Just when you thought you’d had enough crypto news for one month we’re back again. This has been written at some pace so please do forgive us for anything you spot that may be inaccurate!
There have been two releases from HM Treasury (HMT) this morning. The first was the big one we have been waiting for: a consultation and call for evidence on the Future Financial Services Regulatory Regime for Cryptoassets (the Consultation), while the second is a Response to the Consultation on Cryptoasset Promotions (the Response). We look at both of these papers below and pull out the key points.
Cryptoasset Regulation in the UK
For those of you who are familiar with the EU’s Markets in Cryptoassets Regulation (MiCA), the areas of focus for the UK’s proposed approach set out in the Consultation will not be a surprise, though in our view, the Consultation has been written with second-mover advantage. It looks like they are fixing some of the problems that MiCA raises, with some activities, definitions and proposals clearly influenced by the omissions from, and reactions to, MiCA. Having talked the talk for a number of years about making the UK a crypto hub, while at the same time perhaps doing a few things that have encouraged crypto firms to leave the country, it appears that the UK is making a concerted effort to bring cryptoasset activities onshore – at least to the extent that firms wish to have UK customers. The Consultation explicitly proposes to capture cryptoasset activities provided in or to the UK.
Perhaps the key difference between the UK’s planned regime and MiCA is that the UK’s proposal is to bring cryptoassets within scope of existing legislation, rather than create bespoke regulation specific to cryptoassets and activities in relation to them. The Consultation proposes to expand the list of “specified investments” in Part III of the Regulated Activities Order (RAO) to include cryptoassets, which forms the basis of the rest of the proposals. Amendments to the Financial Services and Markets Act 2000 (FSMA), made through the Financial Services and Markets Bill (FSM Bill) currently working through Parliament affirms the use of the RAO power for the financial services regulation of cryptoassets. This clarifies that people who are carrying out certain activities involving cryptoassets “by way of business” would be performing regulated activities and therefore require authorisation under Part 4A of FSMA. HMT does, however, confirm that it does not intend to expand the definition of “financial instrument” in Part 1 of Schedule 2 to the RAO to include presently unregulated cryptoassets. Therefore, while mainly the proposals will mean that existing regulated activities will now apply in relation to cryptoassets in addition to previously specified investments, there are also proposals for some new RAO activities, specific to cryptoassets.
Perhaps inevitably, the FCA will consider whether to update the Senior Management Arrangements, Systems and Controls sourcebook, which contains the SM&CR regime, and other financial crime rules to apply to the new cryptoasset activities that are outlined in the Consultation – this will be one of many big changes that the industry will have to manage.
HMT notes that firms which are already FSMA authorised and intend to undertake these new activities will generally need to apply for a variation of their permission from the FCA (and the PRA for dual-regulated firms). Regulatory permissions would not be automatically granted for firms which are already authorised. The Consultation states that the FCA will adopt a “timely and proportionate authorisation process” for existing registered firms, in order to avoid duplicative information requests of businesses, taking into account the supervisory history of businesses during the authorisation process. HMT also promise to work with the FCA and industry to “ensure standards for approval are clearly available to crypto firms operating in the UK”. There is no other indication of when this would come into force and the extent to which any transition period would apply.
Ominously, HMT states that this consultation marks the next – but not the final – phase of the government’s approach to regulating cryptoassets. Let’s deal with this first though.
Cryptoasset Activities
As mentioned, the Consultation proposes to include cryptoassets as specified investments, however it makes clear that it will be activities in relation to cryptoassets that will be regulated rather than the tokens themselves. Interestingly, asset- and crypto-backed tokens, as well as algorithmic stablecoins are not given any special prominence, but will be subject to the same requirements as “unbacked crypto assets”. A separate FCA regime (similar to the payments and e-money rules) will apply to fiat-backed stablecoins, which is to be defined in the statutory instrument expected to be laid in H1 2023. HMT confirm that further details on the government’s approach to fiat-backed stablecoins will be set out in due course. All cryptoassets, including NFTs and utility tokens, have the potential to be included in the future regulatory perimeter if a specified activity is carried out in relation to them.
There are several other key points to note in relation to activities and licensing generally (before we consider some specific activities below).
