How do you regulate an asset like crypto?

May 2023  |  SPECIAL REPORT: FINANCIAL SERVICES

Financier Worldwide Magazine

May 2023 Issue

How to regulate an asset like crypto is a difficult question and one that regulators are grappling with worldwide. In the UK at least, the publication of HM Treasury’s ‘Future financial services regulatory regime for cryptoassets’ consultation (Regulatory Regime Consultation) moves us toward a slightly clearer position, albeit subject to the outcome of the consultation, further proposed regulation from the UK’s Financial Conduct Authority (FCA) and no doubt a further implementation period.

This article considers the present and future of the market with a focus on the UK and some comparison with Europe. However, to put these plans into context, it is equally important to appreciate how far the rise in cryptoassets has come, rising from an anonymous paper posted to a mailing list under the pseudonym ‘Satoshi Nakamoto’ in 2008 and the first Bitcoin transaction in 2010 (supposedly 10,000 bitcoins for two Papa John’s pizzas), to the US banking titan JP Morgan launching its own token, ‘JPM Coin’, in 2019.

Despite this, Jamie Dimon, chief executive and chair of JP Morgan, is famously sceptical of Bitcoin, calling it a “hyped-up fraud”, and emphasising how little people know about how it works. Mr Dimon’s provocative comments highlight the fact that, despite the increasing respectability of crypto, there remains a need for greater trust in the market, which an increase in regulation may well bring.

The case for more regulation – UK consumer adoption

Put simply, UK consumers are increasingly keen on crypto. Research by UK Finance and HMRC found that 10 to 11 percent of UK adults owned a cryptoasset in 2022, which is more than double the figure found by the FCA in 2021. This enthusiasm was reflected by the fact that the UK took the title as the fastest growing crypto economy of Western Europe last autumn.

On the one hand, this should be music to the UK government’s ears. With the UK vying to compete with the Middle East and Hong Kong to win the global race to be the crypto regulatory hub of choice, this signifies a growing mandate. On the other hand, this also represents a growing retail customer base in a largely unregulated, poorly understood and notoriously risky market. Despite the FCA reiterating the statement “if you decide to invest in crypto then you should be prepared to lose all your money” several times, it is questionable whether this is truly appreciated when about half of crypto users responding to the FCA’s 2021 crypto consumer research believe that they “know [their investment will]… make money at some point” when this is not guaranteed or even particularly likely.

The current UK regulatory position

Though crypto products themselves remain unregulated in the UK, the FCA has been the anti-money laundering (AMl) and counter-terrorist financing (CTF) supervisor for cryptoasset firms since January 2020. This means that it keeps a register of firms that must conduct appropriate customer due diligence and checks before onboarding clients and have generally met a level of AML regulation acceptable to the FCA.

However, the FCA was left distinctly unimpressed by applicants’ efforts, approving and registering just 15 percent of applications, with 74 percent of applications either refused or withdrawn and 11 percent rejected. To assist, the FCA has since published guidance on its expectations for prospective applicants and the statistics should also be boosted by its growing knowledge and understanding of the crypto market. Like most professionals operating in this fast-evolving industry, the regulator has undertaken significant ‘upskilling’, fortified by events such as its ‘CryptoSprint’ last spring.

Getting on the FCA’s AML register should be a priority for firms, not only in light of the FCA ‘showing its teeth’ by recently entering and inspecting sites suspected of hosting an unregistered crypto ATM operator in Leeds (a national first), but also in anticipation of the UK’s new crypto financial promotion regime.

Following the government’s policy statement on its approach to cryptoasset financial promotions regulation in February 2023, the FCA released a statement warning that cryptoasset firms marketing to UK consumers must get ready for the new regime, including firms based overseas. The FCA stressed that, under the government policy, a bespoke exemption will be introduced to allow cryptoasset firms registered with the FCA, but not otherwise authorised, to communicate cryptoasset financial promotions to UK consumers. This is key given that otherwise crypto-firms risk breaching section 21 of the Financial Services & Markets Act (FSMA): a criminal offence punishable by up to two years’ imprisonment.

While these plans are still subject to parliamentary approval, investment in AML and CTF systems seems a sensible plan for crypto firms, bearing in mind what is likely to come down the regulatory pipeline, as explored further below.

Big picture plans

With considerable support for increased crypto regulation, 2023 started with a boom in crypto consultations, including HM Treasury’s Regulatory Regime Consultation and the Treasury and Bank of England’s consultation in respect of the ‘digital pound’ (Digital Pound Consultation).

