Crypto View - October 2022

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This month's edition is coming live from Vegas where a few of the Simmons Payments and Crypto team are attending Money20/20. It's been a great way of meeting up with new and existing clients to discuss the market and what trends people are seeing. Another thing we have been discussing a lot is Crypto Reviewer, and the additional jurisdictions that it now covers - now up to 44 with a further 15 in the pipeline - you can see more information and request a demo here. This month we look at a number of jurisdictions developing specific crypto legislation - UK, Hong Kong, Singapore and South Africa - there looks to be a lot of change on the way.

ETH - a security?

Investor uncertainty around the regulatory status of Ethereum has been a highlight this month after the US Securities and Exchange Commission (SEC) signalled that it may now qualify as a security having previously advised that it would not in 2018.

Ethereum's 'Merge', on 15 September, was put into action to transition the Ethereum blockchain from proof-of-work to proof-of-stake, with a goal to reduce energy consumption and improve productivity over the long term. Following the upgrade, SEC chair Gary Gensler has said that cryptocurrencies and intermediaries that allow holders to "stake" their coins might pass the Howey test, a key test used to determine whether an asset is a security.

Classifying ETH as a security, and also bringing doubt around the status of other proof-of-stake protocols, would cause huge issues for the market. Indeed we have seen ETH lose more than 20% of its value in the month after Gensler's comments. While ETH would not be classed as a security in many other markets, including the UK and EU, the US is obviously a key territory for the digital asset - indeed following a recent case in the US, it seems that the SEC claims jurisdiction over all transactions on Ethereum as the transactions are validated by a network of nodes which are "clustered more densely in the United States than in any other country." Whether this will be confirmed remains to be seen, but it is a huge land grab by the US regulator.

ESMA on cryptoassets and their risks for financial stability

On 04 October, the European Securities and Markets Authority (ESMA), the EU's financial markets regulator and supervisor, published an article called 'Cryptoassets and their risks for financial stability', in which they have set out two broad categories of risk - risks that may be observed in traditional markets already (e.g., speculation or leverage) and novel risks that are inherent to product design, technological development, or the complex infrastructures built around cryptoassets.

In advance of ESMA taking on new duties under the European Union's Markets in Cryptoassets Regulation (MiCA), the report gives insight to how the agency views certain risks in the crypto market, altogether addressing a suite of different risk areas which may in the future become relevant for financial stability. Perhaps unsurprisingly, it's apparent that consumer risk (a 'traditional' financial risk) is a particular focus for the agency, as the document cites volatile markets and aggressive marketing campaigns aimed at the public, in combination with the increasingly complex products being offered by crypto firms (often without adequately disclosing the risks and with little accountability in making misleading statements) as a point of concern.

The report also looks to risks that are new or 'native' to crypto - like the pseudonymity that prevails in cryptoasset markets (making it virtually impossible to assess the creditworthiness or aggregate exposures of participants) which also contributes to concerns around consumer protection due to a lack of transparency and reliable data to assess exposures and risks. Moreover. the report discusses the use of DLT, and in particular attempts to manipulate the consensus mechanisms of distributed ledgers (i.e., through so called "51%" or "Sybil" attacks) which can put value on the entire blockchain at risk. To highlight how much is at stake in this context, the report cites that as of July 2022 there was EUR 57 bn staked on the nodes of the 10 largest smart contract-enabled DLTs.

Amendments made to the FSM Bill specifically addresses cryptoassets

On Friday 21 October, an Amendment Paper to the Financial Services and Markets Bill (FSM Bill) was put through the House of Commons, laying the groundwork for existing EU financial services legislation to be amended at a later stage to bring cryptoassets into scope. These were later approved on 25 October, with the FSM Bill now passing to the House of Lords.

The FSM Bill now looks to amend the Financial Services and Markets Act 2000 (FSMA) as follows:

• Section 21 (restrictions on financial promotion), which prohibits the communication of financial promotions by "unauthorised persons", is amended to bring cryptoassets (specifically, "where an asset, right or interest is, or comprises or represents, a cryptoasset") into the definition of "investment".
• Section 22 (regulated activities), is amended by adopting the same wording as above, and brings cryptoassets into the definition of "investment" for the purposes of regulated activities.
• Section 417 (definitions): this section defines "cryptoassets" as any cryptographically secured digital representation of value or contractual rights that can be transferred, stored or traded electronically, and that uses technology supporting the recording or storage of data (which may include distributed ledger technology).

