Regulation of Cryptoassets - How robust is the UK government’s plan?

Many believe that cryptoassets (including cryptocurrencies and NFTs) are at a fundamental crossroads in respect of their viability and even their ongoing existence.  However, many also argue that the application of blockchain and other forms of distributed ledger technology (DLT) will continue to grow and become more pervasive, including within the established global financial system.

This article examines some ongoing developments in the UK regarding the regulation of crypto assets which may, rather than being the death blow to “crypto”, be its saviour. Note that certain aspects of the underlying technology referred to and terminology used, if not already familiar to the reader, are explained in previous DACB articles, including “Blockchain: Are You Engaged?”, “Chain Reaction” and “A legal ‘rubber stamp’ for cryptoassets and smart contracts”.

On 1 February 2023 HM Treasury published a consultation and call for evidence on the future financial services regulatory regime for cryptoassets[1], described as “ambitious plans to robustly regulate cryptoasset activities – providing confidence and clarity to consumers and businesses alike” (“the Consultation”).  The Consultation is part of the Prime Minister’s plan to grow the UK economy by embracing technological change and innovation.  The government wishes to give responsible actors the regulatory certainty and confidence to participate in cryptoasset markets and investors the confidence to invest in the UK for the long-term.

The proposals focus on unbacked cryptoassets and build on regulatory measures already in place or underway[2] and are an important next step in a longer process, with further work anticipated as the sector continues to evolve and authorities gather further information on the industry.

In this note we first describe HM Treasury’s proposals before discussing the inherent limitations on the effective regulation of cryptoassets.  Governments and institutions in other jurisdictions around the world are considering similar regulation and they are beyond the scope of this article, but examples include the approach currently being take in Israel, covered here.

“FTX’s failure has underscored important questions around conflicts of interest, market conduct and operational resilience. It has also demonstrated that integrated business models – currently prevalent across the [crypotoasset] ecosystem – can result in complex and sometimes reinforcing risk profiles. Mitigating these risks will require a combination of robust prudential safeguards, operational risk controls, transparency and data reporting arrangements, measures to manage conflicts of interest, good governance and adequate record keeping.”  HM Treasury, 1 February 2023.

Scope

The proposals are centred around a number of important cryptoasset activities – including trading, exchange activities, custody and lending activities - which the government is intending to bring within the regulatory perimeter for financial services. For quick reference, the activities being prioritised for the next phase of legislation are summarised in the following table.

HM Treasury proposes to capture cryptoasset activities provided in or to the UK where those are carried out by way of business.

For each activity the consultation sets out key design features of the regime covering themes such as prudential requirements, data reporting, consumer protection, location policy and operational resilience.

The regulation proposed in the Consultation is not intended to replace or negate the FCA’s existing powers in relation to securities tokens which already meet the definition of a regulated investment.

Another key proposal is a market abuse regime for cryptoassets based on elements of the existing regulation of market abuse for financial instruments. The offences against market abuse would apply to all persons committing market abuse in respect of a cryptoasset that is requested to be admitted to trading on a UK trading venue. This will apply regardless of where the person is based or where the trading takes place. Cryptoasset trading venues would be expected to detect, deter, and disrupt market abusive behaviours.

Issuance activities

For cryptoasset issuance and disclosures, the government proposes to follow a similar approach to that for securities and apply regulation when the asset is admitted to trading on a regulated cryptoasset trading venue and therefore becomes exchangeable for fiat currency, or is subject to a public offer.  In line with the approach applied to securities, HM Treasury does not intend to directly regulate the “creation” of unbacked cryptoassets under financial services regulation.  The latter has the potential to be particularly problematic in the worldwide crypto ecosystem.

The issuance and disclosure regime for cryptoassets will be grounded in the intended reform of the UK prospectus regime – the Public Offer and Admissions to Trading Regime – and tailored to the specific attributes of cryptoassets.  This will include a minimum standard of information regarding a cryptoasset being made available to investors, appropriate liability and compensation for untrue or misleading statements being made in disclosure/admission documents, appropriate due diligence on the content of disclosure/admission documents and an appropriate level of investor protection around marketing materials and advertisements.

For admission of cryptoassets to a UK cryptoasset trading venue, the government is proposing to adapt the Multilateral Trading Facility (“MTF”) model from the intended reform of the UK prospectus regime. The FCA would include principles in its rule book for admission and disclosure requirements that cryptoasset trading venues would then be responsible for administering. Cryptoasset trading venues would be responsible for writing more detailed content requirements for admission and disclosure documents as well as performing due diligence on the entity admitting the cryptoasset. Where there is no issuer (as in the case of Bitcoin, for example), the trading venue would be required to take on the responsibilities of the issuer if they wish to admit the asset to trading.

