Crypto View - November 2023

Another quiet month in the digital asset sector (yeah, right - though at least nothing has come out today...) As promised in October's (second) Crypto View, we will be taking a look at the FCA's discussion paper on the regulation of stablecoins.  HMT have also published their response to the consultation on the Digital Securities Sandbox - something we were heavily involved with through UK Finance. Elsewhere in tokenisation, the Investment Association (IA) has published an interim report on the tokenisation of funds - welcomed by the FCA, and surely one of the next big frontiers in the digital asset space. We discuss this report, and look at what the direction of travel is here. The Monetary Authority of Singapore (MAS) has published further guidance on the regulation of cryptoasset providers, and my colleague Ashleigh Low has provided a helpful summary on that. There's also news in tax where 48 jurisdictions have released a joint statement confirming that they intend to implement the OECD crypto-asset reporting framework (CARF) by 2027. Oh, and there's the small matter of $4.3 billion...

Binance Pleads Guilty

Rumours started when the DOJ announced a press conference relating to a "significant cryptocurrency enforcement action" - what had Bitzlato done now?! However, this time, it was the big one. On 21 November, Binance and Changpeng Zhao (CZ) pleaded guilty to criminal charges of money laundering and breaching international financial sanctions. Binance agreed to pay penalties of more than USD 4.3 billion, while, perhaps more importantly, CZ has resigned from his position as CEO of the world's largest cryptoasset exchange (as well as paying a USD50 million fine). As part of the terms of the settlement, CZ is barred from involvement in Binance's management going forward, though it seems that he will remain the major shareholder of the firm. There is still a possibility of jail time, with his sentencing coming next February (SBF's is in March, so it's possible CZ will be in Jail before his rival, who'd have thought that would be the case 6 months ago?). The DOJ confirmed that sentencing guidelines suggest he could face up to 18 months in jail, though the maximum is 10 years.

Let's see what happens next.

Stablecoins

The FCA published a discussion paper this month on its proposed approach to regulating fiat-backed stablecoins that may be used for payments. This sets out the FCA's thinking on how to design a regulatory regime for issuers and custodians. It follows the Government's plans to legislate for a future financial services regime for cryptoassets as part of a phased approach, focusing initially on fiat-backed stablecoins, including where used in payments, followed by the wider cryptoasset regime (see last month's (first) Crypto View on the future financial services regime for crypto).

The paper sets out a broad scope of the proposed UK stablecoin regime and welcomes views on the topics ahead of 6 February 2024. The regime itself is based around two potential avenues for fiat-backed stablecoins to be used as a means of payment in the UK - either a stablecoin issuer will need to seek authorisation from the FCA to issue fiat-backed stablecoins in or from the UK or, for overseas stablecoins, 'payment arrangers' would be regulated under the PSRs and would have to be FCA authorised to assess overseas stablecoins against a set of standards set out by the FCA. The latter approach is particularly interesting and follows the wider steps taken by the regulator (such as the wide territorial reach of the recent FinProm requirements) to address the global nature of the crypto industry.

Other elements of the regime which caught our eye include the proposals that:

• stablecoin issuers would be required to secure their stablecoins with government treasury debt instruments that mature in one year or less, along with short-term cash deposits - with no access to MMFs;
• the backing assets for regulated stablecoins would be held on a statutory trust for customers;
• the FCA is considering requiring regulated stablecoin issuers to appoint a CASS oversight officer who is accountable for overseeing the regulated stablecoin backing assets as part of organisational requirements; and
• a dedicated new prudential sourcebook (CRYPTOPRU) will be added to the FCA Handbook.

Excitingly (I'm assuming if you've got this far, you're into this sort of thing), we are hosting a webinar on this discussion paper on 14 December. My colleagues George Morris and Neelam Hundal will be in conversation with Jane Moore, the FCA's Head of Payments and Digital Assets. We will be looking to hear the FCA's views on its core areas of interest, and to discuss what the FCA is really interested in hearing about from respondents. This is a rare opportunity to hear from the FCA directly on this ongoing discussion process and is not to be missed. You can sign up here.

Digital securities sandbox: HMT publishes consultation response

HMT published its response to the Digital Securities Sandbox (DSS) consultation on 22 November. Publication of the response coincided with the Government's Autumn Statement, where the DSS was referenced as one of the measures supporting economic growth. The DSS will be the first financial markets infrastructure sandbox created pursuant to HM Treasury's new powers under FSMA 2023, enabling participating firms to provide trading and settlement infrastructure for digital securities with the benefit of certain legislative modifications, subject to the close supervision of the UK regulators. The response gives further insights into how the DSS will be designed and what the statutory instrument that establishes the DSS will contain. The statutory instrument is expected to be published in the coming weeks, to be enacted before the end of the calendar year.

