On 1 February 2023, HM Treasury (“HMT”) published a consultation[1] setting out proposals for the UK’s financial services regime for cryptoassets. The UK government has highlighted its ambition to make Britain a global hub for cryptoasset technology. Rishi Sunak previously asserted that “effective regulation” would encourage “the businesses of tomorrow to invest, innovate and scale up on UK shores”[2]. In this article, we explore HMT’s plan for UK cryptoasset regulation and the likely impact it will have on traditional financial services participants, cryptoasset businesses and their customers.

The case for UK cryptoasset regulation

The case for UK cryptoasset regulation is compelling. Surveys from research agency Kantar UK published in July 2022 show “5-10% of UK adults now own cryptoassets, an increase of more than 100% over the past 1-2 years”[3]. However, this popularity has coincided with some high profile failures in the sector, including crypto giant FTX[4] in November 2022. If FTX had to meet more robust regulatory standards, would so many consumers have suffered losses following its failure? HMT’s proposals suggest that “mitigating these risks will require a combination of robust prudential safeguards, operational risk controls, transparency and data reporting arrangements, measures to manage conflicts of interest, good governance and adequate record keeping.”

UK cryptoasset definition

The Financial Services and Markets Bill 2022 includes the following definition of “cryptoasset”, to be introduced into the UK’s Financial Services and Markets Act 2000 (“FSMA”):

““cryptoasset” means any cryptographically secured digital representation of value or contractual rights that—

1. can be transferred, stored or traded electronically, and
2. that uses technology supporting the recording or storage of data (which may include distributed ledger technology).”

This is similar to the definition of “cryptoasset” in the EU’s Markets in Cryptoassets legislation (“MiCA”). Global regulators must arrive at a consistent definition if they are to collaborate on global regulatory standards in the future.

UK cryptoasset legislation

Cryptoassets will be included within the regulatory framework established by the FSMA and the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (“RAO”). Cryptoassets will be added to the list of “specified investments” in Part III of the RAO. This approach leverages the creditability of the existing regulatory system delivering a level playing field between crypto and traditional financial services.

Persons performing certain activities (by way of business) in cryptoassets will be performing regulated activities requiring authorisation under Part 4A of FSMA. This provides the Financial Conduct Authority (“FCA”) with general rule making powers over regulated activities in cryptoassets.

 

Territorial scope for UK cryptoasset regulation

The proposals capture cryptoasset activities “provided in or to the United Kingdom”. This is intended to prevent firms from re-locating overseas and continuing to serve UK customers without authorisation. Acting in this way would be circumventing UK cryptoasset regulation through so-called “regulatory arbitrage”. There is an intention to pursue equivalence arrangements whereby overseas cryptoasset firms authorised in third countries with equivalent standards can provide services in the UK without a UK presence. The equivalence arrangements are likely to be a key component in the success or failure of this scope. Requiring crypto firms to be authorised in every jurisdiction where they have customers is a significant barrier to business. How long will it take for each jurisdiction to establish an equivalent regulatory framework?

The consultation suggests there may be a “reverse solicitation” exception. This would allow UK customers to approach overseas cryptoasset businesses at their own initiative. We expect any reverse solicitation exclusion to be extremely narrow as overseas regulators have expressed concern that the practice may be used to circumvent regulation in the past[5].

UK regulated cryptoasset activities

Below is a list of indicative regulated cryptoasset activities, referencing relevant chapters and phases set out in HMT’s consultation:

Key proposals for UK cryptoasset regulation

Anti-money laundering and counter-terrorist financing (AML/CTF)

The FCA is already the AML/CTF supervisor of UK cryptoasset businesses under the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (“MLR”). Under the proposals, firms undertaking regulated cryptoasset activities will need to adhere to financial crime standards and rules under FSMA. The FSMA requirements are broader than those covered in the MLR, including anti-bribery and corruption, sanctions and fraud.

The few crypto firms that managed to obtain registration under the MLR regime are probably grateful the process is over. However, there could be a more challenging hurdle on the horizon. Under the consultation proposals, crypto firms carrying out regulated activities will need to seek authorisation under FSMA.

Crack down on misleading crypto promotions

Appropriate risk disclosures form a key part of the government’s proposed framework. Expect crypto financial promotions to have clear risk warnings with terms that other financial participants are familiar with. You are more likely to see “your capital is at risk” than “this coin is going to the moon”.

Cryptoasset issuance and disclosures

Anyone (i) admitting (or seeking admission of) a cryptoasset to a cryptoasset trading venue; or (ii) making a public offer of a cryptoasset, will trigger issuance and/or disclosure requirements under UK cryptoasset regulation.  Issuers will need detailed prospectuses for offers to the public. The government wants to ensure that a minimum standard of information is made available so investors can make informed decisions. Where firms are marketing to retail investors, they will need to comply with the financial promotion regime.

