition period for implementation of the Guidelines). 

The FIs involved in these Guidelines which include, or are looking to incorporate cryptoassets and their related activities into their portfolios would do well to ensure compliance and appropriate disclosures are made to the MAS, especially if they have an ESG agenda.

With regard to the “social” aspect of ESG, issues such as diversity and inclusion, financial inclusion human rights and consumer protection take centrestage.

Cryptocurrencies, due to their decentralised nature, are inflation proof and also “inclusive”  and promote diversity, as access is available regardless of differences in age, race, religion or geography.

Financial inclusivity is also a big draw, as all that is required is an internet connection and a suitable device to transact in cryptocurrencies. This is important in parts of the world where certain persons or communities may not have access to, or even be able to open and operate a bank account or store their assets in a safe and reliable entity or institution.

That being said, the decentralised nature of cryptocurrencies, as well as the anonymity of its users does lend concerns regarding possible money laundering and terrorism financing issues. The recent occurrence of the “colonial pipeline” hack and the bitcoin ransom attempt that was foiled by the US Federal Bureau of Investigations have raised concerns regarding criminal activity as well.

That being said, many cryptocurrency platform operators have voluntarily put in place, or comply with both local regulatory and international standards in respect of Anti-Money Laundering (“AML”), Countering the Financing of Terrorism (“CFT”) and other crime prevention and combatting measures.

However, the transparent and traceable nature of cryptocurrency transactions also play a part in preventing the abovementioned evils, as well as the risk of market manipulation.

Further, market participants in the cryptocurrency landscape may find incentive in voluntarily ensuring that they have a positive social impact on their communities, users and other stakeholders. This would in turn, incentivise FIs which use ESG considerations as a metric to assess potential investors or investments, to view such entities and activities positively.

In Singapore, the Payment Services (Amendment) Bill has put in place both general powers, as well as specific measures to combat AML and CFT issues in respect of Digital Payment Tokens (“DPTs”) and platforms using them. These powers also have a broad and discretionary nature, such that they can have both extra-territorial reach, as well as extending to crypto assets and platforms other than those involving, or related to DPTs.

This raises another issue that entities in the cryptocurrency landscape should take account of in their operations: how the extra territorial reach of local and international regulators could have an impact on not just the jurisdiction where such entities are incorporated, but also where their customers are based and the jurisdictions in which the blockchain transactions take place. 

According to McKinsey and Company, Governance is the internal system of practices, controls, and procedures that a company adopts in order to govern itself, make effective decisions, comply with the law, and meet the needs of external stakeholders.

The following factors are typically taken into consideration inn the governance framework of organisations: 

1. Does management take into account sustainability issues in the course of its business?
2. Are the organisation’s operations geared towards sustainability in the long-term by having diversity in its management?
3. Is there tax transparency within the organisation?
4. Are financial crime, bribery and corruption properly managed?
5. Does the organisation have measures in place to deal with cybersecurity attacks which could result in privacy breaches, business interruption and losses to investors?
6. How is executive pay determined and is it linked to sustainability targets? 

While it is unclear to what extent these governance considerations are considered, or even adhered to by cryptocurrency players and the industry, one way forward may well be that as this industry interacts with FIs and other mainstream entities, they will have to adopt necessary governance measures to meet compliance, regulatory and other requirements.

Cryptocurrency entities seeking public listing on stock exchanges or participate in established financial markets would be subject to governance, compliance and disclosure models similar to other public-listed and traded companies as well.

In Singapore, the Stock Exchange of Singapore has a “Code of Corporate Governance” (“Code”). The Code requires all listed companies on the Stock Exchange to disclose their corporate governance practices and give explanations for deviations from their Code in their Annual Reports, akin to a “comply or explain” regime.

As such, cryptocurrency entities that wish to attract Singapore-listed companies as investors, may have to meet the governance requirements imposed by such listed companies, so that their investors listed on the exchange do not fall foul of the Code’s provisions. 

The various issues surrounding ESG values and considerations require the cryptocurrency industry and its players to adopt, or adapt alternative practices, measures and solutions if they wish to work with entities that place importance on ESG criteria.

Conversely, given the state of flux of the cryptocurrency industry and its unique nature, entities with ESG-driven considerations or requirements would have to ensure that proper due diligence and fact-finding is carried out prior to any form of engagement with cryptocurrency-related entities, in order to ensure that its ESG-related requirements are complied with.