Crypto View - February 2023

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We have a bumper edition this month: as well as developments in Dubai, we look at the consultation published by the Hong Kong Securitie and Futures Commission (SFC), outlining their plans for regulating crypto in the jurisdiction. There have also been developments in the UK, first with the publishing of a statement by the UK Jurisdiction Taskforce (UKJT) (an industry-led initiative, tasked with promoting the use of English law for tech and digital innovation) regarding the issuance and transfer of equity and contractual securities on DLT-based systems. We also look at the Court of Appeal's decision regarding  Craig Wright's Tulip Trading. We have news from Germany, and also details of the publication of the Digital Asset Derivatives Definitions by ISDA. There's so much to get through we didn't even have room to mention that the PRA are planning on proposing rules about issuing and holding digital assets - though we expect there will be more from them on that soon.

New Regulations in Dubai

On 7 February 2023, the Dubai Virtual Assets Regulatory Authority (VARA) published its Full Market Product Regulations (FMP Regulations). The FMP Regulations contain VARA's virtual asset licencing regulations and took immediate effect in the Emirate of Dubai (Dubai), including all of its free zones, with the exception of the financial free zone of the Dubai International Financial Centre (the DIFC).

Briefly, the FMP Regulations consist of the Virtual Assets and Related Activities Regulations 2023 (the VARA Regulation) and a number of separate rulebooks. The VARA Regulation is the foundation of the FMP Regulations and sets out VARA's regulatory powers, its licencing and registration requirements, regulated virtual asset activities (VA Activities) as well as anti-money laundering requirements and market offences (such as insider trading and market manipulation). The various rulebooks  in the FMP Regulations falls within one of three distinct categories:

• The Compulsory Rulebooks:  The four Compulsory Rulebooks consist of the Company Rulebook, Compliance & Risk Management Rulebook, Technology & Information Rulebook and Market Conduct Rulebook. They apply to all entities licenced by VARA to carry out one or more VA Activities (VASPs) and contain detailed requirements pertaining to a range of issues, including corporate governance, regulatory capital, financial crime and technology security.
• The Activity-specific Rulebooks: Each VA Activity has a corresponding Activity-specific Rulebook, and VASPs are required to comply with every Activity-specific Rulebook that corresponds to a VA Activity it is licenced to carry out. These Rulebooks generally contain conduct of business requirements, though some also contain corporate governance requirements. Certain Activity-specific Rulebooks also contain margin trading restrictions. VARA has yet to publish its Activity-specific Rulebook for Payments and Remittances Services.
• The VA Issuance Rulebook: The VA Issuance Rulebook applies to those who issue Virtual Assets (as defined below) in Dubai, and contains requirements covering, inter alia, notification/approval requirements and whitepaper content requirements.

VARA's regulations with respect to the marketing of virtual assets and virtual asset activities are set out in Administrative Order No. 01/2022 (the VARA Marketing Regulation), which has been in effect since last year and has not been amended by the FMP Regulations. Together, the FMP Regulations and VARA Marketing Regulation constitute VARA's current regulatory framework, and both are accessible on VARA's website. This regulatory regime constitutes a unique approach to the regulation of Virtual Assets and VA Activities in Dubai. VARA has tailored a regime specifically for Virtual Assets, with crypto-specific issues such as staking and blockchain-based payment systems clearly addressed. Many provisions within the FMP Regulations evidence a strong understanding by VARA of the operation of Virtual Assets and VASPs in general.

Please do contact my colleagues Muneer Khan and Adam Wolstenholme, for more information, or if you are looking to carry out any activities related to virtual assets in Dubai. They have also published a more detailed summary of the FMP Regulations here.

SFC Consults on Regulatory Requirements in Hong Kong

Mere days before the FTX meltdown last year, Hong Kong announced its ambitions to be the leading fintech and virtual asset hub in Asia. The Hong Kong Monetary Authority (HKMA) in particular reflected that radical open-mindedness was needed, together with the right regulatory guardrails. Last week, Hong Kong showed it continues to pursue this goal: HK $50 million was announced in the annual budget as dedicated to developing "Web3" businesses operating on blockchains and the SFC released its consultation paper setting out its proposal for a licensing regime for centralised virtual assets trading. At more than 360 pages long, the consultation paper provides a lot of detail about the intricacies of the likely regime, which is due to come into effect by mid-2023.