The FCA will also consider whether ongoing public disclosures should be required subsequent to cryptoassets being admitted to a trading venue.

Exchange/ trading venue activities

Authorisation will be required for operating a cryptoasset trading venue.  Cryptoasset exchanges are currently required to be registered with the FCA for purposes of money laundering regulation.  The new proposals will require exchanges to obtain full authorisation.

The proposed regulatory framework is based on the existing Regulated Activities Order (“RAO”)[4] activities of regulated trading venues, including the operation of an MTF, with similar detailed regulatory requirements including prudential rules, governance and consumer protection requirements, operational resilience, data reporting obligations and restitution and insolvency powers.

Intermediation activities

The government considers that the activities of cryptoasset market intermediaries have much in common with the existing regulated activities of “dealing in investments as principal”, “dealing in investments as agent”, “arranging deals in investments” and “making arrangements with a view to transactions in investments” set out in the RAO.  It is proposed that requirements similar to these analogous regulated activities would be used and adapted for cryptoasset market intermediation activities.  Accordingly, firms conducting these activities in relation to cryptoassets will have to be authorised by the FCA and requirements similar to those in the FCA’s Handbook will be applied covering management bodies, systems and controls, conflicts of interest, prudential rules and conduct of business.

Cryptoasset lending platforms

Cryptoasset lending and borrowing activities conducted by lending platforms typically fall outside the current regulatory perimeter. This means that most of the safeguards in place for traditional regulated lending and borrowing activities are unavailable to users of similar cryptoasset products and services.

Most jurisdictions that have already established regulatory frameworks for cryptoassets have not brought lending and borrowing activities into the regulatory perimeter, though some have signalled the intention to do so.  HM Treasury believes there is a strong case for developing a cryptoasset lending and borrowing regime as a priority.  Readers will appreciate there are various examples of these activities having been problematic in recent times, including as alleged in the FTX case.

The government is proposing to apply and adapt existing RAO activities and existing regulatory requirements underpinning them, while making suitable modifications to accommodate unique cryptoasset features.

Firms operating a cryptoasset lending platform will be required to be authorised by the FCA, with prudential, governance, consumer protection and operational resilience requirements set by the FCA and the application of existing resolution and insolvency powers.

Custody

Custody is a critical component of the cryptoasset lifecycle, providing investors access to, and safe storage of, their assets. Though conceptually similar to traditional finance custody, as the cryptoasset custodian holds itself out as being responsible for safekeeping a cryptoasset on behalf of another, the method/operation of custody is very different, with the information being recorded using DLT (often pseudonymously) and the custodian generally holding a ‘private key’ that allows access to and use of the cryptoasset. The irreversible, immutable nature of cryptoasset transactions means that protecting against unauthorised access to these private keys is especially important.

The Consultation notes the wide variety of current cryptoasset custody business models and practices. The existing lack of regulation in this area means there would be great uncertainty if a cryptoasset custodian failed.  For security tokens, traditional finance custody regulation and methods can apply.

The Law Commission is currently considering whether English and Welsh law needs to be adapted to accommodate digital assets.  Future recommendations from this work will need to be considered by the government in developing the regulatory regime for cryptoasset custody.

The government intends to adapt existing frameworks for traditional finance custodians under Article 40 of the RAO for cryptoasset custody activities, making suitable modifications to accommodate unique cryptoasset features or putting in place new provisions where appropriate.

Custody requirements for fiat-backed stablecoins will be developed first and it is expected the same custody requirements will be adopted for all types of cryptoassets as they come into regulation. For security tokens it is suggested that the existing regulatory framework that currently applies will be replaced by the new custody regime.

The government is exploring taking a proportionate approach to liability standards for cryptoasset custodians, which may not impose full, uncapped liability on the custodian in the event of a malfunction or hack that was not within the custodian’s control.

Cryptoasset investment advice and portfolio management

According to the Consultation, at present (formal) cryptoasset investment advice and discretionary portfolio management services are relatively limited and geared towards institutional and High Net Worth client segments, presenting relatively little immediate risk of financial harms to retail consumers. The extent to which these services could expand and be provided to retail clients in future is unclear.