While there has been no final decision on whether a ‘digital pound’ will be introduced anytime soon (and rumours are it could take a decade), the Digital Pound Consultation seeks feedback on the conceptual model and six technology design considerations if it is needed in the future.

Through the Regulatory Regime Consultation, the Treasury is proposing to introduce mandatory regulatory authorisation for various participants in the crypto sector conducting specific activities. The proposed activities consulted on include cryptoasset issuance (of a fiat-backed stablecoin) and disclosures, execution of payment transactions involving fiat-backed stablecoins, operating a cryptoasset trading venue, investment and risk management of cryptoasset activities, operating a cryptoasset lending platform, cryptoasset custody activities, and validation and governance activities.

It is also anticipated that firms undertaking regulated cryptoasset activities will be expected to adhere to the same financial crime standards and rules that apply to similar but more traditional financial services activities. These are broader than those required to be on the FCA register and cover anti-bribery and corruption, sanctions, fraud and other aspects of financial crime. Consequently, it is likely that even smaller firms will need to implement more comprehensive compliance programmes to meet regulator expectations.

Keeping up with Europe

While these proposals seek to deliver on the ambition to place the UK’s financial services sector at the forefront of cryptoasset technology and innovation, the UK regime will likely still lag behind the developments in the EU where the equivalent legislation is nearing the end of the legislative process.

However, now that the Regulatory Regime Consultation has provided some detail to the intended UK regime, we can start to compare the approaches between the jurisdictions. Some distinctions to consider are outlined below.

Standalone vs. integrated. While the European Union (EU) has created an entirely standalone regime – the Markets in Crypto-Assets Regulation (MiCA) – the Treasury is seeking to regulate cryptoasset activities within the existing regulatory framework established by the FSMA applying a ‘same risk, same regulatory outcome’ principle.

Issuance of cryptoassets. With the exception of fiat-based stablecoins, the Treasury’s proposals do not seek to regulate the issuance of cryptoassets as such, but rather admittance to a trading venue and public offers of cryptoassets (that are not security tokens). By contrast, MiCA seeks to regulate both the issuance and offering of cryptoassets.

Provision of services. In contrast to the single chapter of provisions with which cryptoasset service providers in general must comply under MiCA, the Treasury specifies separate provisions for separate types of providers (i.e., from trading venues to cryptoasset custodians).

With both regimes subject to changes as they are finalised, there will be an element of watching the space as the full regimes come to fruition.

Is the UK doing enough?

While there is broad support for the Treasury’s consultation, some have commented that there has simply not been enough regulatory action taken, despite the considerable appetite. The Treasury conceded that it “probably will not be legislating in 2023” although noted that there are measures, such as the introduction of the financial market infrastructure (FMI) sandbox in the Financial Services and Markets Bill, which will further the Treasury’s understanding of the use of relevant technology. In particular, the Treasury defended time spent engaging with the industry at this stage given the immature and broad nature of the crypto market.

However, the UK’s resistance to swift action undeniably means that it falls behind in terms of enforcement. If the market is not yet regulated in the UK, the UK regulators simply cannot bring enforcement proceedings. Comparatively, the US considered cryptoassets to fit within the asset classes of its current regulatory regime, leading to a number of enforcement cases. For example, we have seen cases of money laundering and market manipulation brought by regulators in the US, but there cannot be comparable cases in the UK.

Nonetheless, the UK’s ability to deal with cryptoassets involved in existing offences is strengthening both in terms of: (i) powers available, with the expansion of criminal confiscation and civil recovery powers in the Proceeds of Crime Act 2002 to allow for seizure and recovery of suspected criminal cryptoassets thanks to the Economic Crime and Corporate Transparency Bill; and (ii) expertise, with the National Crime Agency recruiting for a new ‘crypto cell’ focused on targeting bad actors in cryptocurrency in the UK.

Therefore, the combination of pro-crypto messaging from the government, consumer uptake and high status on the regulatory agenda means that, even if the UK was a little slow off the mark historically, it will be keen to make up for lost time in terms of crypto regulation and enforcement in the years to come.

 

Katharine Harle is a partner, Zeena Saleh is counsel and Ellen Blakeney is an associate at Dentons. Ms Harle can be contacted on +44 (0)20 7320 6573 or by email: katharine.harle@dentons.com. Ms Saleh can be contacted on +44 (0)20 7320 3830 or by email: zeena.saleh@dentons.com. Ms Blakeney can be contacted on +44 (0)20 7320 4085 or by email: ellen.blakeney@dentons.com.

© Financier Worldwide

BY

Katharine Harle, Zeena Saleh and Ellen Blakeney

Dentons

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