Some key points from the response are:

• Asset scope and denomination: The response goes further than the original consultation (which was open to debt securities, equity securities and money market instruments) to capture "all relevant assets currently in scope of the regulatory perimeter", save for derivatives (and unbacked cryptoassets).
• Activities, designations and authorisations: The response confirms the DSS' activity scope remains unchanged, so will target notary, settlement and maintenance functions plus the operation of a trading venue (meaning calls for payments, custody and other services to be brought within the DSS' scope were rejected).
• Eligibility to participate: In spite of industry requests, the response confirms that firms seeking to participate in the DSS as sandbox entrants must be established in the UK. This will exclude firms that would have liked to participate through a UK branch of an entity established in an overseas country. HM Treasury have confirmed that firms will be permitted to apply as a group or consortium, however, which may serve as an option for non-UK established entities. Non-UK established entities may also interact with DSS infrastructures as participants and/or by providing ancillary services.
• Legislative modifications: The response gives more insight into how certain legislation will be modified through the DSS. Many of the existing CSDR requirements will be disapplied via the statutory instrument, with some rules being replaced by regulator rules. By contrast, modifications to the Companies Act 2006 and the Uncertificated Securities Regulations will be set out in the statutory instrument (as opposed to being disapplied and replaced through regulator rulebooks). The Bank of England will be given powers to offer an exemption from the rules requiring designation under the Settlement Finality Regulations (the 'SFRs') while sandbox entrants are in the DSS. The exemption is optional, and firms will be able to seek SFR designation while participating in the DSS. No modifications will be made to MiFIR, and no exemptions to the transaction reporting requirements in Article 26 will be granted (on the basis HM Treasury considers those requirements to be compatible with digital securities). The Government may bring further legislation into the scope of the DSS by way of further statutory instruments, although we would expect any further statutory instruments to take time to develop and enact. An additional statutory instrument may not also be realistic if the relevant issue is not sufficiently material to the objectives of the DSS, given the constraints on Parliamentary time.
• Duration: As expected, the response confirms the DSS will initially last five years (but may be extended). Sandbox entrants may also exit the DSS before the end of the scheme.
• Digital cash and the payment leg: The DSS will enable flexibility around the digital cash solutions that can be used for settlement. Payments-related legislation will not be modified through the DSS, however, meaning cash solutions will need to comply with all existing payments legislation.
• Custody: In its consultation, the HM Treasury made clear that it expects any custody functions relating to digital securities to continue to be subject to the existing CASS framework. The response confirms that this will remain the case, notwithstanding concerns surrounding how the CASS rules should be applied in a digital context.

As a point of market colour, it is worth noting that the response disclosed that HM Treasury has received 19 expressions of interest, across a mix of incumbent FMIs, existing regulated financial services firms and new entrants (with informal engagement suggesting further expressions of interest will emerge in due course). It is too early to say whether the DSS will be more popular than competitor pilot regimes, but the initial response appears encouraging.

For a full rundown, please see this very helpful article from my colleague Oli Ward, who would be more than happy to discuss the specifics of the sandbox with you.

Tokenisation of Funds

The Investment Association (IA) published an "Interim Report" looking at a blueprint for implementation of UK fund tokenisation. This is an extremely hot topic, and seems to be one of, along with payments, the key use cases of tokenisation. The aim is for funds to be able to issue tokenised shares or units which will represent the investor's interest in them, which can be traded and recorded on DLT, rather than a traditional system of records - there is huge potential for improvements in efficiency. There has already been movement in other jurisdictions, with the report highlighting developments in Germany, Luxembourg, France, Spain and Italy.

The FCA also wrote a letter to the working group of the IA in support of the report. This confirmed (as is also suggested in the report) that it is possible to issue tokenised units under current legal and regulatory frameworks in a "stage one" approach. This involves replacing an authorised fund's traditional register of unitholders with tokens on a private permissioned (not publicly accessible) blockchain for which the authorised fund manager takes responsibility. It would have the following characteristics:

• The structure of the fund, including the existing roles of the parties, would remain unchanged.
• Settlement would be carried out in the usual way 'off chain', with no use of any form of digital money.
• The fund would be comprised of traditional assets.
• The fund would continue to provide a valuation point daily or on another timescale consistent with existing regulation and market practice.

What will be exciting is when the structure of the fund and the existing roles of the parties can change, and when settlement can be carried out "on chain" - we need to wait for that. The report proposed nine recommendations for fund tokenisation.

There are three considerations initially, as part of an incremental series of changes towards the full investment value chain operating on DLT:

1. Regulatory certainty for UK fund tokenisation: Models of fund tokenisation that follow the 'stage one' characteristics should be capable of complying with the existing legal and regulatory framework.
2. Foster DLT innovation across UK investment management industry: The IA will act as a conduit between the industry, FCA and HMT to progress future stages of fund tokenisation, demonstrate incremental delivery and help firms engage with relevant officials
3. Money Laundering Regulation Registration Process: While the MLRs are made by government under legislation, the FCA is exploring whether it could more quickly determine MLR registration applications for firms already authorised by the FCA to carry out regulated financial services activities, where there is a lower risk of harm and where the FCA has evidence of strong control frameworks and non-adverse regulatory histories - this is particularly interesting, and we hope materialises.