Though there are parallels to existing regulated investment advice and discretionary management activities, the nature of cryptoassets means that it would be very difficult for managers and advisors to meet the current standards of experience, competence and suitability assessments applicable for traditional finance instruments.  The price and value of an unbacked cryptoasset is driven by speculative investment decisions, rather than market fundamentals which can be objectively assessed.  In contrast, even for high-risk traditional investments such as illiquid securities, advisors have experience and qualifications to conduct due diligence on the corporate issuer.

HM Treasury seeks views on whether there is a case for making cryptoasset investment advice and portfolio management regulated activities.

Other calls for evidence

HM Treasury is calling for views on the following:

• whether the activity of cryptoasset mining should be regulated;
• the extent to which and how decentralised finance could be regulated;
• what information about environmental impact or energy intensity would be useful for cryptoasset investors and whether there are particular indicators or metrics that can be used to calculate these environmental impacts.

Clearly these are broad and deep questions which involve technical and organisational, as well as legal consideration

The limits of regulation

Regulation of cryptoasset activities in the UK can afford a degree of protection to consumers and market participants who choose to deal with cryptoasset businesses authorised here, who have been vetted by and are supervised by the UK regulators.  No doubt for this reason the government and the UK-based industry will be encouraging UK consumers only to use such UK authorised cryptoasset businesses, who could develop a badge of trust through their FCA authorised status (this being anathema to the current cross-border crypto ecosystem. On the other hand some cryptoasset businesses may favour being “based” in unregulated or more lightly regulated jurisdictions.

Consumer research published by the FCA[5] showed that though 3 out of every 4 crypto users surveyed in the UK used an exchange to buy cryptoassets, of these 86% of crypto users did not use a UK exchange at all and 4% used only a UK exchange.  Plainly the government intends that regulation can encourage crypto users to favour UK exchanges. Nevertheless the highly globalised, fragmented and borderless nature of cryptoassets markets makes them extremely challenging to regulate effectively. Cryptoasset trading venues are globally accessible and there is little geographic nexus between the trading venue, the entity who issued the cryptoasset and those trading it.  There are hundreds of different trading venues domiciled in many different countries.

Furthermore, regulation cannot alter the fundamental characteristics of cryptoassets, with the price and value of unbacked cryptoassets often being driven by speculative investment decisions and typically being highly volatile.  There are signs that market misconduct is rife, but it will be hard to drive out trading techniques that give false market signals or distort pricing to the advantage of the orchestrator.  Cryptoassets have a higher proportion of direct retail participation, dispersed globally, than traditional securities markets which creates a gap in surveillance.  Accordingly, it is hard to impose and police such obligations on direct retail market participants, especially if they are trading in a different jurisdiction.  Some of the key requirements of existing market abuse restrictions are built around the concept of a traditional issuer, who is the main holder and creator of price sensitive inside information.  However with cryptoassets there may not be a clearly identifiable issuer or the issuer may be an individual rather than a corporate entity.  In addition, insider information may be more likely to be held or created by entities or individuals other than the issuer.

Despite the limits of cryptoasset regulation, it could be huge economic success for the UK if a significant proportion of that global trading volume could be moved to UK authorised cryptoasset exchanges and intermediaries, or at least if the UK is a key voice in the narrative.  The underlying technologies, and application of them, are not going away anytime soon.

DAC Beachcroft’s Technology and Financial services lawyers advise some of the world’s leading businesses and our team has a breadth of expertise in cryptoassets and DLT/blockchain.

For more information on our advisory offering please contact Tim Ryan or Angela Hayes and check out our Technology and Media team’s Collection on blockchain and cryptocurrency matters.

[1]https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1133404/TR_Privacy_edits_Future_financial_services_regulatory_regime_for_cryptoassets_vP.pdf

[2] Since January 2020, an Anti-Money Laundering and Counter Terrorist Finance (AML/CTF) registration regime has been in place for businesses undertaking cryptoasset exchange or custody wallet services in the UK, in order to regulate compliance with the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (“MLR”). The government will shortly introduce legislation to require the regulation of promotions of cryptoassets by the FCA to ensure promotions are clear, fair and not misleading. The government is also currently legislating in the Financial Services and Markets Bill 2022 to introduce a regime that will allow for the regulation of fiat-backed stablecoins which are used for payments, similar to that for other payment methods.

[3] The government is already taking forward a regime for fiat-backed stablecoins which are used in payments.

[4] The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001, as amended.

[5] https://www.fca.org.uk/publications/research/research-note-cryptoasset-consumer-research-2021#lf-chapter-id-results-purchase-and-engagement