By Jonathan Brogden, Mathew Rutter & Millie Bailey
|Published 03 February 2022
Following HM Treasury’s Consultation Paper published in July 2020, it published a Consultation Response (the “Response”) on 18 January 2022. The Response confirms the UK Government's plans to expand the current UK financial promotion regime to include cryptoassets, by amending the scope of the Financial Services and Markets Act 2000 (‘FSMA’) (Financial Promotion) Order 2005 ("FPO"), although the precise timing of these changes is yet to be determined.
The UK's financial promotion regime is intended to ensure appropriate controls are in place in relation to the marketing of financial products. These controls essentially require that such products can only be marketed:
(i) by firms authorised by the UK Prudential Regulation Authority or Financial Conduct Authority ("FCA"), in accordance with rules laid down by the FCA, or
(ii) by unauthorised persons, provided that the communication has been approved by an authorised person or where the communication meets the requirements of an exemption set out in the FPO.
Most cryptoassets currently fall outside the scope of the UK regulatory regime, but the FCA consider they may pose similar financial stability and consumer risks as regulated financial products and services. As a result, cryptoassets are not presently subject to the same consumer protections or safeguards found in other areas of financial services and payments. This may expose consumers to harm.
The Cryptoassets Taskforce, consisting of HM Treasury, the Bank of England and the FCA, published a report in 2018 which found that misleading advertising and a lack of suitable information was a key consumer protection issue in cryptoasset markets. It found that cryptoasset advertising, often targeted at retail investors, can overstate benefits and rarely warns of volatility risks.
A financial promotion is an invitation or inducement to engage in investment activity. Investment activity is defined as a "controlled activity" in relation to a “controlled investment”. The regime covers any promotion which is capable of having effect in the UK, wherever the person making the communication is located.
The Response confirms that HM Treasury intend to expand the definition of “controlled investment” to include “qualifying cryptoassets”, thereby bringing them within the financial promotion regime.
Although the exact definition is not yet confirmed, the current proposed definition of a “qualifying cryptoasset” identifies the following defining characteristics: (i) fungibility (ii) transferability (iii) not electronic money, and (iv) not a currency issued by a central bank or public authority.
The requirement for transferability has been introduced by HM Treasury in response to concerns that the original definition could have included digital vouchers and customer loyalty schemes that are cryptographically secure. The transferability requirement will therefore mean that tokens such as travel passes, lunch passes, and supermarket loyalty schemes that are cryptographically secure are excluded from the regulatory regime. By contrast, tokens which can be traded between users for speculation or other purposes, and which meet the other elements of the definition, will be in scope.
The Response also includes some of helpful clarifications. A number of respondents to the consultation raised concerns that the exclusion of non-fungible tokens ("NFTs") could leave buyers of NFTs exposed. HM Treasury have confirmed the view that NFTs bear many of the characteristics of non-financial products and therefore do not belong in the financial promotion regime. As to concerns that this approach could lead to fungible tokens being wrapped inside non-fungible tokens in order to evade the regime, the view of HM Treasury is that a wrapped token could present key characteristics of fungibility if it could be readily interchanged with other similar tokens. If that was the case, it is likely that it would still be caught by the new rules.
While hybrid tokens are not specifically identified under the proposed amendments, HM Treasury have formed the view that it is likely that these tokens will fall to be defined as a qualifying cryptoasset or another controlled investment and in which case the regime will apply to them. Security tokens are already captured as controlled investments.
HMT’s July 2020 proposals included Distributed Ledger Technology (“DLT”) as an element of the proposed definition of qualifying cryptoasset. After feedback, the new proposed definition will not include DLT as a defining feature; this will future-proof the rules after suggestions that while DLT is currently used, this may change as the industry evolves. Crypto wallets will not be within the scope of the regime given the reduced risk profile compared with the buying and selling of cryptoassets.
Legislation amending the FPO is required before the new regime comes into force and its implementation will need to be co-ordinated with the introduction of new FCA rules to ensure that the two elements of the regime come into force at the same time. HM Treasury have announced that there will be a six-month "transitional period" between finalisation and publication of both the amendments to the FCO and the FCA's rules before they come into force.
