28 June 2018
Depending on who you listen to, crypto assets - and crypto currencies in particular, along with their associated technologies like smart-contract-enabled blockchains – are set to either change the way we do business or will be consigned to technological history alongside Betamax and the Google Glass. But, for the time being, they continue to develop and could be the most disruptive technology to hit finance since the internet. Understandably, people are concerned: the Bank of England has – somewhat unsurprisingly – questioned the effectiveness of crypto currencies at performing a currency function (owing to their supposed security risks and the time it takes to effect transactions) and the FCA earlier last year issued a consumer warning on crypto currencies in view of their perceived volatility.
But most crypto currencies – Bitcoin aside - are still in the nascent stages of development and as a result, investors and practitioners the world over are keen to understand how they will be treated for regulatory purposes. Is there a regulatory grey area to be exploited? Or are crypto currencies a necessary evolution of financial products such that they will naturally fall within the regulatory perimeter? In its submissions to the Treasury Committee Inquiry on Digital Currencies, the FCA gave some helpful hints as to how it might treat crypto assets in the coming months and years.
First, some caveats: the FCA's submissions do not at all represent published or proposed guidance. Nor can they be taken to be a guarantee of how they will treat crypto assets which the FCA concedes, are likely to be reviewed on a case-by-case basis. Therefore the information in this article must be read in light of these uncertainties. However, the submissions do give a useful insight into the approach the regulator is likely to take when applying its 'case-by-case analysis'. They may also serve as a useful benchmark for practitioners looking to either confirm or reject their initial thinking on this area.
The FCA begins its submissions by drawing upon the current technological limitations that it believes prevents crypto currencies, presently, from challenging existing payment structures. However it acknowledges that the market is growing fast, now containing over 1500 different coins with a cumulative value of around $311 billion. Not bad for something that less than ten years ago, was strictly the reserve of techies and computer boffins, almost on a need to know basis. Despite the technological limitations highlighted by the FCA, crypto assets have necessarily caused existing currency issuers, banks and payment firms to sit-up and take notice.
Up until now, the FCA has been relatively quiet on confirming whether or not crypto assets fall within its regulatory perimeter. Instead, the market has been left to make its own determinations on whether structures involving crypto assets would lend themselves to conventional investment types – like alternative investment funds or collective investment schemes for example. But as the market has grown, the calls for crypto assets to be brought explicitly within the scope of FCA regulation have become louder. Europe is listening too. The Fifth Anti-Money Laundering Directive, due to come into force in 2019 has brought crypto currency exchanges within its reach, looking to require (for the first time) KYC and CDD to be undertaken on participants looking to make deposits on a crypto currency exchange. For modern criminals looking to take refuge in the world of blockchains, ostensibly, the clock is ticking.
So if you are involved in the business of crypto assets, doubtlessly the burning question is whether or not the activity your business is engaged in is in fact regulated. The table below is adapted from the FCA's submissions to the Digital Currency Inquiry and gives an ex ante indication of the regulator's current thinking.
Cypto assets as a medium of exchange
P2P payments and investment assets like Bitcoin and Ethereum
Regulated payments services which use crypto assets
Where a crypto currency/product acts as an intermediary in cross-border transactions
Derivative instruments referencing crypto assets
Financial instruments that bet on price developments (CFDs) or to hedge a position (futures), e.g. CFD providers like IG, Crupto Facilities and Plus500
Investment assets in crypto assets
Direct investments in crypto assets, e.g. Swedish registered exchange traded notes
Tokens representing transferable security
Used in distribution infrastructures for regulated products such as shares and bonds, e.g. issue of traditional shares on public blockchain. Also in the context of ICOs, when tokens amount to transferable security, more akin to regulated equity-based crowdfunding.
Tokens representing a claim on prospective services or products
Tokens that do not amount to transferable securities or other regulated products and only allow access to a network or product. Can also be used as a fundraising mechanism akin to unregulated donation-based and rewards based crowdfunding, also in the context of ICOs.
As mentioned above, the information contained in the table does not constitute formal guidance and is instead drawn from the FCA's experience with its Fintech Innovate programme (where a third of respondents used crypto assets or distributed ledger technology). If anything, it could be argued, particularly in respect of the determinations on security tokens and utility tokens, which in practice represent a wide class of potentially diverse assets, the FCA has simply confirmed the uncertainty felt by most in the market. Furthermore, FCA has stated that it will continue to treat crypto assets on case-by-case basis and because of this, where a firm believes its product is potentially close to the perimeter, caution is advised. The reminder that no one wants to hear is that to fall foul of the FCA's perimeter guidance can be an offence attracting criminal liability.
Taylor Wessing is well placed to advise on ICOs and other crypto asset related matters. For more information contact Arup Sen.