Financial Services Insights Series 2023 HMT’s proposals for the future regulation of cryptoassets

On 1 February 2023 His Majesty’s Treasury (“HMT”) published its consultation and call for evidence on a future financial services regulatory regime for cryptoassets. HMT proposes to bring centralised cryptoasset exchanges into financial services regulation for the first time, as well as regulate other activities like custody and lending.

This proposal follows various existing regulatory consultations and developments including:

• the Financial Services and Markets Bill 2022 (“FS&M Bill”) (which is in the Committee stage at the House of Lords at the time of writing this article)
• the HMT consultation and call for evidence on cryptoassets and stablecoins; and
• the HMT consultation on cryptoasset promotions.

Despite rhetoric from the Government, there are still significant issues with the proposals, as well as considerable gaps and uncertainties that will need to be resolved if the UK truly wishes to become a world-leader in this area.

Stakeholders (including any business carrying on cryptoasset activities in the UK or providing cryptoasset products or services to customers in the UK) have until 30 April 2023 to consider and respond to this consultation. We have been working with our clients in this area and set out a summary of the proposals and some preliminary thoughts below. Please do get in touch if you require further information or if you have concerns on how the proposals could affect your business.

What does HMT propose?

HMT intends to include the regulation of cryptoassets within the existing regulatory framework established by the Financial Services and Markets Act 2000 (“FSMA”) by expanding the list of “specified investments” in Part III of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (“RAO”) to include cryptoassets. HMT also intends to use the new Designated Activities Regime (“DAR”) contained in the FS&M Bill to legislate for certain types of cryptoasset activities. This means that the FCA will be able to use its general rule making powers to draft tailored rules applicable to cryptoassets. HMT does not currently intend to expand the definition of “financial instrument” in Schedule 2 RAO to include presently unregulated cryptoassets.

HMT refers to the definition of cryptoassets used in the FS&M Bill as: “any cryptographically secured digital representation of value or contractual rights that (a) can be transferred, stored or traded electronically, and (b) that uses technology supporting the recording or storage of data (which may include distributed ledger technology).” HMT has the power to update this definition by passing secondary legislation.

Unlike the definitions of cryptoasset used in Regulation 14A(3)(a) of the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017/692 (“MLRs”) and the EU’s Markets in Cryptoassets legislation (“MiCA”) the FS&M Bill definition does not explicitly reference distributed ledger technology (“DLT”). This is an attempt to encompass potential future changes in the technology underlying cryptoassets and reduce regulatory arbitrage; however, there is certainly a question as to whether this makes the definition unworkably wide.

What kinds of activities will be regulated under the new regime?

HMT proposes to create a broad range of new regulated or designated activities tailored to the cryptoasset market where these activities seek to mirror, or closely resemble, regulated activities performed in traditional financial services. Proposed activities include:

• issuance activities such as the issuance and redemption of fiat-backed stablecoins, admitting a cryptoasset to a cryptoasset trading venue, or making a public offer of a cryptoasset;
• payment activities such as the execution of payment transactions or remittances involving fiat-backed stablecoins;
• exchange activities such as operating a cryptoasset trading venue;
• investment and risk management activities such as dealing in cryptoassets as principal or agent, arranging deals in cryptoassets, or advising on cryptoassets;
• operating a cryptoasset lending platform;
• safeguarding or safeguarding and administering fiat-backed stablecoins or other cryptoassets; and
• validation and governance activities such as mining or validating transactions or operating a node on a blockchain.

Under the proposals, the activities conducted by cryptoasset businesses will be regulated, rather than the assets. Accordingly, several cryptoassets, including exchange tokens, utility tokens, security tokens, and non-fungible tokens (NFTs), could in the future fall within the regulatory perimeter – if the nature of the activity being conducted in respect of them falls within one of the newly regulated activities.

Table 1 (taken directly from the Consultation Paper) sets out a helpful summary of the proposed scope of the cryptoasset activities to be regulated.

What will the process for authorisation look like under the new regime?

Where a person wishes to carry on one or more of the newly regulated activities by way of business, they will be expected to be authorised by the FCA, in advance, in respect of each activity.

Firms that are already authorised under FSMA for other regulated activities and intend to undertake one or more of the new cryptoasset regulated activities will need to apply for a variation of their permission from the FCA (and the PRA for dual-regulated firms).

