Developments in the Regulation of Crypto Assets – If Not The Financial Conduct Authority Then Who?

DAC Beachcroft LLP (August 11, 2023) — A recent report from the House of Commons Treasury Committee, ‘Regulating Crypto’, highlights ongoing concerns about the lack of regulation of cryptoassets in the UK and the significant risks for consumers resulting from price volatility and exposure to losses. The Treasury Committee considers the cryptoasset industry remains a “wild west” and has called on the Government to expedite regulation, proposing that retail trading and investment in cryptoassets be treated as gambling rather than a financial service.

Whilst the report criticises the Government’s inaction and a perceived piecemeal approach to regulation, it recognises that the Financial Conduct Authority (“FCA”) faces challenges in implementing existing and proposed crypto regulations. It also stresses the importance of keeping pace with cryptoasset developments, including “by ensuring that the FCA’s authorisations gateway is open and effective, so that potential productive innovation in financial services is not unduly constrained’.

Other key takeaways from the report include:

• A recommendation that the Government take a balanced approach ‘to supporting the development of cryptoasset technologies’. The Committee recognises that some crypto technologies could result in efficiencies in cross-border transactions but greater regulation is required. At the same, the Government should ‘seek to avoid expending public resources on supporting cryptoasset activities without a clear, beneficial use case, as appears to have been the case with the Royal Mint NFT. It is not the Government’s role to promote particular technological innovations for their own sake.’

• Concerns about the “halo effect” of FCA regulation of cryptocurrencies whereby the mere fact that the FCA regulate it “leads consumers to believe that this activity is safer than it is, or protected when it is not“. The Committee suggests that consumer speculation in crypto currencies more closely resembles gambling than a financial service and call for consumer trading to be regulated by the Gambling Commission.

The Financial Services and Markets Act 2023 (‘FSMA’)

On 29 June 2023 the Government announced that FSMA ‘enables the regulation of cryptoassets to support their safe adoption in the UK’. The final version of the Act is not yet published but it creates a regulatory framework, called the Designated Activities Regime (“DAR”), for the regulation of financial markets activities (financial products, instruments, and investments – including cryptoassets). The DAR works alongside the existing FSMA framework for regulated activities requiring authorisation under the Act. Enabling ‘designated activities’ that were previously regulated under retained EU law, (such other activities as HM Treasury decides), to be regulated by the FCA outside the context of authorisation.

HM Treasury has been empowered to determine what activities to bring within the scope of the DAR, and the FCA may regulate it by making rules and directions relating to designated activities. A designated activity must comply with the requirements set out by the Treasury in secondary legislation or in FCA rules, unless there is an exemption. The DAR shows the Government’s agility in preparing for future developments in financial services markets.

The expansion of the regime could see entities caught by new regulatory rules leading to greater scrutiny by the FCA and we could also see the potential prohibition of certain activities entirely.

FCA needs more powers to regulate

The FCA has raised concerns about a significant rise in crypto trading addictions and the absence of controls to protect vulnerable consumers. It wants more powers to regulate this market.

Sarah Pritchard, Executive Director of Markets and International at the FCA, called for “an open debate about risk, mitigation and the limits of regulation” in her speech, at City Week 2023, on ‘Regulation of Digital Assets in the UK’ in April. Pritchard recognises that the FCA has a substantial role to play in preventing harm to consumers from financial crime but currently its powers to regulate crypto (beyond compliance with existing anti-money laundering and counter terrorism legislation) is limited until the Government legislates. She also made plain that even with safeguards in place ‘the cryptoasset sphere will still not offer the same level of market integrity and protection for consumers as traditional markets’, and that ‘consumers are highly unlikely to be covered by the Financial Services Compensation Scheme and the Financial Ombudsman Service if they buy crypto and it goes wrong’. The bottom line is consumers who buy cryptocurrencies must be prepared to lose all their money.

The FCA has been working closely with the Government on crypto regulation, creating the Cryptoasset Taskforce, and has also recently published a Policy Statement (PS23/6) “Financial promotion rules for cryptoassets” which is intended to bring cryptoasset promotions in the UK within the regulator’s remit with effect from 8 October 2023. These new rules aim to ensure cryptoasset financial promotions are subject to the requirement to be fair, clear and not misleading. Firms must ensure investors have appropriate knowledge and experience to understand the risks involving in investing in cryptoassets, and marketing must include clear risk warnings. More information about the new promotion rules can be found in our recent article here.

