Crypto View - December 2021

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In an earlier edition than normal, we thought we would treat you to a bumper festive edition of Crypto View. Even though it’s only been a couple of weeks since November’s edition, there have been plenty of developments in crypto to discuss. We look at the discussion paper the European Central Bank (ECB) issued on central bank digital currencies (CBDC), the targeting of crypto firms by the Advertising Standards Authority (ASA), some interesting litigation developments in the world of crypto, as well as some institutional developments with ISDA and debt markets. This should hopefully leave you with enough to read over the holiday period until the next edition at the end of January!

ECB CBDC

Earlier this month, the ECB published a paper on Central Bank Digital Currencies. In particular it looks at the success factors of CBDC, and how it might avoid the risk that has been raised by many banks that CBDC might be too successful and lead to bank disintermediation. The ECB launched a two year investigation into a digital Euro project earlier this year, and it seems from the tone of this paper that there is a definite expectation that a digital Euro will eventually be issued. The paper highlights three key success factors of a CBDC, namely:

• Widespread merchant acceptance;

• efficient distribution of CBDC;

• demand from consumers to pay with CBDC.

It also looks at the possible scope that a CBDC may have. On one hand, a central bank is in a unique position in terms of credibility and economies of scale that it makes sense to aim for as broad a scope as possible, further, too narrow a scope could mean that a CBDC would not be as attractive, leading to low demand. On the other hand, the narrower the scope, the lower the risk of crowding out the private sector, and a broad-scope CBDC might prove hard to manage from a project perspective and suffer delays in introduction.

Overall, it is an interesting discussion paper, which doesn’t come to any firm conclusions, indeed it acknowledges that many questions about the design of a CBDC still need to be addressed, specifically the functional scope, business model and controls required to meet demands and ensure robust use. Nevertheless, it does seem that it is a matter of when, not if, a Euro CBDC is launched.

Adverting in the UK

The ASA has been in the news this week, issuing rulings against seven cryptoasset firms for breaching their CAP Code (well, six crypto firms and a pizza company). This follows the ASA’s announcement that it was going to clamp down on misleading marketing for crypto. While the ASA does not have any real power to carry out enforcement action against those it issues rulings against, it can refer firms that consistently breach its Code to the Competition and Markets Authority, which could in theory lead to prosecution. The ASA has said that it will set out further guidance on crypto advertising next year, which is welcome considering that the current guidance it has in place is both confusing and confused, saying that those cryptocurrencies and assets that are outside of the FCA’s remit “are not financial products even if they are presented as such.", while simultaneously relying on the CAP Code Rule 14 on Financial Products in all of its rulings against cryptoasset firms.

This comes against the backdrop of HM Treasury’s consultation into Cryptoasset Promotions, the responses to which should be being published soon (it was suggested Q4 this year, though that is running out quickly). We noted in Nikhil Rathi’s appearance at the Treasury Select Committee on the 8th of December that he is expecting the FCA “to get some new powers around financial promotions and cryptoassets,” which as we have mentioned previously, could be a real issue for the industry. The appearance was also interesting in that it confirmed our suspicions that a lot of the complaints to the ASA on advertising have not come from the public, but rather the FCA. It also shows a continuing negative approach from Mr Rathi to the cryptoasset industry. This is definitely an area to keep a close eye on as we head into the new year.

Change to FCA procedure for registrations under the Money Laundering Regulations (MLRS)

In other FCA news, which we didn’t manage to squeeze into the November edition of Crypto View, the FCA issued PS21/16 on “Issuing Statutory Notices – a new approach to decision makers”. This sets out changes that could impact the crypto industry, as while broad, it includes decisions made under the MLRs. You may have seen that in October this year the FCA reported that 90% of applicants assessed up to that date had either been rejected or had voluntarily withdrawn following “robust” engagement with the regulator. Until recently, if a disappointed firm wished to challenge the FCA’s decision it could have done so before the FCA’s Regulatory Decisions Committee (RDC). The RDC is a committee of the FCA Board which is independent of the team responsible for considering the firm’s application. The RDC would act as the FCA’s decision-maker regarding the application, after hearing representations from the applicant and the FCA Authorisations team. However, following a change which came into effect on 26 November 2021, the FCA’s decision maker for such applications will now be “executive decision makers” – essentially senior FCA staff who will not have the same level of separation from the Authorisations team as the RDC. If an applicant wishes to challenge their decision it must do so before the Upper Tribunal, a Court which is wholly independent of the FCA and which will hear the case afresh with the benefit of full disclosure from the FCA. While the option of challenging before Upper Tribunal was always available to the applicant following the RDC’s decision, it is now the immediate next step if the applicant disagrees with the FCA’s decision. For more information on this, please reach out to my colleague Doug Robinson.