Firms already registered with the FCA under the MLRs will also need to seek separate authorisation under the new FSMA-based regime, although the proposals state that the FCA will “endeavour to avoid” duplicative requests of businesses. Given (i) the current issues with the MLR registration process (the FCA has only approved and registered 15% of the applications received since 10 January 2020) and (ii) the fact that new crypto firms not yet registered under the MLR regime will not separately need to apply for MLR registration, there is certainly a question as to whether requiring MLR-registered crypto firms to complete a full new regulatory application for authorisation (as opposed to some kind of variation application) is proportionate or whether it places an undue burden on firms (and the FCA) relative to the benefit incurred.

What is the proposed territorial scope of the new regime?

HMT proposes to capture cryptoasset activities provided in or to the UK, including activities provided by UK firms to persons based in the UK or overseas, as well as those provided by overseas firms to UK persons.

Consumers can (and frequently do) easily access cryptoasset products and services which are provided by overseas companies, so the proposals aim to avoid firms moving offshore to evade regulation but still serving UK customers. However, there may be exceptions to consider to this approach. For example, “reverse solicitation” – where a UK customer accesses a cryptoasset product or service from an overseas firm entirely at their own initiative and the firm does not deliberate market to or solicit business from such customers, then it is possible that this may not, in certain circumstances, trigger an FSMA-authorisation requirement for that overseas firm.

It is not clear from the consultation whether firms carrying out all or certain activities would be required to have a physical presence in the UK to obtain authorisation. HMT suggests that will be for the FCA to determine the point at which firms apply for authorisation (taking into account the nature and scale of the firm’s activities and the risk of harm the activities could cause). However, in our view, many firms will need to have clear guidance on this before they make a decision on whether to apply for FCA authorisation and lack of certainty may also mean that requirements are imposed inconsistently on firms with similar offerings.

Are there any data reporting requirements in the consultation?

Under the proposals, venues may be required to keep, and make available at all times, accurate and comprehensive data related to trading on their exchanges, whilst authorities will retain the ability to propose more regular and wider reporting over time (for example, in line with international standards). HMT notes that “[m]arket participants in traditional finance are required to regularly report market data” and appears concerned that this is extended to cryptos in a proportionate manner; however, there does not appear to be any consideration or even recognition of the particular way in which blockchain or DLT more broadly is used to record and share data. Failure by HMT or the regulator to tailor the rules to the relevant technologies could mean that any data reporting obligation imposed on participants is far more burdensome than it need be.

What are the detailed elements of the proposed new regime?

The consultation contains chapters on the specific aspects of the new regulatory regime:

• Issuance and Disclosure: the proposed regime sets out the minimum information that investors must receive on cryptoassets that are admitted to trading on a cryptoasset venue and offered to the public. It is designed to enable investors to make informed investment decisions and ensure that appropriate liability and compensation is available for untrue or misleading statements made in disclosure/admission documents. The proposed regime will leverage the intended reform of the UK prospectus regime (the Public Offer and Admissions to Trading Regime) and be tailored to the specific attributes of cryptoassets.
• Operating a cryptoasset trading venue (or “exchange”): the proposed regime is designed to ensure orderly, open, and resilient conditions for trading on cryptoasset trading venues which provide fair access and transparent operating rules, and adequate systems and controls to facilitate fair and efficient trading. The proposed regime will be based on existing framework regulating the operation of trading venues, including multilateral trading facilities (“MTFs”).
• Intermediation Activities: the proposed regime will apply to cryptoasset intermediaries like dealers and liquidity providers who make markets in cryptoassets, firms that facilitate cryptoasset trading by arranging transactions which take place “off-exchange”, or agency brokers that help to execute trades on behalf of investors and other market participants. The proposed regime will be based on analogous “arranging”-type regulated activities (see Article 25 RAO) and adapted for cryptoassets, with additions where necessary to address specific cryptoasset market risks.
• Custody: the proposed regime sets out prudential, conduct and operational resilience requirements that will apply to cryptoasset custody activities. The proposed regime will apply / adapt existing frameworks for traditional finance custodians (see Article 40 RAO), making suitable modifications to accommodate unique cryptoasset features, or putting in place new provisions where appropriate.
• Market Abuse Requirements: the proposed regime will prohibit insider dealing, unlawful disclosure of inside information, and market manipulation in relation to all cryptoassets that are requested to be admitted to trading on a UK trading venue (regardless of where the person is based or where the trading takes place). Certain market participations, like cryptoasset trading venues will be expected to detect, deter, and disrupt market abusive behaviours. (HMT acknowledges that the objectives of this market abuse regime will be difficult to achieve and enforce until there are international standards and coordination in place between the majority of jurisdictions where major exchanges are domiciled.)
• Operating a cryptoasset lending platform: under the proposals, cryptoasset lending platforms will be required to (i) have adequate risk warnings for consumers lending to said platform (e.g. that the consumer could lose all their money, clarity on lack of FSCS protection); (ii) have adequate financial resources – capital and liquidity – and wind down arrangements to carry out their business; and (iii) have clear contractual terms on ownership and, if applicable, ringfencing of retail funds in case of insolvency. However, the proposed approach will not pursue all of the same outcomes delivered by different traditional lending and borrowing regulations, such as FSCS protection, affordability assessments and forbearance periods.