When the regime commences, all virtual asset trading platforms that carry on business in Hong Kong or who actively market to Hong Kong investors will need to be licensed and regulated by the SFC. The SFC has taken an overarching "same activity, same risks, same regulations" approach, and many of the proposed features of the licensing regime proposed mirror the existing regulatory requirements for the licensing share trading platform operators. Some highlights include:

• Safe custody of assets: exchanges would need to hold client money and assets on trust through a wholly-owned subsidiary, with no more than 2% of the virtual assets stored in hot wallets. Exchanges would also be required to either have third party insurance or to set aside a compensation fund on trust, to protect assets under custody. The SFC has also suggested that virtual asset service providers "should not deposit, transfer, lend, pledge, repledge or otherwise deal with or create any encumbrance over client virtual assets".
• KYC and suitability: firms would be required to understand customers' financial situation, investment experience and investment objectives. Platform operators will be required to ensure that customers have a sufficient knowledge of virtual assets, including knowledge of their risks, before providing any services to a customer. So far, there is not much detail as to what amounts to "sufficient knowledge" means in practice, and this is certainly a space to watch.
• Conflicts of interest: platform operators would not be able to engage in proprietary trading or market-making activities in a measure to eliminate actual or potential conflicts of interest.
• Accounting and auditing: the consultation goes into great detail on this area, with one key point being that the SFC intends to take a high-touch approach and has proposed that platform operators will need to provide monthly reports to the SFC on its business activities.
• No lending: customers would need to pre-fund their trading accounts, with a prohibition against providing any financial accommodation for customers to buy virtual assets.
• Dual licence required: in a final twist in the tale, the SFC notes that while this licensing regime deals with non-security tokens, the SFC will still apply the traditional licensing regime for any tokens that fall within the definition of securities. As virtual assets may evolve over time and the characterisation of a token can change from a non-security token to a security token or vice versa, the SFC has proposed that platform operators will need to apply for dual licences - that means exchanges will need both a licence under the existing regime as well as the virtual asset service provider regime.

The SFC has also reinforced its promise to consider allowing retail access to crypto trading. Based on some soft consultations, retail access proposals include:

• No setting of "hard" dollar amount limits for retail traders - that leaves some flexibility, but platform providers will need to navigate how to satisfy the SFC that an appropriate suitability assessment has been performed for each customer, based on their customer risk tolerance and profile.
• The SFC has proposed that retail investors should only get access to "eligible large-cap virtual assets" - the SFC has set out some detail on what this means, including a requirement that permissible virtual assets must be included in at least two "acceptable indices" issued by at least two independent index providers.
• There will be a need for a product disclosure statement listing things like price and trading volume, information about the management team or developer of the virtual asset, terms and features of the assets and, if the assets comes with voting rights, how the exchange will handle those voting rights.

These developments have so far been met with relative enthusiasm, despite the fact that they will be fairly onerous - in particular, the need for dual licences. However, these developments are not out of step with other regulators around the world and Hong Kong's "same risks, same regulations" approach will give those platforms that can become licensed a degree of legitimacy and investors a degree of trust in the virtual assets ecosystem that could reinvigorate enthusiasm for virtual assets in general.  

If you would like to discuss anything about Hong Kong's approach to virtual assets, please do get in touch with Michelle Ta.

Court of Appeal orders claim against developers of bitcoin networks to proceed to trial

In an unexpected move, the English Court of Appeal has found that it is at least arguable that developers of bitcoin networks owe fiduciary duties to token owners. The case will now proceed to trial where the High Court will examine the question more closely and issue a definitive judgment.

As set out in our March 2022 Crypto View, this claim is being brought by Craig Wright (via Tulip Trading), seeking to force developers of certain networks (BV, BTC, BCH and BCH ABC) to implement a software "patch" which would allow Tulip Trading to reclaim £3 billion worth of (allegedly) stolen assets held at two wallet addresses. However, in order to do so Tulip Trading must show that the developers owed a fiduciary duty to owners of the assets associated with those networks. The High Court held that there was no realistic prospect of Tulip establishing such a duty, and refused tulip permission to serve the claim out of the jurisdiction. The Court of Appeal overturned this decision, meaning that the claim can be served and proceed to a full trial to determine whether a duty exists.

Central to the issues in dispute at trial will be whether bitcoin and other crypto networks are truly decentralised. Tulip's case is that they are not, since the developers control the software, and this puts them in the position of fiduciaries. The Court was under no illusions as to the impact such a duty would have on the law; recognising that "for Tulip's case to succeed would involve a significant development of the common law on fiduciary duties". In permitting the case to proceed to trial, Birss LJ stated that "if the decentralised governance of bitcoin really is a myth, then...there is much to be said for the submission that bitcoin developers, while acting as developers, owe fiduciary duties to the true owners of that property".