While this does not mean that cryptoassets are now regulated, (as they will not become specified investments set out in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO)), the amendments clarify that investments can include cryptoassets more generally (i.e., by including tokenised shares in the remit of 'shares' under the RAO). Moreover, this also appears to lay the groundwork for the RAO and the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (FPO) to be amended at a later date to specify certain (or all) cryptoassets - it would be at this point that firms carrying out certain (regulated) activities in relation to cryptoassets would require authorisation to do so - a significant shift from the current circumstances.

Hong Kong

As well as the UK, a number of other jurisdictions announced developments to their regulatory regimes. One such jurisdiction is Hong Kong, with a speech by Julia Leung, Chief Executive Officer and Executive Director, Intermediaries of the Hong Kong Securities and Futures Commission (SFC), at Hong Kong FinTech Week outlining a number of important changes.

Specifically, the SFC is looking to move away from a general restriction for investments in crypto to "professional investors". This already began with the SFC's Joint Circular with the Hong Kong Monetary Authority in January, which allowed the retail distribution of a limited suite of virtual asset-related derivative products traded on conventional exchanges, however there seems to be appetite to move further on this. One such development is that the SFC is actively looking to set up a regime to authorise ETFs which provide exposure to mainstream virtual assets (with appropriate investor guardrails). It is also looking at developing the rules on Security Token Offerings (STOs). Again,  the SFC is willing to adjust its position to allow retail access to STOs, if proper safeguards are put in place. Its preliminary view is that tokenised securities, as digital representations of traditional securities on a blockchain, should be treated in a similar way as existing financial instruments. Finally, the SFC are going to review the virtual asset service provider (VASP) regime, which is was consulted on earlier this year, in relation to the Anti-Money Laundering Amendment Bill. Ms Leung notes that there was a lot of feedback about whether access to SFC-licensed VASPs should be restricted to professional investors only - the SFC is minded to consult the public on whether this requirement could be relaxed. For more information on this, or any other crypto related queries, please reach out to our colleagues Jolyon Ellwood-Russell and Helen Fok.

Singapore

Singapore has also announced some proposed measures. The Monetary Authority of Singapore (MAS) announced two consultation papers last week - covering digital payment tokens (DPT) and stablecoins. The first consultation covers three broad areas. Firstly, Consumer Access - DPT service providers will be required to provide relevant risk disclosures to enable retail consumers to make informed decisions regarding cryptocurrency trading. It is also suggested that this may include retail customers being required to take a risk awareness test before being able to trade. It is also proposed that service providers will be prohibited from offering credit facilities and leverage to retail consumers for cryptocurrency trading. Secondly, Business Conduct - it is proposed that DPT service providers will be required to implement proper segregation of customers' assets, mitigate any potential conflicts of interest which arise from the multiple roles they perform, and establish processes for complaints handling. Finally, Technology Risks - similar to other financial institutions such as banks, DPT service providers will be required to maintain high availability and recoverability of their critical systems.

The second consultation focuses on stablecoins, which it sees as tokens pegged to a single currency (SCS). There are four key proposals in this consultation:

• Value Stability.  SCS issuers must hold reserve assets in cash, cash equivalents or short-dated sovereign debt securities that are at least equivalent to 100% of the par value of the outstanding SCS in circulation, and these assets must be denominated in the same currency as the pegged currency.
• Reference Currency. SCS issued in Singapore can only be pegged to the Singapore dollar or a G10 currency. 
• Disclosures.  Stablecoin issuers will be required to publish a white paper disclosing details of the SCS, including the redemption rights of stablecoin holders.
• Prudential Standards.  SCS issuers must, at all times, meet a base capital requirement of the higher of SGD 1 million or 50% of annual operating expenses of the SCS issuer. They are also required to hold liquid assets which are valued at the higher of 50% of annual operating expenses or an amount assessed by the SCS issuer to be needed to achieve recovery or an orderly wind-down. 

