Crypto view - July 2022

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Welcome to July’s edition of Crypto View. It’s been another busy month, with the crypto markets facing multiple shocks. The start of the month was dominated by the news of the liquidation of Three Arrows Capital, and the related contagion across multiple firms.

This month’s edition looks at the recent Financial Services and Markets Bill which is beginning its journey through the UK parliament and the impact this could have on the world of stablecoins. We also take a look at three papers that the Bank of International Settlements (BIS) have published, continuing a focus of regulators and supranational bodies on stablecoins and CBDCs. There was an interesting English court case looking at enforcing rights against trustees holding stolen cryptoassets, which also featured a world’s first service by NFT. We could not ignore the two UK and a US “Calls for Evidence”. Finally, we continue our new monthly feature on MiCA.

Financial Services and Markets Bill

The Financial Services and Markets Bill (FSMB) was introduced to UK Parliament on 20 July. While the focus of the FSMB is to empower HMT and UK regulators to introduce new legislation to replace retained EU legislation over the coming years, there are several sections of interest to the crypto industry.

First, the FSMB introduces the gateway for financial promotions that we have previously raised. This, when combined with cryptoassets being brought within scope of the financial promotion regime, will mean that authorised firms will need to apply to the FCA to be able to approve the financial promotions of unauthorised firms. Interestingly, the draft FSMB also enables HMT to make regulations to exempt certain activities or firms from the requirement to seek permission to approve the promotions of third party firms. This could be a route to ensure that authorised firms are not required to seek permission to approve the financial promotion of crypto firms – widening the pool of potential approvers to all authorised firms. This could be seen as slightly helpful, but still does not improve the situation satisfactorily: the difficulty that authorised firms are unlikely to take the risk of approving others’ promotions, given the requirement to have the necessary skills to do so, remains

The FSMB also introduces the concept of “digital settlement assets” (DSAs). This is defined in the bill as a digital representation of value or rights, whether or not cryptographically secured, that—
(a) can be used for the settlement of payment obligations,
(b) can be transferred, stored or traded electronically, and
(c) uses technology supporting the recording or storage of data (which may include distributed ledger technology).

Note that this does not require that the DSA is issued on receipt of funds, nor that it represents a claim on the issuer – meaning that it will capture stablecoins that do not meet the definition of electronic money. Notably, the FSMB does not automatically regulate DSAs, but does introduce powers for HMT to do so (including giving them the power to amend the definition itself! - surprising as the perimeter determines what is and what is not a criminal offence and should be the subject of parliamentary scrutiny). It also, more generally, brings the firms that engage with DSAs (DSA Service Providers) into the UK payment services infrastructure. This includes issuers, custodians, exchanges, and any other person that provides services or supports the transfer of money or DSAs to be made using the payment system, including any infrastructure provider in relation to the system.

Also of interest is the formal introduction of the Financial Market Infrastructure (FMI) Sandbox. As discussed in our Insights article on the (then) City Minister, John Glen’s, speech in April, the FMI Sandbox will be run by the Bank of England and the FCA. It provides a regulatory framework for firms to experiment and innovate in providing the services that underpin markets.

In his speech introducing the FSMB, the Chancellor also confirmed that the government will take forward work to understand the application of DLT to the lifecycle of a UK sovereign debt instrument. We’ll be keeping an eye on developments in this area.

One case, two legal firsts: service by blockchain and liability for exchanges

In what marks not one but two legal firsts in England, the High Court has ruled that service of legal proceedings can be effected via the blockchain and crypto exchanges may be liable as a constructive trustees towards the victims of fraud.

Victims of crypto-related frauds will often not know the identities of the fraudsters who have taken their assets. This makes it challenging to serve legal proceedings on them and to recover the misappropriated assets. In D’Aloia v. (1) Persons Unknown, Mr D’Aloia faced just those challenges. His digital assets had been misappropriated by “Persons Unknown” operating a fraudulent clone online brokerage. Mr D’Aloia was able to identify the exchange-hosted wallets where his assets had been moved to, but could not contact the controllers of those wallets for the purposes of serving proceedings on them. There was also the risk that the fraudsters might move his assets from the wallets in the interim.

Mr D’Aloia therefore obtained from the Court permission to serve proceedings on the fraudsters by way of NFT airdrops to wallet addresses known to be associated with them. This is significant because it potentially opens the way to digital service over the blockchain becoming the norm in future. In addition to serving the fraudsters, Mr D’Aloia was also able to protect himself against the risk of assets being moved; he successfully argued that the exchanges may hold his assets as constructive trustee. This is significant because it means that the exchanges (rather than the fraudsters) would be liable to Mr D’Aloia if they permitted the fraudsters to move the assets in breach of trust. Accordingly, exchanges who onboard fraudsters as customers could face significant liability towards fraud victims in future.

BIS

The BIS has been busy this month in the world of crypto, publishing three different papers, covering quite different areas.