If developers do owe duties to asset owners, this could create considerable liability risk for developers while undermining the basis on which many users chose to participate in networks and hold tokens - decentralisation and an immutable blockchain. It could also have unforeseen consequences for other blockchain use cases, such as the tokenisation of traditional financial instruments. 

Digital Asset Definitions

In all the excitement of the UK announcing its direction of travel with regard to crypto regulation last month, ISDA announced that they have published their Digital Asset Derivatives Definitions. Until now, market participants seeking to hedge Bitcoin and Ether exposures via derivatives (or enter derivatives for speculative purposes, for that matter) needed to draft their own bespoke documentation, due to the absence of standardised terms akin to those published by ISDA for traditional assets. This made things like valuation methodologies and disruption events (e.g. forks in the underlying blockchain) difficult to navigate, leading to different approaches and a fragmented market, which in turn hampers liquidity and increases basis risk.

ISDA's standard definitions for digital assets derivatives changes this. The ISDA definitions, published on 26 January, introduce standard terms for non-deliverable forwards and options over Bitcoin and Ether, but could be expanded to cover additional product types in the future.

The new definitions were accompanied by a whitepaper exploring the legal questions raised by the collapse of FTX, and associated issues concerning ownership and intermediation. A further whitepaper on customer assets held with intermediaries is expected later in Q1 2023.

Digital Securities in the UK

Those active in the digital securities space have, for some time, been waiting for greater consensus on whether English law provides the legal certainty needed to support innovation in the digital securities markets. That wait ended on 15 February 2023, when the UK Jurisdiction Taskforce published its legal statement on the issuance and transfer of digital securities under English private law (the Legal Statement). The Legal Statement is a significant milestone for the UK markets, and concludes that the existing common law principles do support the transfer and issuance of equity and debt securities, without the need for statutory intervention. The Legal Statement has been welcomed by market participants and many hope it will spur greater investment in English law projects (and perhaps help the UK bolster its reputation as a global innovation hub).  

The Legal Statement is not law. However, it is likely to be highly persuasive, comparable to an industry legal opinion, and may well be formally endorsed by the English courts in due course. This was the case with the UK Jurisdiction Taskforce's previous legal statement on cryptoassets and smart contracts, which was cited by Bryan J in AA v Persons Unknown.

Siemens AG has issued a crypto security on the Polygon blockchain

With a seamless segue, Siemens AG has issued its first crypto-bond on a public blockchain, under the German Electronic Securities Act (Gesetz über elektronische Wertpapiere, eWpG), on 13 February 2023. The issue volume of the tokenised security was EUR 60 million. In addition to the efficiency and cost benefits for the market participants involved, the issuance sends an important signal to the market. It shows that the regulatory framework with the eWpG offers a suitable basis, even for established market participants. The bond-issue worked on a fully de-materialised basis and without the involvement of a central clearer. Furthermore, the bond-issue by Siemens underlines the direction of travel with the DLT technology as a reliable technical basis even for large issuances. By relying on a public and not a private blockchain, Siemens also wanted to convince other market participants of this approach.

German Federal Fiscal Court (Bundesfinanzhof) rules on taxation of Bitcoin and other cryptoassets

For the first time in its history, the Federal Fiscal Court, Germany's highest fiscal court, is to rule on the taxation of cryptocurrencies. The fundamental question is whether Bitcoin and other cryptoassets qualify as economic assets (Wirtschaftsgut), and are therefore subject to tax law. This decision could have far-reaching consequences for investors in cryptoassets.

The case was initiated by a lawsuit filed by a Bitcoin investor who claimed back taxes from a crypto trade from the tax office almost a year ago. His argument was that Bitcoin does not qualify as an economic asset. The competent tax court in Cologne rejected the claim, whereupon the investor appealed to the German Federal Fiscal Court. Overall, EUR 3.4 million are in question.

The judges did not provide any guidance regarding the outcome after the first day of the hearing, and the next stage will be the decision, which might be as soon as within the next few weeks. Experts assume that the Federal Fiscal Court will subsume cryptoassets under the economic concept and thus make sales transactions taxable. This would have significant consequences for investors.

For any questions on these two updates from Germany, please get in touch with Jochen Kindermann and Lena Menger.