In its long-awaited consultation and call for evidence published on 1 February 2023, the government has set out its proposals on the future financial services regulatory regime for cryptoassets. The government is keen to harness the opportunities of new financial technologies and, in particular, to unlock growth and boost innovation in the cryptoasset markets. However, as with any emerging technology, cryptoassets bring risks as well as opportunities, as highlighted by the recent turbulence in the markets and the high-profile collapse of FTX Trading Ltd, one of the world’s largest cryptocurrency exchanges.
Given the breadth of the consultation, the specifics of a future regulatory regime in respect of cryptoassets remain to be clarified. However, it is clear that more regulation is in the pipeline and that there is a strong policymaker preference to adopt existing regulatory structures where possible. After the consultation closes on 30 April 2023, the government will consider the feedback received and set out its response.
Policy objectives
The regulatory framework under the Financial Services and Markets Act 2000 (FSMA) is technology neutral and is currently applied to cryptoassets in the same way as to traditional financial services (see box “Defining cryptoassets”). However, with the development of innovative financial services technologies, the government has recognised the need to establish a proportionate regulatory framework for cryptoassets that enables innovation while maintaining financial stability and standards. As a result, it is proposing a number of new regulated or designated activities that are tailored specifically to the cryptoasset market, resembling the regulated activities performed in traditional financial services under FSMA.
The four overarching policy objectives of the proposals are to:
- Encourage growth, innovation and competition in the UK.
- Enable consumers to make well-informed decisions with a clear understanding of the risks involved.
- Protect UK financial stability.
- Protect UK market integrity.
In addition to these policy objectives, the government will be guided by three core design principles.
Same risk, same regulatory outcome. This design principle describes the government’s technology-agnostic, activities-based approach to regulation while acknowledging that specific entities may pose systemic risk that warrants further regulation.
Proportionate and focused. This principle denotes that financial stability and market integrity risks must be balanced with the danger of disproportionate or burdensome regulation.
Agile and flexible. This principle illustrates the importance of accommodating evolving markets and products. This is consistent with the Future Regulatory Framework that is expected to be established by the Financial Services and Markets Bill (the Bill).
A phased approach
The consultation outlines the planned phased approach to cryptoasset regulation, which prioritises the areas of greatest risk and opportunity. Phase 1 focuses on legislating for a new regime to regulate fiat-backed stablecoins. This will include issuance and custody activities relating to fiat-backed stablecoins as well as payment-related activities for fiat-backed stablecoins that are used in payments.
Phase 2 encompasses the proposed new regime to regulate broader cryptoasset activities, which is the focus of the current consultation. This phase would target areas associated with a higher degree of consumer risk, but also those that pose greater opportunities to support the UK’s growth agenda.
The Bill has laid the foundations for the new regime, and draft secondary legislation and further consultation for both phases is expected to follow.
New regulated cryptoasset activities
The financial services regulation of cryptoassets would be contained within FSMA, as updated by the Bill, given its established nature in regulating UK financial services. The list of specified investments in the Financial Services and Markets Act 2000 (Regulated Activities) Order (SI 2001/544) (RAO) would be expanded to include cryptoassets so that certain activities involving cryptoassets performed by way of business would require authorisation under Part 4A of FSMA. Activities that might not be suitable for regulation under the RAO could be regulated under the new designated activities regime, as set out in the Bill.
The consultation lists a number of activities that it is proposing to bring within the regulatory perimeter during Phase 2, but warns that these are “for illustrative purposes only”. These include:
- Issuance activities, such as admitting a cryptoasset to a trading venue or making a public offer of a cryptoasset.
- Exchange activities, including operating a cryptoasset trading venue.
- Investment and risk management activities, including dealing in cryptoassets as principal or agent, arranging deals in cryptoassets, and making arrangements with a view to transacting in cryptoassets.
- Lending, borrowing and leverage activities, such as operating a cryptoasset lending platform.
- Safeguarding and administering activities, including means of access.
The consultation dedicates a chapter to each of the above activities and explains in further detail how the regulatory regime might apply in specific cases.
