Cryptoassets are considered high risk speculative investments and there is a wide range of regulatory responses to these assets globally. These range from prohibition, no regulation, limited regulation of certain classes of assets etc., and even acceptance as legal tender (El Salvador). Here we examine some of the key regulatory trends in the UK.
If your company is planning to provide financial services, digital assets, or crypto assets it’s important to be prepared for regulatory changes. In this quickly evolving environment, our financial services solicitors are on-hand to help and answer any questions.
What are crypto assets?
Cryptoassets (which include cryptocurrencies, crypto coins and virtual currencies) are considered high risk and speculative investments. The recent Binance-FTT-FTX saga brought some of these issues to the fore and raises questions about regulatory oversight, or lack thereof, of cryptocurrencies and exchanges. The 'contagion' effect of this saga, among other things, resulted in a fall in values of cryptocurrencies. There are news reports that Binance CEO Zhao has suggested that the industry needs more regulation. In the UK, the Treasury Committee held the first session of its inquiry into the crypto-assets industry on 14 November, and the witnesses included officials from Binance, Ripple, CryptoUK and Galaxy Digital. It is likely that more regulation will be the outcome of all these developments, particularly for consumer protection.
Globally, there has been a wide range of regulatory responses as to how cryptoassets should be governed and regulated. These responses range from outright bans (as in China) to the acceptance of certain cryptocurrencies as legal tender (as in El Salvador).
While there is no internationally consistent definition of cryptoassets, the UK’s Money Laundering Regulations 2017 (the 'MLRs'), defines a cryptoasset as a “cryptographically secured digital representation of value or contractual rights that uses a form of distributed ledger technology ('DLT') (e.g. a blockchain) and can be transferred, stored or traded electronically”. This is potentially a wide definition and therefore captures a range of digital assets. The most popular forms of cryptoassets considered by the UK regulators include tokens (commonly known as cryptocurrencies or exchange tokens) such as Bitcoin. Cryptoassets can also include utility tokens (i.e. those that grant access to a current or prospective products), security tokens (i.e. those that represent ownership or other rights akin to specified investments under the Regulated Activities Order), e-money token (i.e. any token that meets the definition of e-money under the Electronic Money Regulations) and exchange tokens (i.e. tokens used as a means of exchange such as Bitcoin, other cryptocurrencies).
UK approach to regulation
We currently have a very light touch approach to the regulation of cryptoassets and those businesses that facilitate cryptoasset transactions. However, this approach belies the complexity of existing and proposed regulations which could impact various aspects of transactions involving cryptoassets. Cryptoassets have a variety of features. Different types of cryptoasset are used to conduct a wide range of activities, some of which may be regulated in the UK under Financial Services and Markets Act 2000 ('FSMA') and the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 ('RAO'), or under the Electronic Money Regulations 2011 ('EMRs') or the Payment Services Regulations 2017 ('PSRs'), or may not be regulated at all. In essence, the nature of a cryptoasset is determined by examining its structure and characteristics, and this would also determine the extent of regulation.
The key regulatory considerations in the UK are not dissimilar to those globally: (i) anti-money laundering requirements; (ii) oversight and regulation by the financial regulator; (iii) appropriate disclosure / advertising standards to protect consumers; and (iv) environmental, social and governance ('ESG') considerations are increasingly becoming significant given the significant resources (computing and energy) involved in mining.
How are cryptoassets and crypto businesses currently regulated in the UK?
Other than security tokens and e-money tokens, other cryptoassets are currently unregulated in the UK. However, even unregulated cryptoassets may be subject to money laundering regulations.
Firms issuing or creating cryptoassets, marketing cryptoasset products and services, buying or selling cryptoassets and firms holding or storing cryptoassets will all need to evaluate if they need to be registered with the FCA for anti-money laundering purposes under the MLRs. In addition, these firms will need to ascertain if any of their activities constitute regulated activities under the FMSA regime and therefore require the firm to obtain the requisite Part 4A (FSMA) permission. For example, because a crypto wallet provider is safeguarding and administering investments.
In addition, marketing of cryptoassets may need to be compliant with the financial promotion regime. Promotions of unregulated cryptoassets will need to be assessed against Advertising Codes issued by the Advertising Standards Authority ('ASA').
In addition, in relation to the nature of cryptoassets it is important to evaluate and exclude other applicable regulations if appropriate such as the Prospectus Regulation (2017/1129) and the Market Abuse Regulation (596/2014).