Do the proposals cover decentralised finance (“DeFi”)?

The HMT proposals contain a call for evidence on decentralised finance (“DeFi”). HMT recognises that DeFi organisations are globalised and borderless in nature and have participants operating across many jurisdictions. HMT also acknowledges that the typical financial services regulatory framework (which relies on the authorisation and supervision of individuals and firms undertaking specified activities) may be difficult to apply to DeFi networks (e.g., Decentralised Autonomous Organisations (“DAOs”) who have no central authority or recognised corporate structure).  

HMT is of the view that the outcomes and objectives achieved via the detailed new regime (summarised above) should also somehow be applied to DeFi networks, and indeed to all cryptoasset activities regardless of the underlying technology, infrastructure, or governance mechanisms. But there seems to be little thought leadership from the HMT or UK government in this area, merely a plan to rely on the “work of international organisations” and statement that the UK will not develop a “prescriptive framework for the UK that would need to be re-shaped once international approaches and standards crystalise”.

There is a suggestion that certain DeFi-specific activities, for example, “establishing or operating a protocol”, could become regulated activities under the RAO (or the DAR), but there is also a statement that “the objective would not be to regulate the activity of developing software, but if software developers go on to maintain, run and operate systems used for regulated financial activities (e.g., exchange, lending) then they should be subject to financial services regulation”, which unhelpfully seems to suggest that DeFi might only start to be recognised or regulated when certain activities occur in a centralised way (e.g. central maintenance and operation of systems).

It is clear that HMT’s thinking in this area is nascent. This is unfortunate because the industry needs clarity in order to grow: if the UK is truly to become a world-leader in this area, more work needs to be done. On the up side, it appears that there is still time to significantly influence government and regulatory thinking in this area.

Does HMT consider sustainability in its proposals?

Yes. HMT is seeking views on (i) what information about environmental impact or energy intensity would be useful for consumers making decisions about investing in cryptoassets, (ii) at what time in the investor journey these would be helpful to consumers, and (iii) whether there are any particular indicators or metrics that can be used to calculate these environmental impacts.

Is there anything else in the consultation that I should be aware of?

HMT is considering whether it should bring investment advice and discretionary management services for cryptoassets into the regulatory perimeter. HMT considers that these activities have potential to generate risks but is unclear about the extent to which they will be provided to retail clients in future.

At the moment, it seems unlikely that HMT will seek to regulate the mining cryptocurrency, particularly as the decentralised nature of certain cryptoassets create significant difficulties in enforcement.

What happens next?

While the new proposals are a welcome move by the Government for cryptoasset businesses, there are still areas of uncertainty/difficulties around the proposals which require further consideration, and obvious limitations to retrofitting an existing regime to a new asset class with unique features and risks. If the obligations of this regulatory framework are unduly burdensome then innovation will be stifled, and businesses will move overseas.

There is a lot of work still to be done by the government and the regulator to get crypto-regulation right and, if the UK truly wants to be a “market leader”, not a lot of time to do it in. It is imperative that business and other stakeholders (particularly those that understand the technology) feed into this process, in order that we get UK rules and guidance that are fit for purposes.

Please do get in touch if you require further information, assistance in understanding how proposals may affect your business, or if you would like our help in responding to the consultation.

HMT intends to pursue a phased approach for regulating cryptoassets, which is being prioritised according to the areas it considers are of greatest risk and opportunity. Phase 1 will focus on fiat-backed stablecoins that are used for payments and Phase 2 will focus on the regulation of a broader set of cryptoasset activities, including uncollateralised algorithmic stablecoins (see table). Future phases will depend on market evolution.