Operating a cryptoasset trading venue

Operating a cryptoasset trading venue is likely to be extremely similar to the existing RAO activities of regulated trading venues. This includes the operation of a multilateral trading facility (“MTF”). Firms looking to perform this activity will need to satisfy extensive requirements for prudential controls, consumer protection, governance, operational resilience, reporting and resolution/insolvency planning. HMT states that “Firms operating cryptoasset trading venues would likely require subsidiarisation in the UK given their critical role in the cryptoasset value chain.”

Intermediation activities (crypto brokers and market makers)

Crypto intermediaries make markets in cryptoassets, boosting liquidity and adding depth to the market. However, just as we see in financial markets, these business models come with inherent risks attached such as conflicts of interest, credit and liquidity. There are well established regulatory frameworks for intermediaries in financial services. Crypto firms “arranging deals in investments” and “making arrangements with a view to transactions in investments” will be subject to the same standards. Expect best execution and conflicts of interest management to be at the forefront of new challenges for crypto intermediaries.

Cryptoasset custody

The government is proposing to apply and adapt existing frameworks for traditional finance custodians for cryptoasset custody activities.

It will be interesting to see how similar the cryptoasset custody requirements are to the custody provisions in the Client Assets Sourcebook (“CASS”) given the unique characteristics of cryptoassets. Nevertheless, consumers will welcome the news that proposals may open the door for claims against failed authorised cryptoasset custodians under the Financial Services Compensation Scheme (“FSCS”).

Market abuse

The consultation acknowledges that the types of abusive activities and behaviours that are seen in traditional financial services are mostly applicable to cryptoassets. There is currently nothing to prevent market abuse in cryptoassets, such as high profile social media personalities operating “pump and dump” strategies at the expense of their followers. The need for regulation is clear, but the consultation acknowledges substantial difficulties in achieving this.

The “highly globalised, fragmented, and borderless nature of cryptoasset markets” makes it extremely difficult to prevent and detect abusive behaviours. “There is little geographic nexus” between the trading venue, the issuer, intermediaries and investors. The effectiveness of market abuse controls will require regulatory co-operation on a global scale. HMT indicates that “work is being undertaken in international forums”, but this is likely to take some time.

The market abuse proposals within HMT’s consultation will be familiar to existing financial services participants, with trading venues and other regulated entities (intermediaries) responsible for having appropriate systems and controls in place to prevent, detect and disrupt market abusive behaviours. The regime will apply to any person committing market abuse on a cryptoasset that is requested to be admitted to trading on a UK trading venue.

Operating a cryptoasset lending platform

HMT noted that “cryptoasset platforms engaged in lending activities have often held high proportions of illiquid or ‘less liquid’ assets on their balance sheets, which has made it difficult to meet liabilities in periods of stress.” The consultation proposes obligations for lenders covering prudential, governance, consumer protection, operational resilience, and resolution requirements.

Other cryptoasset activities

The consultation closes with a call for evidence on several topics, including: (i) decentralised finance (“DeFi”); (ii) investment advice and portfolio management; (iii) post-trade activities; (iv) crypto mining and validation; and (v) staking. We can expect further proposals in relation to these topics after the consultation period has closed.

Conclusion

HMT’s proposals for UK cryptoasset regulation are rooted in the existing UK financial services regulatory framework. This is a deliberate move and consistent with HMT’s core design principle: “same risk, same regulatory outcome”. The theory makes sense, but will it work in practice?

Cryptoassets have unique characteristics that will no doubt be challenging to fit into existing framework. We have also witnessed operational challenges when the FCA became the AML/CTF supervisor for crypto businesses under the MLR. Hopefully, the lessons from that experience will pave the way for a smoother introduction of the UK’s financial services regime for cryptoassets.

How can C&G help?

We assist firms with FCA cryptoasset registration under the MLR.  We monitor the development of crypto regulation in the UK to help firms prepare for upcoming changes in this sector.

Contact us today if you need assistance or advice.

References

[1] 2023. Future financial services regulatory regime for cryptoassets. HM Treasury, 1 February 2023. Available at: https://www.gov.uk/government/consultations/future-financial-services-regulatory-regime-for-cryptoassets

[2] 2022. UK finalises plans for regulation of ‘wild west’ crypto sector. Financial Times, 5 December 2022. Available at: https://www.ft.com/content/481d45d8-943e-484b-84ca-3b11f02c0ee4

[3] 2022. Individuals holding cryptoassets: uptake and understanding. Kantar UK commissioned by HM Revenue and Customs (HMRC), 5 July 2022. Available at: https://www.gov.uk/government/publications/individuals-holding-cryptoassets-uptake-and-understanding

[4] 2022. Crypto giant FTX collapses into bankruptcy. BBC News, 11 November 2022. Available at: https://www.bbc.co.uk/news/business-63601213

[5] 2021. ESMA reminds firms of the MiFID II rules on reverse solicitation. European Securities and Markets Authority, 13 January 2021. Available at: https://www.esma.europa.eu/press-news/esma-news/esma-reminds-firms-mifid-ii-rules-reverse-solicitation