Territorial Scope and Equivalence
Under FSMA, a requirement to be authorised applies to firms that carry on activities by way of business “in the United Kingdom”. When an activity is deemed to be carried on “in” the UK is different for different activities, however the Consultation suggests bringing all activities in relation to cryptoassets within scope to the extent they are carried out in or to the United Kingdom. This is a significant shift, and will capture both activities provided by UK firms (whether to clients in or outside of the UK) as well as activities provided by overseas firms to UK persons. This would have potentially huge ramifications, and the Consultation does confirm that HMT recognises that there may be nuances in the application of this for specific activities, for example through limited reverse solicitation exclusions (see below) – we look forward to any further details on this. The tone suggests though that the ability to operate offshore and service UK customers will be pretty limited.
It is not clear yet whether firms carrying out these activities would be required to have a physical presence in the UK in order to obtain authorisation, but the Consultation does suggest that HMT are considering pursuing equivalence type arrangements, whereby firms authorised in third countries can provide services in the UK without needing a UK presence, provided they are subject to equivalent standards. Firms authorised under MiCA is the obvious example here, though we are yet to see a broad equivalence regime emerge between the UK and EU in relation to financial services, so we will see whether this will prove successful.
FSCS Protections
Firstly, the Consultation suggests that it is not the government’s intention for Financial Services Compensation Scheme (FSCS) protections to apply to investor losses arising from cryptoasset exposures (though this is ultimately the responsibility of the PRA and FCA), however it does suggest that FSCS protection may be available for claims against failed authorised cryptoasset custodians, though this is under consideration and to be determined by the FCA. This could be very big move and would demonstrate a show of support to the industry.
However whilst we would support this, we feel this may not make through to the final rules given that the FSCS is primarily designed to prevent runs on banks (that lend on a fractional reserve basis so don’t always have the assets to satisfy customers wishes to withdraw) whereas a crypto custodian will almost certainly (as a result of FTX) be expressly required to keep the assets safe and not do anything with them – meaning if the rules work as they should then the assets should always be there for even mass redemptions.
Exemptions
The Consultation also suggests formalising the concept of reverse solicitation for cryptoasset activities that are provided from overseas companies. Under this exception, if a UK customer accessed a particular cryptoasset service entirely at their own initiative from an overseas firm and the firm does not otherwise solicit from such customers, then this may not trigger a FSMA-authorisation requirement for that overseas firm in relation to that particular service. It would be interesting to see how this works with other regulated activities – currently under FSMA for securities a form of reverse solicitation is only available for activities where that activity is deemed to be occurring outside the UK (i.e. the Overseas Persons Exclusion), while the proposals here are that all activities would be covered.
The Activities
The Consultation provides a helpful table summarising the activities covered, both existing and new, as well as providing further proposals in relation to some specific activities.
Operating a Cryptoasset Trading Venue
Under the proposals, operating a cryptoasset trading venue will become a regulated activity under the RAO. HMT is proposing to establish a regulatory framework which is based on existing RAO activities of regulated trading venues – including the operation of an MTF. It is not clear how tightly defined a cryptoasset trading venue will be, and we have seen from MiCA that there are few if any current cryptoasset exchanges that operate the same way as an MTF does (i.e. matching trades directly between two counterparties, as opposed to matched principal trading).
It is not suggested that exchanges will de facto be required to separate their functions, but there is a monitoring requirement in relation to this, and if conflicts of interest are not able to be appropriately identified and managed then firms may be obliged to separate.
Interestingly, the Consultation suggests that exchanges will probably need to be onshore (i.e. a UK company) - this will likely be through “subsidiarisation”. This is due to HMT’s view that such trading venues have a critical role in the cryptoasset value chain. There are, however, wider “arranging” permissions, similar to those currently in existence for securities. These permissions may be available to obtain for offshore firms (though this is not confirmed). It is not suggested that this would apply to custodians as well, but we predict that this onshore requirement may be extended to custody given the critical nature of that service to protect users.
Cryptoasset Intermediation Activities
Like TradFi, the cryptoasset industry sees a number of firms that act as intermediaries, brokers and market makers. The government proposes that requirements applying to analogous regulated activities – such as “arranging deals in investments” and “making arrangements with a view to transactions in investments” set out in article 25 of the RAO – would be used and adapted for cryptoasset market intermediation activities. There is little surprise here, and to the extent that cryptoassets are brought within scope of “specified investments” then this seems an inevitable extension.
Cryptoasset Lending Platforms
The Consultation notes that lending and borrowing activities make up a significant amount of activity in the cryptoasset and DeFi markets. These activities are not considered in MiCA, and while they may fall within dealing or arranging activities, the Consultation is proposing to introduce a new activity of “Operating a cryptoasset lending platform”. This will include facilitating collateralised and uncollateralised borrowing of cryptoassets or borrowing of fiat currency with collateral provided in cryptoassets. This is somewhat unexpected but makes sense – MiCA’s omission of regulating lending platforms is telling, and this is clearly something that the UK has adopted via its ability to use second move advantage, particularly given market developments in lending in the last 6 months or so.