Industry should then identify the prioritisation of future stages, working with regulators to implement them:

1. Industry to develop the details of further stages of fund tokenisation: Industry to develop the details of further stages of fund tokenisation, and to work with the FCA to consider impacts on Handbook rules & with HMT to consider impacts on legislation
2. Availability of digital forms of money to settle transactions: Industry to decide upon the optimal form of digital money for funds, and explore the possibility of leveraging the Bank of England's work on Synchronisation to enable wider industry access to the RealTime Gross Settlement service and enable funds settlement in digital central bank money
3. Legal considerations for investible assets: The ability of investment funds to hold tokenised versions of mainstream assets may be assisted by legal clarification. The report recommends that industry partners work with HMT to identify barriers in legislation for holding digital investible assets, and then to enable necessary legislative change, potentially through the Digital Securities Sandbox or another sandbox
4. Central Securities Depositary requirements and evolution of responsibilities: Holding a digital security via a traditional central securities depositary may not be an optimal process, but one that could be addressed via the Treasury's Digital Securities Sandbox. Firms who wish to look at this should express interest in participating in the Digital Securities Sandbox (see above)
5. Availability of digital identity: The group recommends that the government support building awareness of the digital identity legal framework set out in the Data Protection and Digital Information Bill, including the trust framework, and encourage industry adoption
6. Availability of Banking Services: The group recommends that HMT consider whether further action is needed on access to business accounts.

Developments in Singapore

On 23 November 2023, the Monetary of Singapore (the MAS) published guidance on certain measures it would implement in respect of cryptocurrency service providers (known as 'digital payment token service providers') in Singapore. This is the second part of a response to the consultation that came out in October last year, with the first part of the response coming out in July 2023. This second response looks at three key areas: consumer access, business conduct, and the management of technology and cyber risks.

With regard to business conduct requirements, digital payment token service providers would soon be required to:

• identify, mitigate and clearly disclose potential and actual conflicts of interest;
• publish policies, procedures and criteria that govern the listing of a Digital Payment Token; and
• establish effective policies and procedures to handle customer complaints and resolve disputes.

The MAS has also decided on imposing the following measures on digital payment token service providers, to discourage cryptocurrency speculation by retail customers:

• determining a customer's risk awareness to access Digital Payment Token services (such assessment is to be developed by industry players for now);
• prohibition on offering any incentives to trade in cryptocurrencies (such as marketing perks, rebates or discounts - similar to the new UK approach);
• not providing financing, margin or leverage transactions;
• not accepting locally issued credit card payments; and
• limiting the value of cryptocurrencies in determining a customer's net worth (in particular, for the purposes of determining whether a customer would be treated as an accredited investor, rather than a retail investor).

These changes would be made effective in phases from the beginning of Q2 2024 onwards, giving digital payment token services providers time to implement such changes in their respective businesses.

For more details, please feel free to reach out to my colleagues Ashleigh Low and Yingyu Wang.

Cryptoasset Reporting Framework

In an important step forward towards exchange of information on transactions in cryptoassets, a number of jurisdictions have released a joint statement confirming that they intend to implement the OECD cryptoasset reporting framework (CARF) by 2027.

The CARF was developed in response to a mandate from the G20 and in the light of the rapid growth of the crypto-asset market and provides for the reporting of information on transactions in cryptoassets in a standardised manner. CARF provides for the automatic exchange of information on crypto-assets, similar to the way in which the Common Reporting Standard (CRS) provides for exchange of information on financial accounts. Following the delivery of CARF to the G20, the G20 has asked the Global Forum on Transparency and Exchange of Information for Tax Purposes to build on its commitment and monitoring processes to ensure the widespread implementation of the CARF by relevant jurisdictions.

This month, 48 jurisdictions have published a Joint Statement committing to implement CARF, including the UK, USA, Canada and most EU member states. In particular, the statement notes that the widespread, consistent and timely implementation of the CARF will further improve the ability to ensure tax compliance and clamp down on tax evasion, which reduces public revenues and increases the burden on those who pay their taxes.

My Simmons Tax colleagues have prepared a more detailed briefing here, but you can also reach out to my colleagues James Cherry or Martin Shah for further information.

AI View

Slightly off topic, but I'm pleased to announce that another View has been born. My colleagues Minesh Tanna and Angus Brown have launched a newsletter looking at AI developments - there's a lot going on in this space and they are definitely on top of it. You can see the last issue here, and sign up for the mailing list here.