Banks in Singapore will be allowed to issue SCS as well, and no additional reserve backing and prudential requirements will apply when the SCS is issued as a tokenised form of bank liabilities given the existing rigorous capital and liquidity frameworks applied to banks. For non-issuance services, DPT service providers can offer all types of stablecoins provided that they clearly label the MAS-regulated SCS to distinguish them from the unregulated ones. Both of these consultations close on 21 December 2022. If you would like to discuss these further, or any other questions for Singapore, please contact our colleagues Yingu Wang or Sonia Lim.

South Africa

The Financial Sector Conduct Authority (FSCA) of South Africa published a declaration that Cryptoassets are to be classed as a financial product under the Financial Advisory and Intermediary Services Act 2002 (FAIS). This brings providers of services in relation to cryptoassets into the scope of the FSCA's regulatory perimeter.  The FSCA published a Policy Document supporting the Declaration at the same time. The Policy Document provides clarity on the effect of the Declaration, including transitional provisions, and the approach the FSCA is taking in establishing a regulatory and licensing framework that would be applicable to Financial Services Providers (FSPs) that provide financial services in relation to Cryptoassets. However, as well as the Declaration and Policy Document, the FSCA also published a Draft Exemption of persons rendering financial services in relation to cryptoassets from certain requirements. The Draft Exemption proposes to exempt licensed Crypto Asset FSPs from certain requirements, including the General Code of Conduct for Authorised Financial Services Providers (General Code), and the Determination of Fit and Proper Requirements, 2017 (Fit and Proper requirements). Requirements contained in the General Code and Fit and Proper requirements will apply to all Crypto Asset FSP's once licensed, except those requirements that they are exempted from in terms of the draft General Exemption.

It is possible to submit feedback to the draft General Exemption, with the FSCA looking to receive stakeholder inputs on the proposed regulatory framework that will apply to licensed Crypto Asset FSP's. Submissions on the draft Exemption must be made using the submission template available on the FSCA's website and be submitted in writing on or before 1 December 2022 to the FSCA at FSCA.RFDStandards@fsca.co.za. 

FSB proposes framework for the international regulation of cryptoasset activities

On 11 October, the Financial Stability Board (FSB) published a proposed framework for the international regulation of cryptoasset activities. The proposal is comprised of the following recommendations, which have been issued for public consultation:

• recommendations that promote the consistency and comprehensiveness of regulatory, supervisory and oversight approaches to cryptoasset activities and markets and strengthen international cooperation, coordination and information sharing; and
• revised high-level recommendations for the regulation, supervision and oversight of global stablecoin arrangements to address associated financial stability risks more effectively.

The FSB has set out the recommendations are grounded in the principle of "same activity, same risk, same regulation", meaning where cryptoassets and intermediaries perform an equivalent economic function to one performed by instruments and intermediaries of the traditional financial sector, they should be subject to equivalent regulation. However, the FSB's view is that regulation should also take into account the specific risks and 'novel' features that are unique to cryptoassets, in order to address financial stability risks that may arise from the growing interdependencies between the cryptoasset system and the traditional financial system (or real economy).

In order to address this, the two sets of recommendations have been drafted as stand-alone documents that are intended to work together, reflecting the 'interlinkages' between the two systems and highlighting where certain risks are beginning to emerge. The FSB has published a list of questions in order to get feedback on its proposals - if you are interested, responses are required by Thursday 15 December 2022.

This month in MiCA

A quick note from us on MiCA this month to wrap up - while last month saw the finalisation of the technical negotiations, on 05 October, the EU Council approved the text, seeing the proposal through to Parliament for a vote.

You may have seen that we have started a series of webinars looking at MiCA in more depth. The first was a general overview of the regulation, while the second looked specifically at MiCA from the perspective of exchanges and custodian wallet providers. The third in the series was on 26 October and looks closely at issuing cryptoassets and stablecoins under the new regime. You can listen back to all the previous webinars and sign up to the next one in the series - looking at how MiCA impacts already regulated financial institutions here.