English courts apply trusts to cryptoassets

English commercial law is largely based on longstanding concepts such as property rights. For parties transacting in cryptoassets it is important to understand the extent to which those concepts will apply if they are to have legal certainty. The Courts have recognised cryptoassets as property under English law, meaning that parties can, for example, obtain freezing orders in respect of it. In Wang v Darby the Court continued this trend, applying the concept of trusts to cryptoassets for the first time.

The case concerned Tezos (XTZ). A holder can transfer Tezos to another for the purposes of generating yield. Mr Wang transferred Tezos to Mr Darby in exchange for Bitcoin, it being understood that Mr Darby would use the Tezos to generate yield and at a future date return the Tezos to Mr Wang in exchange for the Bitcoin. The relationship broke down and Mr Wang alleged that Mr Darby held the Tezos on trust for him.

The Court concluded that a trust did not arise on the facts because the transaction was more like a repo: Mr Wang was not entitled to the return of the Tezos until he returned the Bitcoin. Nevertheless, the Court recognised that the Tezos could in principle be held on trust. It will therefore be possible for a trust over cryptoassets to arise depending on the nature of the transaction. For example, where one party holds cryptoassets on behalf of another a trust may arise.

Court orders information disclosure by exchange

In Mr Dollar Bill Limited v Persons Unknown [2021] EWHC 2718 the Court was asked to make a Norwich Pharmacal order against a crypto exchange. A Norwich Pharmacal order is a form of disclosure order, requiring a third party to disclose information so as to enable a claimant to trace assets or to bring proprietary claims against another. Here, a fraud victim sought an order against exchanges for the purposes of obtaining information from them concerning alleged fraudsters who used the exchanges.

A closely related kind of order, called a Bankers Trust order, has in the past been granted against crypto exchanges. However, until now it had been thought that a Norwich Pharmacal order could not be obtained against an exchange based outside the UK, because the criteria for service out of the jurisdiction could not be satisfied. Mr Dollar Bill case suggest that it is indeed possible, albeit the case was heard without the exchanges in question being present to make submissions. It is not clear whether the Court considered all of the counter-arguments that might have been made against the order and therefore whether this decision might be reversed in future. In any event, it provides a further illustration of the English Courts applying longstanding legal concepts to cryptoassets.

Law Commission update on digital assets and smart contracts

As promised last month, we’ve looked further at the Law Commission’s advice to the Government on smart contracts. The Commission is undertaking work to ensure that English law recognises and protects digital assets and to analyse the application of the law to smart contracts. In November 2021 the Commission published an update on this work and its advice to Government on smart contacts.

The Commission’s update states that it would be useful to resolve the current ambiguity as to the legal categorisation of certain digital assets, which is considered to be an important area of legal uncertainty. The Commission will therefore publish a consultation paper in mid-2022 which will consider whether it would be appropriate for the law to recognise that certain digital assets could fall within a new “third category” of personal property. This third category would be distinct from the two existing categories of personal property, namely “things in action” and “things in possession”, and would reflect more accurately the idiosyncrasies of digital assets, which operate in different ways to the two existing categories.

Regarding smart contracts, the Commission has concluded that the current legal framework in England is able to support the use of smart legal contracts, without the need for statutory law reform. Current legal principles can apply to smart legal contracts in much the same way as they do to traditional contracts, albeit with an incremental and principled development. Although some types of smart legal contract may give rise to novel legal issues, in particular those that are solely in code form with no use of natural language, existing legal principles can nevertheless accommodate them. The Commission notes that the market has an opportunity to anticipate potential uncertainties in the legal treatment of smart legal contracts by including express terms aimed at addressing them. For example, the Commission encourages parties to include their choice of court and law in their smart legal contract.

ISDA

ISDA, the derivatives trade association, announced this week that it was in the process of developing contractual standards to cover disruption events. The paper that it published addresses three key areas, it:

• Identifies novel technology and market-driven events that could disrupt the operation of a digital asset derivatives transaction and provides a framework for dealing with these events;

• Explores how digital assets (and the derivatives that reference them) can be valued and what happens when a valuation cannot be obtained; and

• Analyses how digital assets might interact with the existing ISDA documentation architecture, including the ISDA Master Agreement and industry standard collateral documentation.

The aim is to bring together derivatives market participants, members of the crypto-asset community and other stakeholders to help develop common legal standards and definitions – an important development in the cryptoderivatives world, especially with more and more institutional financial services firms getting involved with the asset class. Interestingly we also saw Coinbase and FTX both joining ISDA, highlighting the developments and progress that is being made with regards to this section of the industry.

SIX Group

Finally, this month we saw the world’s first digital bond issued in a fully regulated environment. SIX, the Swiss exchange, launched its Digital Exchange by issuing a digital bond, with a total volume of CHF 150 million and maturity in 2026. This marks a milestone in the tokenisation of securities, and we’re looking forward to how this develops further in 2022.