HMT – Regulatory Regime for Crypto Special

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Just as I was finalising October's Crypto View, HM Treasury decided to put out three publications - the response to the future financial services regulatory regime for cryptoassets (the Response), an update on plans for the regulation of fiat-backed stablecoins, and a response to the consultation on managing the failure of systemic digital settlement asset (including stablecoin) firms. HMT have clearly been busy. We take a look at the key points from the primary consultation response on the future regulatory regime below (it's a long one), but are going to cover the other two responses in the October Crypto View (don't worry, it's still coming!)

The government reiterates its ambition to make the UK a global hub for cryptoasset technologies, and seeks to provide clarity for firms looking to operate in the space while ensuring customers have the protections necessary for confidently using these technologies. In general, the Response sticks very closely to what had previously been consulted on (if you want to remind yourself of the original consultation, you can read it here), though there are one or two interesting points. Our main observations are that the government has become more restrictive in relation to the territorial scope of the activities - the consultation held out the possibility of reverse solicitation, though this seems to have been walked back. However, there are certainly helpful noises in relation to staking.

Legislative approach

Specified Investments

The headline point of the response is that the government has confirmed that it will expand the list of 'specified investments' in the Regulated Activities Order (RAO) to include cryptoassets. This will mean that firms undertaking certain activities involving cryptoassets (by way of business) will need to be authorised by the FCA under Part 4A of the Financial Services and Markets Act 2000 (FSMA). This was laid out in the original consultation and is the expected course. HMT confirm that there is no plan to expand the definition of 'financial instruments' in Part 1 of Schedule 2 of the RAO to include unregulated cryptoassets.

Definition of cryptoassets

It seems as though there was a lot of feedback regarding the broad definition of "cryptoasset". However, HMT confirmed that this is intentional and that it needs to ensure that the definition is futureproof. Interestingly, the government confirmed that the precise legal mechanism for distinguishing between tokens that are in and out of scope will be set out in the relevant secondary legislation and FCA rules, so we are likely to see narrower subsets of assets being legislated for in relation to specific activities.

Licencing

Firms that are currently registered under the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs) will need to apply for a separate authorisation under FSMA. Firms who are already authorised under FSMA will need to apply for a Variation of Permission (VoP) - they won't have an automatic permission to carry on newly regulated cryptoasset activities. While we would assume that the new FSMA regime would replace the requirement to be registered under the MLRs, this isn't clear from the Response - it notes that the introduction of an authorisation regime under FSMA means that crypto firms already registered with the FCA under the MLRs will need to also seek authorisation from the FCA under the new FSMA-based regime.

Territorial scope

This is perhaps the most controversial aspect of the Response. It confirms that HMT's position is that a person (whether legal or natural) will generally be required to be authorised by the FCA under Part 4A of FSMA if:

• they are undertaking one of the regulated activities;
• by way of business; and
• they are providing a service in or to the UK.

This is broader than the position in relation a lot of traditional finance, and obviously brings all crypto asset service providers within scope of the UK regime to the extent that they have a customer based in the UK. The Response goes on to confirm that "the government does not support expanding the OPE [Overseas Persons Exclusion] to cover cryptoassets." But, confusingly then suggests "the government's position is that firms dealing directly with UK retail consumers should be required to be authorised irrespective of where they are located." Which leaves some scope for a potential exemption from authorisation when dealing with institutional clients.

It also raises further questions with the FCA's approach to the financial promotion regime where they interpret the regime as bringing the provision of services within scope of the promotion of services. If that interpretation were correct, there would presumably be no need for this clarification from HMT regarding the undertaking of the activities.

HMT does suggest that there may be room in the future for equivalence type arrangements to be developed, which would be very welcome for the industry, though they do note that such conditions are not yet in place. However, it still wants to ensure that UK users have access to global liquidity pools, and so proposes continued ability to access a global liquidity pool which is being operated in a jurisdiction which is meeting international recommendations and standards on a time-limited basis. It suggests that one way of achieving this could be to permit UK firms who are operating a regulated cryptoasset trading venue in an overseas jurisdiction to be able to apply for authorisation for a UK branch extension of their overseas entity. The branch could be authorised to specifically handle trade matching and execution activity.