Are there any protections for retail cryptoasset investors?
In the UK there is a general prohibition against a person carrying on a regulated activity in the UK unless they are authorised or exempt. A regulated activity is a specified kind of activity that relates to a specified investment or property of any kind and is carried on by way of business in the UK. Most crypto assets cannot be classed as specified investments and therefore retail consumers currently have few protections.
For instance, holders of cryptoassets cannot benefit from the financial services compensation scheme. This means that, unlike money in a bank account or investments in a stocks and shares ISA (where the government guarantees that someone’s assets will be protected up to £85,000 for each of cash and investments per institution), holders of cryptoassets have no such protection.
Cryptoassets have other risks too. Cryptoassets can be quite volatile, meaning that you could lose the entire value of your investment overnight. Further, cryptoassets have risks that other investments don’t have. For instance, if you hold your cryptoasset in an online wallet, you could forget the password or if you hold them on a USB stick, you could lose that USB stick and lose the cryptoassets forever. At the moment disclosure of risks is a key tenet of protection for retail consumers. We expect stronger protections for specific crypto asset classes will eventually be required as the consumer warnings are perceived asan inadequate response to misleading advertisements of crypto assets. These are reflected in findings of the House of Commons Treasury Committee report in 2019, where it is clear that AML and consumer focus continue to be important tenets of the proposed UK regulatory response.
What is the UK proposing to do?
The Financial Services Markets Bill (the 'FSM Bill') is currently being reviewed by Parliament and is at the committee stage. At this stage, MPs conduct a line-by-line review and can propose and vote on amendments.
The FSM Bill initially intended to regulate stablecoins as forms of payment. The Government has now proposed a number of amendments to regulate cryptoassets more broadly. Some key amendments (a non-exhaustive list) are summarised below. Should you have questions around any of these, please do not hesitate to get in touch.
New definition of Digital Settlement Asset
The FSM Bill has introduced a new definition of digital settlement asset ('DSA') which differs slightly from the definition of cryptoasset in the MLRs. DSA is defined as a digital representation of value
or rights, whether or not cryptographically secured, that:
(a) can be used for the settlement of payment obligations,
(b) can be transferred, stored or traded electronically, and
(c) uses technology supporting the recording or storage of data (which may include distributed ledger technology).
The key difference is that the proposed definition includes digital assets that may not be cryptographically secured, and that it is used for the settlement of payment obligations (potentially excluding those DSAs that aren’t used for settlement of payment obligations). In addition, the FSM Bill permits the Government to change the definition of DSA as it sees fit, thereby potentially expanding its remit and taking it beyond stablecoins. The FSM Bill allows HM Treasury to make sweeping regulations for (i) payments that include arrangements using DSAs; (ii) recognised DSA service providers; (iii) making insolvency arrangements for (i) and (ii). The FSM Bill provides that the provisions that is made by regulations could apply legislation relation to regulation of e-money and payments to DSAs. As such while the FSM Bill does not itself provide for crypto regulations, it enables HM Treasury to do so in consultation with the FCA and the Bank of England.
An amendment to the FSM Bill proposes that HM Treasury should have the power to designate and regulate businesses that choose to raise money other than through an offering of shares or bonds, such as through an initial coin offering ('ICO') where the issuer raises funds in return for the utility tokens (a more limited cryptographic asset that can only be redeemed for limited services or goods provided by the issuer of the token), thereby potentially bringing these entities within the regulatory purview.
The bill proposes to bring cryptoassets under the FCA’s purview. In short, the amendments enable the FCA to treat cryptoassets as specified investments for the purposes of financial promotion and regulated activities. The Financial promotions regime is likely to be enhanced to cover 'qualifying cryptoassets' per HM Treasury. Amendments currently proposed to the FSMA are on these lines and the final shape of regulation in this regard is likely to be responsive to the consumer risks perceived as arising as a result of cryptoasset investments. This means that anybody who promotes a cryptoasset (such as promoting an ICO) or conducts a regulated activity in relation to a cryptoasset (such as providing investment advice) should expect to be regulated by the FCA.
The rules around cryptoassets are quite technical and complex and, given the proposed changes in the FSM Bill, those will become even more complicated. Given the FTT/FTX saga, more regulatory scrutiny is likely. In this changing environment, our financial services experts are here to help so please feel free to reach out to us if you have any questions.