Technological development in the cryptoasset space is rapid and regulatory focus on cryptoasset technologies is intense.
The COVID-19 pandemic has increased the appetite for cryptoassets – especially Bitcoin, which has reached highs not seen since 2018. The challenge for regulators is to identify when they need to take action to protect consumers from the harm that cryptoassets can cause, and when they need to take steps to harness the potential benefits of cryptoassets (by removing barriers to competition, for example).
Against the backdrop of this challenge, 2019 and 2020 have been busy years for cryptoassets. The highlights include guidance from the Financial Conduct Authority on how cryptoassets interact with the FCA's 'perimeter', and the European Commission launching a consultation followed by legislative proposals on its regulatory framework, in addition to a broader consultation on the EC's digital finance strategy for Europe.
So what are the key cryptoasset-related developments in the UK and EU?
The word "cryptoasset" covers a multitude of instruments, which are treated differently by the UK regulatory regime. From those cryptoassets which constitute securities, treated like shares or bonds, to those akin to electronic money or e-money, each category of cryptoasset is treated differently.
To shed some light on this complex landscape, the FCA published guidance on cryptoassets in July 2019. The FCA explained that the guidance "will enable market participants to understand whether certain cryptoassets fall within our perimeter or are otherwise regulated". The FCA's guidance considers two categories of cryptoassets (unregulated and regulated tokens) and provides practical case studies.
Broadly speaking, there are two types of regulated token: security tokens and e-money tokens. Tokens that do not provide any rights or obligations akin to specified investments, as regulated tokens do, are generally considered to be unregulated.
Security tokens are "those tokens that provide rights and obligations akin to specified investments as set out in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO) excluding e-money. These tokens may also be financial instruments under MiFID II".
The types of specified investments contained in the RAO of most relevance in the context of security tokens are shares, debt instruments, warrants, certificates representing certain securities, units in collective investment schemes, and rights and interests in investments.
E-money tokens are "tokens that meet the definition of e-money under the EMRs". Under the Electronic Money Regulations 2011, e-money is defined as "electronically (including magnetically) stored monetary value as represented by a claim on the electronic money issuer which: (a) is issued on receipt of funds for the purpose of making payment transactions; (b) is accepted by a person other than the electronic money issuer; and (c) is not excluded".
The FCA explains that electronic storage of monetary value includes the possibility of using distributed ledger technology and cryptographically secured tokens to represent fiat money (for example, GBP or EUR).
Cryptoassets which establish a new sort of unit of account (rather than representing fiat money) are unlikely to amount to e-money unless the value of the unit is pegged to a fiat currency, but even then it will still depend on the facts of each case.
Unregulated tokens are "those tokens that do not provide rights or obligations akin to specified investments (like shares, debt securities and e-money)", so essentially all other tokens not covered by the security and e-money token categories.
Where a person is engaged in activity by way of business in the UK, that relates to a security token, or to a token that constitutes e-money, they should consider whether those activities require authorisation or registration.
The FCA understands that there can be "particular difficulty" in categorising tokens, and that a cryptoasset could potentially fall within the regulated category, even if it started its life as an unregulated token. Therefore, the exact activity will determine what permissions a firm requires from the FCA.
In July 2019, the FCA published a consultation on a proposed ban of derivative instruments referencing certain cryptoassets. The scope of the ban would apply to derivatives (that is, options, futures and contracts for differences) and exchange traded notes (ETNs) that are based on “unregulated transferable cryptoassets” by FCA regulated firms to retail clients.
The FCA considers that crypto-derivatives and ETNs are not suitable for retail consumers due to:
Based on its cost-benefit analysis, the FCA estimates that a ban on crypto-derivatives and ETNs could reduce losses for retail consumers by between £75 million and £234.3 million.
From January 2020, the FCA became the Anti Money Laundering and Counter Terrorist Financing supervisor of businesses carrying on cryptoasset activities. Any UK business conducting specific cryptoasset activities falling within scope of the regulations – such as Cryptoasset Exchange Providers and Custodian Wallet Providers (including persons making an initial coin offering) – need to comply with the FCA's requirements which, among other things, require cryptoasset businesses to:
More recently, in July 2020, the Joint Money Laundering Steering Group, which comprises UK financial services industry trade bodies, published new guidance for Cryptoasset Exchange Providers and Custodian Wallet Providers regarding compliance with anti-money laundering obligations. The guidance provides an outline of the risks posed by cryptoassets and how cryptoasset firms can mitigate such risks.
