The UK Cryptoasset Taskforce comprising the Financial Conduct Authority (FCA), HM Treasury and the Bank of England (BoE) has published a Report that reflects the policy and regulatory approach to distributed ledger technology (DLT) and crypto assets, highlighting some risks and outlining possible regulatory developments. This report has impact on UK crypto industry, including issuers and investors, exchanges and other market participants.
Report sets out future plans of the Taskforce and states that for risk mitigation purposes HM Treasury, the FCA and the BoE will take actions collectively and will consult on:
- guidance to clarify which crypto assets fall within the existing regulatory perimeter and which will fall outside (by the end of 2018);
- possible extension of regulatory perimeter in relation to crypto assets that are similar to specified investments, but currently are not regulated (by the end of 2018);
- potential prohibition of sale of derivatives referencing certain types of crypto assets (for example, exchange tokens, such as Bitcoin), including contracts for differences, options, futures and transferable securities to retail investors (by Q1 2019);
- implementation of the fifth EU Anti-Money Laundering Directive and additional mechanisms to crypto industry participants (legislation in 2019); and
- revised guidance on the tax treatment of crypto assets (by early 2019).
Classification of crypto assets
The Taskforce considers three types of crypto assets which in its view are mainly used as a means of exchange, for investment, and as a capital raising tool:
- Exchange tokens — crypto assets that are not backed by a central bank or other central body, and do not provide the types of rights or access provided by security or utility tokens (often referred to as cryptocurrencies);
- Security tokens — crypto assets that fall within the definition of an existing regulated investment in the UK, typically providing rights such as ownership, repayment of a specific sum of money, or entitlement to a share in future profits;
- Utility tokens — crypto assets that can be redeemed for access to a specific product or service that is typically provided using a DLT platform.
The Taskforce emphasises that businesses are required to assess carefully on a case-by-case basis type of particular crypto instrument and applicable regulatory framework under existing rules and legislation, including with regards to aspects of general contract law, consumer law and advertising standards.
Report confirms that certain crypto assets can be used as a means of exchange, however they are not considered to be a currency.
Report demonstrates how current regulatory perimeter is applicable to crypto assets in correspondence with crypto assets’ functionality.
Some examples are set out below:
- Use of crypto assets as a means of exchange — payment services regulation under the UK’s implementation of PSD2 applies, but only to activities involving fiat currency. Some crypto assets may meet the definition of e-money if they are issued by a central issuer.
- Investments in crypto assets — direct investment in crypto assets does not fall within the perimeter unless the crypto asset is a security token or the investment is made by a regulated investment vehicle.
- Indirect investment through financial instruments that reference crypto assets — should be considered as regulated activity.
- In the ICO context — issue of security tokens falls within the regulatory perimeter.
The Taskforce also reminds regulated firms about applicability of certain FCA rules and principles to unregulated activities — FCA may hold regulated firms and senior management responsible for breaches relating to systems and control requirements, financial resources or financial promotion rules where such firms engage in unregulated crypto assets activities.
According to the report DLT is still developing, however it could deliver significant benefits in financial services and other sectors. DLT could enhance system resilience, improve the efficiency of end-to-end settlement processes and reporting, auditing and oversight, and enable greater automation.
As stated in the report there are some challenges for wider adoption of DLT such as interoperability of systems, banking relationships, settlement finality as well as legal challenges given below:
- Competition legislation: issues may arise in relation to the use of DLT in financial services, e.g. access by market participants to a permissioned DLT network in a scenario in which the network has developed to become an essential market infrastructure.
- Data protection legislation: the possibility of tension between the legal “right to be forgotten” and the immutable nature of data storage on some DLT networks;
- Enforceability of smart contracts in the UK;
- Settlements: in payment and other settlement systems, it is essential to know the point at which a payment becomes final and irrevocable. Using DLT could present interpretative challenges as to the precise moment when a transaction processed by the system has been submitted to, or completed by, the network;
- Governance: firms will have to pay careful attention to allocating individual responsibilities where they use a DLT network that does not have a central point of authority. The requirements on UK regulated firms to have in place effective systems and controls to ensure the continued availability, reliability, and security of key regulated services will also need to be carefully considered by firms wishing to use DLT to facilitate regulated financial services.
In its report, the Taskforce concludes that there are no regulatory hurdles in the further adoption and development of DLT. The FCA takes a technology neutral approach to regulation and has issued a Discussion Paper on DLT concluding that no regulatory changes are required. It is therefore anticipated that the continual growth of DLT will enjoy strong support from the UK government and authorities.
Taskforce concludes that the use of crypto assets for illicit activity remains low. However, certain features of crypto assets considered to be attractive for use of crypto assets in criminal activities. For risk mitigation purposes UK government proposes to develop a robust regulatory response, which will go significantly beyond the requirements set out in the EU Fifth Anti-Money Laundering Directive (5MLD).
The Treasury will consult in early 2019 on proposals related to 5MLD in the UK in order to address the risk of use of crypto assets for illicit activity by reducing the anonymity impact . Extension of AML/CTF obligations will cover following crypto infrastructure participants:
- Platforms that facilitate peer-to-peer exchange of crypto assets between individuals;
- Crypto asset ATMs;
- Non-custodian wallet providers that function similarly to custodian wallet providers.
The consultation will also include proposals to extend UK AML/CTF obligations to firms based outside the UK when providing services to UK consumers, and a proposal for the FCA to be appointed as the supervisor of otherwise unregulated firms engaged in crypto-asset activity in relation to their AML/CTF obligations.
According to the Report FCA is aware of harm caused by certain crypto assets derivative products such as contracts for difference (CFDs) referencing crypto assets. The FCA will therefore consider prohibition of the sale to retail clients of all derivatives referencing exchange tokens (e.g. Bitcoin) such as CFDs, futures, options and transferable securities.
This measure is not intended to capture derivatives referencing crypto assets that are classified as a securities. The FCA intends to refuse the listing of a transferable security on exchange or of a fund that references exchange tokens, unless it has confidence in the integrity of the underlying market and is satisfied that all regulatory criteria for fund authorisation have been met.
Risks to consumers may also result from immature market structures and potential failings by services providers such as crypto exchanges, trading platforms, and wallet providers, such risks may limit/restrict consumers easy access to their invested funds and/or secondary market trading and can result in significant delays in the payment chain.
Following various measures by the FCA to increase public awareness of the risks associated with crypto assets, the Taskforce expressly warns consumers to be cautious when purchasing crypto assets and to be prepared to lose money. The authorities will continue to actively warn consumers of associated risks.
As areas for further development Report indicated market abuse issues. The Taskforce notes concerns around “market abuse-style activities” currently occurring in relation to crypto assets, and the potential for new abusive behaviours not captured by current monitoring tools.
The Taskforce takes the view that the issuance of crypto assets through ICOs should be subject to regulation. In early 2019 the government will consult with the industry on whether such crypto assets exist in the UK market and the merits of extending the regulatory perimeter to ICOs.
As per exchange tokens, investment/trading activities relating to exchange tokens and custody aspects are viewed as creating new challenges for existing regulation. Taskforce also identified inherent need for a consistent international approach. Consultations to re-evaluate the regulatory approach and means for effective regulation are planned for early 2019.
The Report states that the authorities comprising the Taskforce remain committed to be actively involved in international efforts on crypto economy in order to ensure global regulatory coherence and coordination (including through the G20 and G7).
The Report demonstrates the UK authorities’ commitment to their respective objectives and desire to enable and support innovation as a thought leader of future regulation. In that regard, the Report sets out the direction for the UK’s regulatory approach based on existing findings and work undertaken to date.