The first came on 30 June, and was the second consultation on the prudential treatment of cryptoasset exposures. This consultation seeks to address concerns raised by respondents to the first consultation, from June 2021, by adding more detailed tests, but does not fundamentally alter the conservative approach adopted earlier, which would in our view continue to restrict the adoption of crypto assets by banks.

One example of this is the quantitative test for a stablecoin to be in Group 1b and then subject to a lower capital charge. In this paper, BIS accepts that the test as proposed earlier could lead to cliff edge results, and introduces a more granular two-pronged test:

• Redemption risk test: The objective of this test is to ensure that the reserve assets are sufficient to enable the stablecoin to be redeemable at all times, including during periods of extreme stress, for the peg value (i.e., the value of the reference asset(s) to which one unit of the stablecoin is designed to be redeemable).
• Basis risk test: The objective of the basis risk test is to ensure that the holder of the stablecoin can sell it in the market for an amount that closely tracks the peg value. As before, the extent of deviation allowed is 10bps but adds that (1) if the peg-to-market value difference does not exceed 10bp more than 3 times over the prior 12 months, the stablecoin has “fully passed” the basis risk test. (2) if the peg-to-market value difference exceeds 20bp more than 10 times over the prior 12 months, the stablecoin would have “failed” the basis risk test and finally, (3) if the cryptoasset has neither “fully passed” nor “failed” the basis risk test, it is considered to have “narrowly passed” the basis risk test.

Stablecoins that meet all the classification conditions for inclusion in Group 1b, but only narrowly pass the basis risk test, will be subject to an add-on to risk weighted assets.

Comments should be uploaded at www.bis.org/bcbs/commentupload.htm by 30 September 2022.

A second paper was published by BIS on 11 July. It discussed options for access to and interoperability of CBDCs for cross-border payments. This is something that we are seeing regulators increasingly interested in, and this paper looks to ensure that different jurisdictions who are working on a CBDC must take the cross-border functionality into account at an early stage to avoid unintended barriers later. There is huge scope and promise for CBDCs to improve cross-border payments, however if functionality is not inbuilt from the start, the conflicts between different CBDCs may block this potential.

The report is a response to Action 2 of Building Block 19 of CPMI report to the G20, and presents different options for access to and interoperability of CBDC systems to facilitate cross-border payments. The various options are assessed against five criteria: do no harm, enhancing efficiency, increasing resilience, assuring coexistence and interoperability with non-CBDC systems, and enhancing financial inclusion.

The final paper came out on 12 July and covers the application of the Principles for Financial Market Infrastructures to stablecoin arrangements, against a background of the G7, the G20 and the Financial Stability Board (FSB) calling upon the standard-setting bodies to revise standards and principles, and provide guidance in light of stablecoins’ potential impact on the financial system. The report provides guidance on the application of the Principles for Financial Market Infrastructures (PFMI) to stablecoin arrangements (SAs) that are considered systemically important financial market infrastructures (FMIs), including the entities integral to such arrangements. The guidance covers Governance, Comprehensive risk management, Settlement finality, and Money settlements.

Calls for Evidence

The government has published a Call for Evidence on the tax treatment of decentralised finance (DeFi) transactions involving the loaning and staking of cryptoassets. The purpose of the call for evidence is to obtain more evidence about how the tax treatment impacts DeFi activities and to inform the government’s options for reducing the administrative complexity for taxpayers arising from the application of current tax law. Our tax team have published an article covering this in more detail. The Call for Evidence is open for responses until 31 August 2022. We will be contributing to the call for evidence and if you would like to discuss or share particular feedback, please contact Martin Shah or James Cherry for further details.

The Treasury Committee has also released a Call for Evidence, this time on the cryptoasset industry more broadly. The inquiry is focused on the role of cryptoassets in the UK, the potential impact of DLT and the regulatory requirements needed to manage the risks posed to consumers and business. The inquiry is currently open, closing at 17:00 on Monday 12 September 2022, and we would encourage as many of those who are interested in this industry to respond.

Finally, the U.S. Department of the Treasury also released a notice seeking public comment regarding potential opportunities and risks presented by developments and adoption of digital assets. This follows President Biden’s Executive Order 14067 of 09 March on “Ensuring Responsible Development of Digital Assets”. Comments must be received on or before 08 August.

This month in MiCA

Well, we finally got there - a provisional agreement was reached on 30 June between the French Presidency and the European Parliament regarding the proposal on regulating cryptoasset markets. Under the new regulatory framework, cryptoasset service providers, for cryptoassets that are not governed by other financial instrument regulation, will be required to obtain authorisation to operate within the EU. We have prepared a summary here, and we also hosted a panel discussion going into more depth about what MiCA means for the industry. This panel discussion was moderated by Konstantinos Adamos - Senior Legal Counsel at Revolut, and featured our colleagues Derek Lawlor (Dublin), Cathrine Foldberg Møller (Lux), Emilien Bernard-Alzias (Paris) and George Morris (London). We considered the market, action taken by regulators in respect of crypto providers and the regulators' stance, as well as looking at how this compares with the current and future regulatory regime in Europe. You can listen back to the panel here.