In respect of existing regulations, these changes would bring cryptoasset activities that are currently in scope of the UK’s anti-money laundering regulations into the FSMA regulatory framework. Therefore, in time, authorities would look to operate a single register and authorisation process for firms undertaking cryptoasset activities. Cryptoasset firms that are already registered with the Financial Conduct Authority (FCA) under the anti-money laundering regime would be required to also seek authorisation under the new FSMA-based regime. However, to smooth the transition, the FCA will endeavour to avoid duplicative information requests, taking into account the supervisory history of businesses during the authorisation process. Firms that are already FSMA authorised would generally need to apply for a variation of their permission in order to carry on regulated cryptoasset activities.
The treatment of existing cryptoassets that already qualify as specified investments is likely to remain unchanged for the most part.
Territorial scope
Given that cryptoassets are often provided and consumed digitally, and are not confined to a specific jurisdiction, it can be difficult to determine the location in which cryptoasset activities are carried out. In terms of the territorial scope of Phase 2 activities and beyond, the government proposes to capture cryptoasset activities that are provided in or to the UK, encompassing activities provided by UK firms to both UK and overseas persons, as well as those provided by overseas firms to UK persons, with possible nuances for specific activities. This is pending further consideration of available exceptions, such as so-called “reverse solicitation” of cryptoasset activities that are provided from overseas companies.
For overseas firms, the question of whether they would be required to have a physical presence in the UK in order to obtain authorisation to carry on cryptoasset activities would be for the FCA to determine during the application process.
The consultation also outlines the government’s intention to pursue equivalence-type arrangements to allow firms that are authorised in third countries, and subject to equivalent standards, to provide services in the UK without needing a UK presence.
Market abuse
The consultation puts forward a case for a cryptoassets market abuse regime based on elements of the retained EU law version of the Market Abuse Regulation (596/2014/EU) (UK MAR) for financial instruments. Offences would apply to all persons committing abuse on a cryptoasset that is requested to be admitted to trading on a UK trading venue, regardless of where the person is based or where the trading occurs. Cryptoasset trading venues would be expected to detect, deter and disrupt market abuse. Other market participants may also be required to establish systems and controls to prevent and detect market abuse.
Calls for evidence
The consultation includes a number of calls for evidence, seeking views on:
- Decentralised finance (DeFi), including how DeFi can be regulated while balancing a proportionate, innovation-friendly approach and encouraging a thriving DeFi industry.
- Other cryptoasset activities, including whether cryptoasset investment advice, portfolio management, and mining and validation activities should be regulated in the UK. Post-trade activities, such as settlement and clearing, will be shaped by lessons from the financial market infrastructure sandbox initiative.
- Sustainability, including looking at the types of information that consumers would find useful for investing in cryptoassets and when in the journey this information would be most helpful, as well as the indicators and metrics that are available to calculate the environmental impact of cryptoassets.
Impact of the new regime
There is certainly more work to be done before it is clear what shape the UK’s cryptoasset regime will take; however, the consultation’s proposals mark a significant first step. The cryptoasset industry will likely welcome the core design principles guiding the framework, particularly the emphasis on proportionality.
For cryptoasset firms already registered with the FCA, the possibility of having to obtain full authorisation should not be underestimated, as this will likely constitute a significant undertaking in order to meet the FCA’s expectations and requirements. These firms may wish to consider their approach to implementing relevant policies, systems and controls now in order to get ahead, including with respect to moving towards meeting regulatory expectations on topics such as product design, consumer duty, governance, risk management and senior leadership. These considerations are equally relevant to cryptoasset firms that are not currently required to be registered with the FCA, given that regulation is clearly on the way and draws heavily on the existing regulatory framework.
Overseas firms looking to provide services to UK customers should also take note of the territorial scope of the proposals. Putting aside the question of enforcement, cryptoasset businesses that are not based in the UK are unlikely to be familiar with the regulatory and operational implications of being a regulated entity in the UK, particularly where market operators have chosen to base themselves in other “crypto-friendly” jurisdictions. Businesses that are already servicing UK customers will, in time, need to weigh up whether continued access to the UK market outweighs the burdens of regulatory compliance. International firms with expansion plans that include the UK may need to reconsider their jurisdictional priorities, given that the timescales and costs for launching, and maintaining, a business in the UK will no doubt increase. However, any equivalence framework to reduce these would be a welcome addition.
Martin Cook is a partner and head of fintech, Brandon Wong is a solicitor, and Victoria McCarron is a trainee solicitor, at Burges Salmon LLP.
This article first appeared in the March 2023 issue of PLC Magazine: https://uk.practicallaw.thomsonreuters.com/Browse/Home/Resources/PLCMagazine