As part of a wider review of its financial promotion rules for high risk investments, the FCA are proposing including qualifying cryptoassets within their new rules restricting promotions relating to "Restricted Mass Market Investments". The FCA cites the pandemic as a cause for accelerating consumer trends in higher risk investments. Whilst the FCA recognises that high risk investments have a place in a well-functioning consumer environment, it makes clear that consumers need to understand the risks involved. The FCA is concerned that financial promotions which adhere to the current rules may not offer enough protection for consumers in the high-risk environment. Further, cryptoassets often sit outside the regulatory perimeter (presently the FCA only regulates crypto asset firms for money laundering purposes). The Consultation Paper seeks to establish three categories of financial promotions to which varying levels of marketing restrictions will apply.
The FCA have sought to simplify the classification categories which determine the levels of marketing restrictions on each product. Therefore, “Qualifying Cryptoassets” will now fall within a new category of Restricted Mass Market Investments ("RMMI"). While mass marketing to retail investors of RMMIs will be allowed, it will be subject to new restrictions. This category will be subject to the same restrictions which currently apply to Non-Readily Realisable Securities (NRRS) and Peer-to-Peer (P2P) investments.
The restrictions applicable to RMMIs will include:
The ban will apply to any ‘refer a friend’ or ‘new joiner bonus’ schemes which are designed to achieve rapid growth in investment. Even when these schemes are used legitimately, the FCA considers that these inducements may influence consumers investment decisions and result in consumers not fully considering the risks involved.
Accordingly, any financial promotions which include monetary or non-monetary benefits that incentivise investment into high risk investments will be banned.
The FCA is concerned that consumers are not engaging with current risk warnings such as “your capital is at risk” and therefore proposes new wording which will be required for all Restricted Mass Market Investments. Rules and guidance as to the presentation of the risk warning will be provided in order to ensure that this has the intended effect on consumer behaviour.
The FCA’s aim is to prevent consumers from rushing into investments which they have failed to adequately consider the risks of. The FCA has proposed to introduce 2 "positive frictions", designed to prevent customers from just clicking through and investment in products they do not understand:
a) A personalised risk warning pop-up for first time investors with a firm.
b) A 24-hour cooling off period for first time investors with the firm.
These positive frictions are only intended to apply the first time that consumers look to invest with a firm.
The FCA seeks to address the concern that individuals are categorising themselves as ‘high-net worth’ or ‘sophisticated’ without realising the impact of this categorisation.
The FCA propose to implement an evidence declaration where consumers are required to state why they meet the relevant criteria. In order to assist with this, the FCA will recommend simplifying the language used in the declaration.
The FCA is also proposing further guidance on the scope of the appropriateness test to be applied to all direct offer financial promotions of RMMIs, including qualifying cryptoassets.
Direct offer financial promotions are any financial promotion which includes an offer from a firm to conduct investment business with anyone who responds to the promotion, or invites those who respond to make an offer to the firm to engage in investment activity.
The current appropriateness test requires firms to gather information on an investor to assess the investor's knowledge and experience, but the FCA has identified multiple issues with how firms currently implement the test.
The FCA propose to introduce guidance on the types of question to be covered by the appropriateness assessments for RMMIs, including qualifying cryptoassets. The FCA have clarified that this will not be a complete list of items to cover in the appropriateness test.
The FCA further propose that direct offer financial promotions for RMMIs should only be made to the following types of investor:
a. Certified High Net Worth Investors – Investors that have signed a statement confirming that they are a high net worth individual.
b. Certified Sophisticated Investors – Investors that are certified as sophisticated given there prior experience and knowledge.
c. Self-certified Sophisticated Investors – Investors who have signed a statement confirming that they are sophisticated.
d. “Restricted Investors” – Individuals who have signed a statement confirming that they are not investing more than 10% of their net assets in the product.
The FCA intend to publish their final rules in summer 2022 and propose that the changes in the Consultation will apply to promotions of qualifying cryptoassets from the date they are brought within the financial promotion regime.
Retail investment in the crypto market exploded in 2021. It is a hugely volatile market with new currencies and tokens being launched on a regular basis. The increase in leveraged and derivative trading opportunities also exposes investors to increased risk of complexity and the prospect of losses over and above the value of their initial investment.
Increased regulatory interest and involvement in the way in which cryptoassets are marketed and sold has been inevitable and the proposals are, in broad terms, a proportionate response to the risks inherent in the market without stifling it. Whether regulators take a greater interest beyond these steps remains to be seen.
It is particularly important to note that proposals from HM Treasury and the FCA will only apply to promotions of cryptoassets. They will not affect the regulatory status of the underlying activity, so if an activity relating to cryptoassets is not regulated under the current regime it will remain unregulated under the new rules. The new rules will also not affect the existing AML/CTF regulatory perimeter.
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