Government consultation on broadening the regulation of cryptoassets
On 20 July 2020, HM Treasury released a consultation paper regarding cryptoasset promotions (the "Consultation"). In this alert, we briefly review the current regulatory status of cryptoassets in the UK, the changes proposed in the Consultation, and what this means for cryptoasset businesses.
Current state of play for cryptoassets in the UK
The Consultation describes a cryptoasset as "a cryptographically secured digital representation of value or contractual rights that uses some type of distributed ledger technology (DLT) and can be transferred, stored or traded electronically". This definition is the same as that in the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (the "MLRs"). Since 10 January 2020, existing cryptoasset exchange providers and custodian wallet providers have been required to comply with the MLRs, and to register with the Financial Conduct Authority ("FCA") for the purposes of supervision.1
In March 2018, the UK Government set up the Cryptoassets Taskforce (the "Taskforce") consisting of HM Treasury, the FCA and the Bank of England. One of the objectives was to explore the potential impact of cryptoassets in the UK, on both consumers and businesses. In a report published in October 2018, the Taskforce identified certain risks posed by cryptoassets to consumers and markets, concluding that these risks should be mitigated. Risks identified by the Taskforce have been mitigated by actions such as the supervision of certain cryptoasset businesses for the purposes of financial crime compliance (see above), the FCA's consultation and ban on the sale of cryptoasset-based derivatives to retail customers, and the FCA's work on clarifying which cryptoassets already fall within the regulatory perimeter (the "Cryptoasset Guidance").
Under the Financial Services and Markets Act 2000 ("FSMA"), it is a criminal offence for a person to undertake regulated activities in the UK, by way of business, without being authorised to do so (unless an exemption applies). This is known as the "general prohibition". Regulated activities are set out in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (the "RAO"), and comprise "specified activities" carried out in relation to "specified investments". The Cryptoasset Guidance sets out which types of cryptoassets, in the FCA's view, count as specified investments: namely, security tokens. Other types of cryptoasset, called utility tokens, or exchange tokens, are described as unregulated cryptoassets. Electronic money tokens are regulated separately under the Electronic Money Regulations 2011.
In the Taskforce's report, HM Treasury committed to consult on whether the regulatory perimeter currently described by the RAO should be extended to include unregulated cryptoassets, where they are comparable to specified investments. This is addressed by the Consultation, which contains proposals which are intended to further mitigate the risk to consumers, and to ensure market integrity. The Consultation stops short of proposing that cryptoasset business activities be covered by the general prohibition.
The UK Government is concerned that unregulated cryptoassets expose consumers to unnecessary risks, including:
- purchasing unsuitable products without having access to adequate information
- being exposed to fraudulent activity
- risks arising from the immaturity or failings of market infrastructures and services.
The Taskforce identified in particular that misleading advertising and a lack of suitable customer information are a key consumer protection issue. The Government proposes to extend the perimeter of the financial promotions regime to cover promotions of cryptoassets. This is intended to ensure that cryptoasset promotions are held to the same high standard as other financial services promotions, and more specifically, that they are clear, fair, and not misleading.
The financial promotions regime is set out in FSMA, and supplemented with specific FCA rules. Under FSMA it is an offence for a person to, in the course of business, communicate an invitation or inducement to engage in investment activity or claims management activity, unless that person is authorised, the communication has been approved by an authorised person, or the financial promotion is exempt. Investment activity is:
- entering, or offering to enter into, an agreement, the making or performance of which by either party is a "controlled activity"; or
- exercising any rights conferred by a "controlled investment" to acquire, dispose of, underwrite or convert a controlled investment.
Controlled investments and controlled activities are set out in the FSMA 2000 (Financial Promotion) Order 2005 (the "FPO"). Controlled activities include, for example, dealing in securities and contractually based investments, arranging deals in investments, and managing investments. Controlled investments include government and public securities, options and futures.
Currently security tokens (which meet the definition of securities in the RAO) and e-money tokens are specified as controlled investments in the FPO. Most stablecoins will also be "caught" under those categories. The Government now proposes to amend the FPO to include certain unregulated cryptoassets as controlled investments, and to amend certain controlled activities.
The Consultation proposes that "qualifying cryptoassets" are added as controlled investments. The proposed definition reflects that in the MLRs, and is: "any cryptographically secured digital representation of value or contractual rights that uses a form of distributed ledger technology and which:
- is fungible
- is transferable or confers transferable rights, or is promoted as being transferable or as conferring transferable rights
- is not any other controlled investment as described in this Part
- is not electronic money within the meaning given in the Electronic Money Regulations 2011, and
- is not currency issued by a central bank or other public authority."
This definition will cover stablecoins which are not already caught under the FPO, as well as other currently unregulated cryptoassets which are both fungible and transferable. It is those characteristics which the Government considers makes a cryptoasset more likely to give rise to consumer protection concerns. These features make qualifying cryptoassets comparable to other traditional financial services products, such as stocks or bonds. The consumer may, therefore, expect that these products will hold a stable value (or rising value) and be easily transferable on a deep, and liquid market. This is clearly not the case for all cryptoassets.
The Government also intends to make amendments to the controlled activities set out in the FPO, so that they include activities related to the buying, selling, subscribing for or underwriting qualifying cryptoassets. Notably, the Government considers that the activities of cryptoasset exchanges and ATMs, as well as airdrops (as a distribution mechanism) would be covered by those proposed activities.
Exemptions for cryptoasset promotions will be consistent with those available for other activities and investments. However, it proposes one additional exemption: "the financial promotion restriction does not apply to any communication which merely states that a person is willing to accept or to offer qualifying cryptoassets in consideration for the supply of goods or services".
What does this mean for cryptoasset businesses?
There are no immediate changes. The Consultation closes on 25 October 2020, and it will take some time for any changes to be implemented as a Statutory Instrument will be required to make changes to the FPO. Because of this, there will be no transition period.
Once implemented, the changes will significantly impact how affected cryptoasset businesses operate in the UK. Businesses will need to factor in approval of financial promotions to their timelines and budgets, and all promotions will need to be compliant with the FCA's rules on financial promotions. Most notably, all promotions will be required to be fair, clear, and not misleading. As a result of the changes, the FCA will have powers to, for example, require firms to change or withdraw marketing material. In serious cases, firms may be prosecuted and subject to financial penalties.
Whilst there may be changes to the proposals as a result of responses to the Consultation, any changes are likely to be minimal. The Government has made it clear that retaining the status quo is not an option: the unfettered promotion of unregulated cryptoassets poses unacceptable risk to consumers, and it is appropriate that the FCA regulate and supervise cryptoasset activity, given its similarities with other activities and products falling within the FCA's existing remit.
HM Treasury is consulting separately on plans to require authorised firms to obtain specific permission from the FCA in order to be able to approve financial promotions, but currently any authorised firm may approve promotions (provided it does so in accordance with the FCA rules).
The Consultation does not rule out, in the future, 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 requires further analysis to consider whether it would be appropriate and proportionate, and is not being pursued currently.
Nevertheless, the Government is continuing 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 reflecting the Government's commitment in the 2020 Budget to consult on the UK's broader regulatory approach to cryptoassets, including stablecoins. Policy proposals may include measures to supervise the cryptoasset market, particularly with regard to market abuse and manipulation, which the Taskforce has previously identified as a concern.