Response to calls to regulate as gambling or to ban cryptoassets altogether

HMT note that a number of respondents called for the government to either ban cryptoassets or to regulate activities in relation to cryptoassets as gambling (you may remember that the House of Commons Treasury Committee called for something similar earlier this year). In line with its response to that committee, the government reiterated its commitment to regulating cryptoassets in line with international standards.

Cryptoasset Issuance and Disclosures

The Response confirms the government will bring in a requirement for disclosure documents for all cryptoassets that are available for trading in the UK - including Bitcoin and Ether, and other well-established tokens. It intends to ensure that consistent, minimum standards of information are available to consumers. There will be transitional arrangements put in place to ensure that there is time to avoid cliff edges requiring the withdrawal of any assets from trading.

Venues will ultimately be responsible for defining the content requirements for admission disclosure documents, though HMT is supportive of a centralised coordinating body - potentially an industry association - to organise this effort. There has also been some consideration of the liability that venues might face, with HMT confirming that cryptoasset exchanges - which choose to take responsibility for the disclosure documents - should not be held liable for all types of consumer losses arising from events relating to that token, provided that they have taken reasonable care to identify and describe the risks. HMT also agrees that the disclosure requirements could differ for venues that only permit institutional clients to trade.  It also lays out certain exemptions from the requirement, the flavours of which are taken in part from the Prospectus Regulation approach to exemptions:

• Requirements will apply only to tokens that are made available to the UK public (i.e. not to all newly created tokens)
• Requirements will not apply to offers:
  • made for no consideration,
  • where the value of consideration is below a certain threshold,
  • made to a limited number of persons
  • made only to professional investors,
• Requirements will also not apply to tokens acquired solely through a consensus protocol reward mechanism

Cryptoasset Activities

HMT has confirmed its approach that it will generally follow any existing regulated activity with regard to a corresponding cryptoasset activity.

Operating a cryptoasset trading venue

HMT intends to proceed as consulted and regulate trading venues using existing regulated activities as a basis, however it reiterates the need to take into consideration specific characteristics and risks of cryptoasset trading activities. It also notes that it intends to apply the insolvency provisions in Part 24 FSMA, which would bring the protections for consumers using cryptoasset trading venues in line with authorised firms and payment/e-money firms. Note also the location requirements referred to above - there would be a requirement to have some sort of presence in the UK if dealing with UK customers.

Cryptoasset intermediation activities

This covers those activities such as dealing in cryptoassets as principal or agent, arranging (bringing about) deals in cryptoassets, and making arrangements with a view to transactions in cryptoassets - all with a basis in the existing regulatory framework. While there is already guidance on these activities, HMT does accept that the existing approach, and subsequent rules set by the FCA, will need to carefully consider specific aspects of crypto markets and implications for concepts which may not map across well from the traditional financial services sector.

Interestingly, it acknowledges the risk that it is possible for no trading venues to set up in the UK, and for offshore firms to rely on these intermediation activities instead. This could lead to firms not triggering the market abuse or disclosure rules that apply to such venues. To counter this, HMT will require a disclosure / admission document to be lodged on the National Storage Mechanism (NSM) maintained by the FCA by a trading venue, prior to any intermediary being able to deal or arrange deals in a given token.

Cryptoasset custody

There will be a new regulated activity for custody covering the (i) safeguarding, (ii) safeguarding and administration, or (iii) the arranging of safeguarding or safeguarding and administration, of a cryptoasset. These will be based on the frameworks for traditional finance custodians under Article 40 RAO, though HMT notes the novel and unique scenarios, risks and technology solutions applicable to cryptoassets.

Importantly it has been confirmed that where firms provide the software for customers to use their own self-hosted or non-custodial wallets, this will not fall under the definition of 'safeguarding' or 'safeguarding and administering' (i.e. the new regulated activity for custody).

It may be the case that where firms outsource physical custody to secure asset storage companies, such arrangements could be captured by the 'arranging' limb of the custody regulated activity - depending on the terms of the contract between the firm and secure asset storage company.

Custody wallet providers will also be pleased to note that HMT does not plan to impose full, uncapped liability on custodians in the event of a malfunction or hack that was not within the custodian's control.

While security tokens which meet the definition of an existing specified investment will generally be regulated in line with existing rules and regulations (as they are now) - HMT has suggested that the custody of security tokens will no longer be regulated in the same way as other specified investments and will instead be specified by a new regulated activity. This is intended to reflect the fundamental differences in the way that cryptoasset custody operates versus traditional custody arrangements (for example, some firms may only safeguard cryptographic private keys which provide access to cryptoassets).