Although the guidance is not legally binding, once approved by the HM Treasury, UK courts will take into account whether a firm has complied with the guidance when determining if it has committed a money laundering offence, and the FCA will also take the guidance into consideration when investigating breaches of its rules.
Also in July 2020, HMT announced a consultation on a proposal to bring certain cryptoassets into the scope of the UK's financial promotions regime. Currently, only security tokens and e-money tokens fall within the regime, but the proposed amendments would bring unregulated cryptoassets (including utility tokens and exchange tokens) into scope.
There are concerns that applying the financial promotion regime to too wide a range of cryptoasset activity could stifle innovation without a proportionate benefit to consumer protection. Accordingly, the proposed definition of “qualifying cryptoassets” includes only those cryptoassets that are both fungible and transferable.
HMT's July 2020 consultation contains additional thinking in relation to other changes to the regime more generally, such as including cryptoassets as specified investments in the RAO. This would mean that cryptoasset businesses would need to be authorised by the FCA in order to conduct activities in the UK. However, cryptoasset businesses may breathe a sigh of relief as the consultation notes that this option will require further analysis to consider whether it would be appropriate and proportionate and is not currently being pursued.
Nevertheless, the government continues to consider wider regulatory measures to address other risks arising from the buying and selling of cryptocurrencies. There will be a further consultation on this later in 2020 (expected Q4 2020/Q1 2021) to reflect the government's commitment in the 2020 Budget to consult on the UK's broader regulatory approach to cryptoassets.
In September 2020, BoE Governor Andrew Bailey made a speech with a focus on stablecoins and digital currencies. Mr Bailey recognised that stablecoins can offer some useful benefits, for example by reducing frictions in payments, however, he warned that "if stablecoins are to be widely used as a means of payment, they must have equivalent standards to those that are in place today for other forms of payment types". This will ensure that consumers can use them with confidence.
The Governor also advised that the BoE "will strongly consider the need for an entity to be incorporated in the UK" for any sterling retail stablecoin wanting to operate at scale in the country. However, he added that as a global stablecoin is a "cross-border phenomenon" which "can be operated in one jurisdiction, denominated in another's currency and used by consumers in a third", the regulatory response must match this by being grounded in internationally agreed standards.
Mr Bailey went on to consider whether a better outcome would be for central banks to "harness much of the technological and IT systems innovation and directly digitise cash". Offering a Central Bank Digital Currency (CBDC) would allow broad access to central bank money in a digital form. But the Governor noted that while offering a lot of potential, CBDC raises profound questions about the shape of the financial system, the role of the central bank, and to what extent it would "disintermediate" the banking sector.
In December 2019, the EC launched a consultation, inviting stakeholders to "express their views on the best way to enable the development of a sustainable ecosystem for cryptoassets while addressing the major risks they raise".
The consultation is a first step towards establishing a regulatory framework designed to facilitate the deployment of new technologies and ran in parallel with a consultation on digital operational resilience.
This consultation is just one part of the EC's new Digital Finance Strategy for the EU. The EC intends to present its Digital Finance Strategy in October 2020, which will promote digital finance in the EU while regulating the risks that digitalisation presents.
In its wider Digital Finance Strategy consultation (launched in April 2020), the EC identifies the following priority areas for the development of digital finance in the EU:
In June 2020, the EC outlined its current thinking, in relation to the regulation of cryptoassets, based on the responses it has received to its consultations to date. It explained that "lack of legal certainty is often cited as the main barrier to developing a sound crypto-asset market in the EU" and that it intends to change that. But, in order to make changes "we need a common approach: one that supports and stimulates innovation".
In particular, the EC intends to:
The EC has since published a draft Regulation on the market in cryptoassets in the EU. This legislation sets out a bespoke legislative regime for markets in cryptoassets, a pilot regime for DLT market infrastructures, and amendments to the definition of "financial instruments" under MiFID II, providing greater legal certainty around cryptoassets.
If you'd like to discuss any of the issues raised in this article, please contact a member of our Financial Services Regulatory team.
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