Regulation outside the UK

The EU

The UK’s ‘staged approach’ to regulation is in contrast to the more comprehensive approach taken in the EU under MiCA. The EU is anticipated to become the first major jurisdiction with a comprehensive regulatory framework on crypto assets, through a framework called ‘Markets in Crypto Assets’ (‘MiCA‘), MiCA aims to ‘protect investors by increasing transparency and putting in place a comprehensive framework for issuers and service providers including compliance with the anti-money laundering rules‘. It covers a wide range of cryptocurrencies and treats them as financial services, and seeks to protect investors, preserve financial stability, while allowing innovation and fostering the attractiveness of the crypto-asset sector.

MiCA was adopted by the EU on 20 April 2023 and provisions on asset-referenced tokens (ARTs) and e-money tokens apply from 30 June 2024. Other provisions, particularly those regulating crypto-asset service providers, will apply from December 2024.

MiCA will not apply to security tokens which would qualify as transferable securities and other cryptoassets that qualify as financial instruments but there is a review clause within MiCA that could lead to specific regulatory regimes that may be introduced in the future, if necessary.

The EU has also implemented a digital finance strategy, Digital Operational Resilience Act (DORA), that covers cryptoasset service providers, and a proposal on distributed ledger technology (DLT) pilot regime for wholesale uses. The Council of the EU and the European Council’s press statement said that this framework was designed to ‘bridge a gap ensuring that the current legal framework does not pose obstacles to the use of new digital financial instruments and, at the same time, ensures that such new technologies and products fall within the scope of financial regulation and operational risk management arrangements of firms active in the EU.’

The US

The U.S. Securities and Exchange Commission (‘SEC’) has taken firm action to bring cryptocurrency under its regulatory scope. In June 2023, the SEC charged Coinbase, Inc. and Binance (and its founder) – two of the largest global cryptocurrency exchange platforms – for the unregistered offer and sale of securities in connection with its staking-as-a-service programme, including operating their ‘crypto asset trading platform as an unregistered national securities exchange, broker, and clearing agency’ and ‘unlawfully facilitating the buying and selling of crypto asset securities’ without registration.

This is not the first time the SEC has taken action against the cryptoasset industry. In 2018, the SEC conducted actions against Kik Interactive Inc and, in 2020, against Ripple Labs Inc for conducting an unregistered securities offering.

However, in a ruling last week, the court dealt a partial blow to the SEC’s position by finding, at least in some material respects, that sales by Ripple did not classify as securities transactions. Whilst undoubtedly a set back, it seems certain that the SEC will appeal.

The SEC’s actions demonstrate that cryptoasset regulation is tightening and it is targeting cryptocurrency firms that it considers to have sought to bypass regulation by allegedly obfuscating the difference between on and offshore services (Binance) or by classifying trade as unregulated securities (Coinbase).

It’s clear that the SEC does not see cryptoassets as an industry that necessitates a truly unique and new regulatory regime. Instead, the SEC’s approach is that cryptoassets are digital versions of pre-existing financial instruments, of which the SEC already regulates. The SEC seems set to continue to litigate to hold crypto firms to existing regulation.

Global

The International Organisation of Securities Commissions (IOSCO), an umbrella group of international market regulators, has also been active. It has called on the governments across the globe to regulate cryptocurrencies in the same way as it regulates traditional financial products like bonds and stock. It is keen to promote an international level playing field, with global standards on trading and storage of crypto assets. The FCA is a member of IOSCO and the FCA supports the need for a global solution with international cooperation and coordination.

Where next?

A final decision on the regulation of cryptoassets rests with the UK Government. As the Financial Services and Markets Bill received Royal Assent last month, debates over the regulation of crypto assets will be flushed out and further decisions made down the line.

The Committee’s proposed classification of investment in crypto assets as “gambling” and regulation by the Gambling Commission is at odds with the both EU’s MiCA and IOSCO’s call for cryptoassets to be treated as financial products and services. The Committee’s proposal also differs from the US regime of categorising certain cryptoassets as unregistered securities. If the Government followed the Committee’s recommendation, it would put the UK out of step with the rest of the world in its treatment of cryptoassets. Meanwhile, the FCA has indicated that it is best placed to regulate cryptoassets and there is a widely held view that the Gambling Commission would not have the resources to take on this role in any event.

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