Cryptoasset Custodians
Along with exchange services, custody is perhaps the key activity in the cryptoasset industry. The UK has an established body of legislation and rules (notably the CASS Sourcebook) relating to custody, and HMT is proposing to apply and adapt these existing frameworks for TradFi custodians under Art. 40 of the RAO for cryptoasset custody activities, making suitable modifications to accommodate unique cryptoasset features, or putting in place new provisions where appropriate. One divergence that the Consultation proposes is that the activity in relation to cryptoassets would be broader than Art. 40 RAO as it would capture firms that only safeguard (but do not administer) assets (e.g. firms that solely safeguard cryptographic private keys which provide access to cryptoassets). This broader definition is in line with the definition of cryptoasset custodians in the Money Laundering and Terrorist Financing (Amendment) Regulations 2019 (MLRs). Interestingly the consultation does not consider how multi-sig, MPC or sharded custody solutions will fall within the new rules, but we would expect this to be covered in some form when the rules are published to provide some certainty.
The Consultation also notes that there is a Law Commission consultation currently exploring whether English and Welsh law needs to be adapted to accommodate digital assets – this looks specifically at custody arrangements. HMT confirm they will consider the results of this consultation in drafting any legislation specific to the custody of cryptoassets.
HMT is also considering what liability standards will be applied to custodians. It suggests that the government is looking to take a proportionate approach which may not impose full, uncapped liability on the custodian in the event of a malfunction or hack that was not within the custodian’s control. As noted above – there is also a suggestion that cryptoassets held in a UK authorised custodian could benefit from FSCS protection. This is an unexpected move and we hope to hear more on this in the coming weeks.
###Cryptoasset Issuance and Disclosures
While the Consultation and proposed UK regulatory regime doesn’t have quite the same focus on token issuance as MiCA does, there are some important proposals laid out. It notes that there is a simultaneous reform currently being carried out in relation to the UK prospectus regime, the Public Offer and Admissions to Trading Regime, and the Consultation proposes to establish an issuance and disclosures regime for cryptoassets grounded in this, though tailored to the specific attributes of cryptoassets. There will be two regulatory trigger points as to when a cryptoasset issuance has deemed to have occurred (both of which look a lot like MiCA):
Admitting (or seeking the admission of) a cryptoasset to a cryptoasset trading venue
Making a public offer of cryptoassets (including ICOs)
Where cryptoassets are admitted to a cryptoasset trading venue, the FCA would specify principles in their rule book for admission and disclosure requirements that cryptoasset trading venues would then be responsible for administering. Cryptoasset trading venues would be responsible for writing more detailed content requirements for admission and disclosure documents as well as performing due diligence on the entity admitting the cryptoasset. Liability will be attached to the preparer of the documents (this could be the issuer or the trading venue), which is similar to MiCA’s whitepaper requirements. However, in a departure from MiCA, where there is no issuer (e.g. Bitcoin), the trading venue would be required to take on the responsibilities of the issuer if they wish to admit the asset to trading. Venues would be required to reject the admission of cryptoassets should they consider that it may result in investor detriment.
Market Abuse
There has always been a suggestion that people engaging in cryptoasset trading are able to benefit from abuses that would not be possible in the regulated traditional markets. Pump and Dumps and rumours of front-running have been in the industry for years. The Consultation proposes to introduce a cryptoassets market abuse regime based on elements of the MAR for financial instruments. This will include offences covering insider dealing, market manipulation and unlawful disclosure of inside information. HMT intends that offences against market abuse would apply to all persons committing market abuse on a cryptoasset that is requested to be admitted to trading on a UK trading venue. This would apply regardless of where the person is based or where the trading takes place. It does note that there are significant challenges dealing with market abuse in the cryptoasset industry when compared to TradFi, not least the highly globalised, fragmented, and borderless nature of cryptoasset markets. In light of this, the Consultation notes that the government does not expect to be able to achieve the same outcomes as MAR.
As a corollary, exchanges and venues will have to have suitable systems and controls in place to monitor and report on trading activities in order to detect these abuses.