Operating a cryptoasset lending platform

One of the new activities will be that of 'operating a cryptoasset lending platform'. The government notes that there are clear differences between lending to retail consumers and lending between wholesale counterparties, and intends to ensure that these differences are reflected in any legislation. It confirms that the lending platforms discussed in the original consultation were with retail customers in mind. It would appear that wholesale cryptoasset lending may be regulated in a similar fashion to securities (i.e. in line with the UK Securities Financing Transactions Regulation (SFTR)). This will not be in the same phase as the other regulation discussed in the Response.

Staking

HMT acknowledges concerns raised by the industry with regard to staking and is accelerating its engagement with stakeholders, in order to:

• develop a clear definition of cryptoasset staking on a PoS blockchain and distinguishing this from other, riskier, activities which may be referred to, or marketed as 'staking';
• establish a taxonomy of the different PoS staking business models currently in the market; and
• identify how to mitigate the associated risks and take advantage of the potential benefits of a carefully defined, permitted form of staking in the UK.

HM Treasury proposes a definition of staking as:

the process where a given amount of native cryptoassets are locked up (staked) on smart contracts in a PoS consensus mechanism blockchain (on-chain), in order to activate validator nodes (computers) which collaboratively validate subsequent transactions and achieve consensus on the network's current state. Rewards, consisting of newly minted native tokens and/or a portion of transaction fees on the blockchain, are then subsequently allocated to the network participants staking their cryptoassets and to the validator node operators.

Helpfully, HMT confirms that the specific process of operating a validator node using on-chain staked cryptoassets would generally constitute a technical function essential to the operational activities and security of a PoS blockchain, rather than a financial services activity. The Response also noted that existing UK rules for collective investment schemes (CISs) may capture on-chain staking services provided by intermediaries (indeed, practically all activities can fall within the notoriously broad definition). The government explicitly confirms it does not intend to ban staking - which is a potential consequence of over-regulating or determining that staking constitutes a CIS, and states that HM Treasury is therefore signalling an intent to carve out staking from the CIS rules (where it meets certain requirements). While we are of the view that staking can, and normally does, fall outside the definition of a CIS, it is helpful that the government is taking this approach to bring clarity to the activity.

Investment Advice

HMT is keen to bring cryptoassets investment advice and portfolio management within the regulatory perimeter, however it highlights the lack of professional qualifications concerning cryptoassets and the challenges of conducting due diligence on the issuers of cryptoassets competently, which results in difficulty for an investment adviser to provide suitable cryptoasset recommendations to customers. As such, it will remain under review for the time being.

Mining and Validation Activities

The government does not intend to regulate mining as a regulated activity at this stage. Mining in the UK makes up an insignificant amount of global activity and any unilateral action taken by the UK would simply push the minimal activity occurring in the UK to jurisdictions with more lenient or no regulation.

Market abuse

The government has confirmed that it intends to proceed with its implementation of the market abuse regime in line with the consultation. We, among many, have doubts as to the effectiveness of the regime when considering the global nature of the cryptoasset industry - to remind readers, HMT intends that market abuse offences would apply to all persons committing market abuse related to 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. This means that if the market abuse is carried out by someone in Japan, on a venue in the Seychelles, providing that the asset is also listed on a UK venue (or requested to be admitted), then it would be in breach of the UK Market Abuse regime.

HMT says that it disagrees with the position that the overall scope of the regime should be more narrowly defined as this would not deliver adequate protection to UK consumers, and that UK financial services regulation already affects firms based overseas in many areas such as consumer credit, market abuse and financial promotions. It suggests it will work with the FCA to devise ways to mitigate the risks posed by overseas firms in this context. We are interested to see what steps will be taken.

Helpfully the government also confirmed that additional guidance will be made available by the FCA to provide clarity on what constitutes market abusive behaviour (including a non-exhaustive list of examples).

Decentralised Finance (DeFi)

HMT confirmed that it would be premature and ineffective for the UK to regulate DeFi activities currently. Instead, the government will support efforts at the international level through work at both the FSB and standard setting bodies to inform a future domestic framework.

We will of course keep an eye on the legislation that comes out of this Response - and look out for your usual monthly Crypto View coming soon!