FCA closes in on UK crypto regulation clarity
The UK is close to producing its much awaited guidance on the regulatory treatment of crypto assets which use distributed ledger technology.
The UK’s regulatory watchdog, the Financial Conduct Authority (FCA) intends to publish a policy statement in a matter of weeks outlining its final guidance. This follows on from its January consultation paper, which took soundings from the market in the period between January and April of 2019.
Sensitive to the need to preserve the UK’s reputation as a competitive business friendly and consumer protective environment with top notch financial integrity, the FCA has carefully monitored and piloted various applications of tokens and underlying technologies through its regulatory sandbox. It is now confident that it can correctly classify and regulate crypto assets and is putting the finishing touches to its guidance.
Taking a step back, distributed ledger technology, often appearing under the (not entirely accurate) shorthand “blockchain” enables the sharing and updating of standardised records of activity, acted on by various participants and cryptographically secured without the need for a centralised ledger. This technological innovation has been steadily growing and improving since 2008 to the point where many financial, commercial and charitable organisations are harnessing the advantages of DLT as they strive to improve transaction recording and process efficiency.
Many styles of “assets” have been built using DLT and the FCA has acknowledged that they are game changers in the way we transact and store data. It is predicted that the industry will undergo exponential growth in the next few years and these assets will become ubiquitous. At the same time, there have been high profile issues with transparency, fraud, privacy and sharp business practices which have dented consumer confidence and, as a result, the FCA was keen to gain a comprehensive understanding of them and understand what appropriate regulation was necessary from the perspective of the financial services industry.
The FCA has been careful to take its time in producing guidance, meaning that it has lagged behind challenger jurisdictions such as Malta who emerged with their comprehensive regime around “virtual financial assets” last year. However, the additional time taken has meant that the FCA’s position is very carefully considered though it admits there will need still need to be further vigilance and possibly updated guidance in future.
The approach adopted by the FCA is to focus on the assets that utilise DLT, classify them and then use this classification to decide whether its current regulatory perimeter (deriving from the Financial Services and Markets Act 2000) should apply. This depends on two factors (i) is the crypto asset a “security token” which in effect represents a security such as equity or debt (and has these characteristics, ignoring labels) and (ii) if so, whether the activity around it falls into regulated activities which are set out in its 2001 Regulated Activities Order. If the answer to both of these questions is “yes” then the Financial Services regulatory perimeter will wrap around it and all of the usual requirements, licensing, restrictions, fines and compensation arrangements will apply, as will the ambit of regulations from the EU (under MIFID II) such as the Market Abuse Regulations and Prospectus Regulations.
If the crypto asset is not a security token (ie a utility token (platform restricted) or exchange token (such as Bitcoin) then the above regulatory perimeter does not apply. This means that the assets, and activities around them are not regulated as a financial service. However, other regulations still apply such as AML regulations and also the civil and criminal law (eg for mispresentation in a whitepaper). Additionally, the FCA applies a relatively agnostic approach to underlying technology platforms on the basis that it won’t endorse or regulate a platform as such, it will simply focus its regulation on the financial activities that surround security tokens. This is a slightly different approach to jurisdictions such as Malta which have a specific technology licensing regime (ITAS).
Market participants will need to be careful to study the guidance, particularly in relation to issues such as whether a utility token is really a security token and whether activities are licensed or not. There is detailed “perimeter guidance” on such matters and participants need to consider issues such as equity rights, voting and dividends, transferability and restrictions on use to decide whether a token falls into the status of utility token or security token. The regulatory outcome is fairly dramatic depending on which side on the line it falls on and we have seen international regulators such as the SEC adopt a tough stance on security tokens being cloaked as utility tokens.
It is also worth noting that tokens which digitally represent centrally issued fiat currencies are not part of the financial services regime and are separately regulated as E-money under the Electronic Money Regulations 2011 (EMR). This includes assets such as fiat backed stablecoins.
The hope is that the emerging crypto industry will have a much clearer position going forward as to how regulations will apply to activities such as token issuance, custodianship of crypto assets. This is aimed not only to ensure that the public is protected where it needs to be (principally around security tokens) and a light touch approach is made to encourage the growth of the industry where significant risks do not exist. The intention is that the UK is seen as an attractive, transparent jurisdiction in which to operate DLT backed businesses in future as part of its mandate to preserve the UK as a fintech centre of excellence on the global stage.