Call for Evidence
As well as consulting on the regulatory framework, the Consultation also includes four chapters calling for evidence in relation to Decentralised Finance (DeFi), other cryptoasset activities not covered within the Consultation (notably investment advice, clearing and settlement, mining, and staking) and sustainability considerations. HMT is seeking views from respondents as to how to approach these issues, before considering them further. Changes to these areas are not the primary focus for upcoming legislation.
HMT have requested responses to the Consultation by the 30th April 2023.
Cryptoasset Promotions
As well as the mammoth Consultation outlined above, HMT also released the Response to the consultation on cryptoasset promotions. On the face of it, very little has changed since the Consultation of July 2020. The government will bring “qualifying cryptoassets” within scope of the Financial Promotion Order (FPO), and so be subject to the Financial Promotion Restriction found under s.21 FSMA. This provides that a person must not, in the course of business, communicate an invitation or inducement to engage in investment activity or “claims management activity”. This will now apply to activities in relation to qualifying cryptoassets. The Financial Promotion Restriction does not apply if:
the communication is made by an authorised person;
the content of the communication is approved by an authorised person;
the financial promotion otherwise meets the conditions of an exemption within the FPO.
This means that in order to issue a cryptoasset promotion in the UK, a firm will need to be authorised under FSMA, or have that promotion approved by an authorised person. While the Consultation above does lay the groundwork for cryptoasset firms to become authorised, there is no timeframe for such authorisations being practically available, with some suggestions that this may not be until 2024 or 2025. This means that until firms can get authorised they will need to rely on others to approve their promotions for them. It was raised in responses to the consultation that this posed a significant challenge for the industry as there are a vanishingly small number of authorised firms who have the relevant experience of cryptoassets (required due to the new gateway). Further, those small number of firms are competitors of the other cryptoasset businesses so it is not clear whether they would approve any promotions anyway. While the industry will be pleased to hear that “the government acknowledges this concern”, unfortunately they consider that “this risk is justified by the importance of the measure more broadly.”
One thing that was suggested in the press release accompanying the release of these two papers was that UK registered firms would be able to approve their own promotions during a temporary transition period. This proposal is not mentioned in either the Consultation or the Response, though in the Response it does note that the “FCA will shortly consult on its rules for the implementation of this measure, which will in turn inform which firms will take on the role of approving promotions.” We hope more clarity on this is forthcoming as this is a huge issue for the industry, as has been communicated to the FCA and HMT on numerous occasions.
One positive to be confirmed is that while the government proposed not to have a transition period in the original consultation, given the clear feedback from much of industry that a transition period would be necessary to ensure suitable compliance with the regime, the government will introduce a six-month transition period for this measure.
We look at two other key points raised in the Response below.
Qualifying cryptoassets
One change from the original consultation is that DLT has been removed from the definition of qualifying cryptoassets, in order to future proof the definition. As such, “qualifying cryptoassets” will be:
any cryptographically secured digital representation of value or contractual rights which is fungible and transferable.
The definition will exclude other controlled investments, electronic money under the Electronic Money Regulations 2011, and central bank money. Interestingly it excludes NFTs, which is unusual given that the Consultation seeks to regulate activities relating to NFTs – so slightly bizarrely, promoting exchange in relation to NFTs (for example) won’t be a financial promotion (as they aren’t qualifying crypto assets) but you will need to be authorised to carry out that exchange activity itself. We’d suggest it would be more coherent for NFTs to be covered by both requirements, or neither.
The controlled activities for the purposes of the FPO remain the same – with the government not choosing to add any others. This means that the relevant activities are:
one
dealing in securities and contractually based investments
arranging deals in investments
managing investments
advising on investments
agreeing to carry on specified kinds of activity
We assume that this will be updated to reflect the new activities specified in the Consultation mentioned above. The Response does confirm that custody services will remain out of scope, however.
Exemptions
Another concern was how the exemptions found under the FPO might apply to cryptoasset promotions. These exemptions allow unauthorised firms to communicate financial promotions without requiring the approval of an authorised firm, and fall outside the regulatory perimeter of the FCA. In the FPO, some exemptions apply to all controlled activities, while others are limited to certain activities or investments. In the consultation, the government set out that exemptions for qualifying cryptoassets should be consistent with the approach taken to exemptions for other controlled investments within the FPO.
This has meant that while exemptions for communications to investment professionals, journalists, and overseas recipients will apply to cryptoasset promotions, HMT will not include exemptions for high net worth individuals or self-certified sophisticated investors. The argument is that these were originally implemented for capital raising purposes, apply only to a specific set of controlled investments and should not apply to cryptoassets, which doesn’t feel like a strong justification. This is certainly a disappointment to the industry.
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