FCA Consultation on Cryptoassets — Response to Q1 (Exchange Tokens)
I am currently working through the “FCA consultation on Cryptoassets (CP19/3)”. I will submit a written response on behalf of LexByte in due course, but I thought I’d already put those out for discussion as I go along, allowing me to improve them on the way. Enjoy, comment, and please do provide feeback if you want (stefan at lexbyte dot io, or message me on LinkedIn)
Question 1 — Draft response 27/Jan
Q1: Do you agree that exchange tokens do not constitute specified investments and do not fall within the FCA’s regulatory perimeter? If not, please explain why.
I agree that exchange tokens — if properly defined — do not constitute specified investmentsand that therefore a priori they should not fall under the FCA’s regulatory perimeter. There are a number of issues however that, from a pragmatic rather than a legal point of view, would counter that assessment.
Firstly there is the “properly defined” point. The reason why exchange tokens should not be regulated is that they are more or less like currencies, and currencies are not, so they should not be either. On the other hand, currencies are nowadays a pretty well understood asset class, and they are associated to one sovereign / nation state issuer (or a group thereof). Consumers tend to understand who are the quality issuers and which currencies are highly risky and speculative and they tend to have a feel for the volatilities involved — currencies have been around long enough.
Exchange tokens are like currencies — except that they are privately issued, and their value depends on a number of parameters that are even hard to assess by experts, let alone by the public: first of all, there are the underlying technical issues. Exchange tokens for example are only sound if the underlying cryptography is, and there are instances where for example this is up for heated discussion. Secondly, for an exchange tokens to be sound the technology must be, meaning there must be a competent and motivated group of developers, and the problems must be solvable. In this context, consider for example the issues and discussions around state channels and sharding. Lastly, the economics of the token must be robust, and there is generally very little understanding of the valuation of tokens that are neither supporoted by a central bank nor tied to some economic or taxation power, and ultimately whose only value is scarcity.
The second major point is that we should claim that exchange tokens are more or less like currencies more seriously — that is their raison d’etre after all. In this sense, exchange tokens other than those that are held in self custody should be considered electronic money so the regulations on safe-keeping of client money should apply for example for custodial wallets and custodial exchanges. This also would arguably put them at part with stable coins on which I will comment below. In my view, for the average consumer and merchant stable coins are much more useful than exchange tokens, and a permissive regulatory regime for stable coins is much more conducive to innovation in the financial services space than an equivalent one for exchange tokens. It would be a tragedy if for regulatory reasons business that should really go down the stable coin route is going down the exchange token route with the only benefit of this being the ability to avoid regulations.
Finally there is an issue with loss of private keys, where loss can mean either the rightful owner losing access to their private keys, or a third party gaining access to it. This is a new issue that did not quite exist before the advent of technology, and it will probably eventually require guidance for (or even regulation of) wallet providers like Trezor or Ledger who provide off-the-shelf solutions for self-custody.
To summarise: exchange tokens that are held in custody (eg on an exchange or in a wallet) should be treated similar to eMoney and exactly like stable coins. In particular there should be no regulatory incentive to use exchange tokens over stable coins. Also regulation should take into account that whilst that investments in exchange tokens might legally be similar to those in fine wine or in cars the ease of access for the medium customer makes to a qualitatively different issue. Finally the issue of keeping private keys safe in self-custody solutions must be addressed as the average consumer will not be capable of dealing with this issue adequately.
Stefan Loesch a managing partner at LexByte, an advisory firm specialising on tokenised investments. He has more than 20 years experience in financial markets, and his previous roles include advisory at J.P. Morgan and McKinsey and quant development at Paribas. He is the author of “A Guide to Financial Regulation for Fintech Executives” (Wiley 2018).
