Crypto-assets – the UK’s response to regulation
February 2019 | SPECIAL REPORT: CORPORATE FRAUD & CORRUPTION
Financier Worldwide Magazine
February 2019 Issue
Cryptocurrency is a relatively new form of currency which can be transferred electronically between users without the involvement of intermediaries or the oversight of a central authority. The ledger is stored electronically by a method known as blockchain. The ledger is publically available and all transactions must be verified through the agreement of multiple users.
Although the term cryptocurrencies is in common usage, the Bank of England has stated that they do not perform the requisite features of a currency – a store of value, a medium of exchange and a unit of account – and should therefore instead be referred to as crypto-assets.
Some take the view that crypto-assets have a short shelf life due to the dramatic fluctuation in value and perceived lack of security. However, recent steps taken by UK authorities suggest that crypto-assets are being taken seriously in the financial market and crypto-asset-related crime will require significant resources to fund the fight against it in the future.
Treasury Committee report
In September 2018, the Treasury Committee released a report on crypto-assets which the UK Government and the Financial Conduct Authority (FCA) have recently responded to.
Currently, neither crypto-assets themselves nor the buying and selling of crypto-assets fall within the scope of FCA regulation. They do not meet the criteria to be considered a specified investment under the Regulated Activities Order, neither do they qualify as ‘funds’ or ‘e-money’ in the Payments Services Directive and E-Money Regulation 2009. The UK government stated that it “stands ready” to give the FCA more power to oversee crypto-assets after MPs warned of a “Wild West” crypto market exposing consumers to a host of risks.
The Treasury highlighted the following risks associated with the use of crypto-assets: (i) high price volatility; (ii) a risk of hacking of crypto-asset exchanges; (iii) consumers losing passwords to their digital wallets and being prevented from future access; (iv) coordination of price manipulation; (v) acting as a vehicle for money laundering; and (vi) adverse implications on financial stability.
A consultation will be launched in early 2019 to determine what elements of the cryptocurrency market should be formally regulated. The FCA also said in September 2018 that it was considering a ban of the sale of derivatives based on crypto-assets which would be the regulator’s first major intervention in the market.
Anti-Money Laundering (AML) Directive
Measures are underway in the EU to bring crypto-asset exchanges into the money laundering regulation. The Fifth Anti-Money Laundering Directive (AML) is due to be implemented into national law by 2020 and the UK has confirmed this will go ahead even though it will be post-Brexit. The Directive extends AML and counter-terrorist financing rules to virtual currencies. Any entity that deals with virtual currencies will have to identify their customers and report suspicious activity to the regulator.
There has been some debate about whether crypto-assets have introduced a major risk of money laundering to society, largely due to their anonymity and absence of regulation. In his evidence to the Treasury Committee, David Raw at HM Treasury stated that: “the latest risk assessment from the National Crime Agency is that [crypto-assets] use for money laundering and terrorist financing is currently low. They are seeing cases of it, but it is not widespread”. He highlighted certain features of crypto-assets which make them undesirable to criminals, namely a transparent record of transactions which could be auditable.
However, the FCA has argued that the role of crypto-assets in money laundering could be more significant than previously thought. The risk of crypto-assets being used in money laundering was assessed as relatively low in 2017 in the National Risk Assessment. However, after conducting further work in the area, the FCA has now concluded that there is an indication of wider-scale criminal use and the potential harm is now greater. The Fifth AML Directive will be a step forward to deal with the problem.
The potential rise in crypto-asset crime poses a substantial challenge for the police and other enforcement agencies. A particular challenge which the police face is being able to locate and seize funds which are being laundered through a crypto-asset transfer. Officers have reported that they feel insufficiently trained in this area and as a result, City of London police are rolling out a pilot scheme which will train fraud investigators in how to deal with cryptocurrency as part of their Economic Crime Academy. The introduction of such training indicates that there is a focus upon resources for crypto-asset criminal investigations.
New court house
It was confirmed in 2018 that a new 18 courtroom legal centre will be built at Fleetbank House in London which will primarily deal with cyber crime, fraud and wider economic crime. The court, which has an estimated completion date of 2025, is intended to reinforce the UK’s position as a “global legal hub”. Lord Chancellor David Gauke stated that the creation of the court will send a message to the world that Britain “stands ready to deal with the changing nature of 21st century crime”.
A specialist court of this nature has not existed before in the UK and its creation demonstrates that UK authorities expect an increase in economic crime, largely due to the development of crypto-asset crime. The potential increase in such crime could be vast and of particular concern are the unknown opportunities for crime that could arise in this relatively new and unregulated area.
FCA “Dear CEO” letter
While the Fifth AML Directive is being transposed, the FCA has been taking interim steps to remind financial authorities of their responsibilities. A “Dear CEO” letter was issued in June 2018 which provided instruction to banks on how to deal with the financial crime risks arising from crypto-assets. It defined these crypto-assets as “any publicly available electronic medium of exchange that features a distributed ledger and a decentralised system for exchanging value”, such as Bitcoin or Ether.
It is pointed out that there are many legitimate uses of crypto-assets, such as using them as high-risk speculative investments or as a way of funding innovative technological development. However, due to certain features of crypto-assets, such as potential anonymity and cross-border transfers, there is a risk of the product being abused.
Several potential high-risk services are identified, such as crypto-asset exchanges which effect conversions between fiat currency and crypto-assets and/or between different crypto-assets, trading activities where the source of wealth is derived from crypto-assets and arranging, advising on or taking part in ‘initial coin offering’.
The FCA then went on to detail the measures which should be taken by banks to reduce the risk of cryptocurrency crime. These include: (i) developing staff knowledge on crypto-assets to help them identify high risk clients or activities; (ii) ensuring that existing financial crime frameworks adequately reflect crypto-related activities and that they are capable of keeping pace with fast-moving developments; (iii) engaging with clients to understand the nature of their businesses and the risks they pose; (iv) carrying out due diligence on key individuals in the client business; (v) for clients offering crypto-exchange services, assessing the adequacy of those clients’ own due diligence arrangements; and (vi) for clients involved in ICOs, considering the issuance’s investor-base, organisers, the functionality of tokens and the jurisdiction.
Banks are advised to adopt a risk-based approach but to treat each client individually by appreciating that the risk associated with different business relationships can vary and also managing the level of risk appropriately. Banks should assess the risks posed by a customer whose funds derive from the sale of crypto-assets by using the same criteria that would be applied to other sources of wealth or funds.
Although a “Dear CEO” letter does not create a specific rule, any failure to follow the guidance could be taken into account as an aggravating factor in any FCA enforcement action. Therefore, banks and other financial institutions should take heed of the warning and ensure that compliant systems are in place to prevent financial crime.
It is possible to introduce the regulation of crypto-assets into the UK via two methods, either by incorporating it into existing regulation or creating a new framework specifically for crypto-assets. The UK government’s consultation in 2019 will explore the options further. With the correct regulation in place it is thought that the UK could become a global centre for crypto-asset activity. In the meantime, banks are advised to remain vigilant.
Rianne McCartney is a solicitor at Saunders Law. She can be contacted on +44 (0)20 7632 4325 or by email: firstname.lastname@example.org.
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