UK FCA Publishes Guidance on Cryptoassets
On January 23, 2019, the United Kingdom’s Financial Conduct Authority (“FCA”) released initial Guidance on Cryptoassets (the “FCA Guidance”). The FCA Guidance further develops the work of the UK Cryptoassets Taskforce, which in October 2018 issued its Final Report on the UK regulatory environment for cryptoassets and distributed ledger technology. The UK Cryptoassets Taskforce noted the need for regulatory clarity on cryptoasset activities. The FCA Guidance addresses which cryptoasset activities currently fall under FCA regulations, as well as providing recommendations on unregulated cryptoasset activities which may be regulated in the future. Interested parties have an opportunity to offer feedback on the FCA Guidance until April 5, 2019 before final guidance is published in the summer of 2019.
What about Brexit?
The risk of the UK leaving the European Union in March 2019 has had an impact on many asset classes, including cryptoassets. The FCA Guidance emphasizes that under the deal agreed to by the EU and UK, there is intended to be a Brexit implementation period from March 29, 2019 to December 2020. During the Brexit implementation period, EU law will continue to apply to the UK, including EU legislation that is in the process of being implemented, such as the EU’s Fifth Anti-Money Laundering Directive (the “5th AMLD”).
FCA Concerns with the Cryptoasset Market
The first part of the FCA Guidance addresses the agency’s concerns with cryptoasset markets and steps to address potential harms.
Cryptoassets are a complex and unpredictable asset class, and consequently represent significant risk to investors. For example, investors may purchase cryptoassets which are the subject of highly technical project whitepapers, fraudulent activity or misleading marketing. In addition, the extreme illiquidity and volatility in the prices of cryptoassets increases the likelihood that investors may suffer large losses. Volatility is exacerbated in the case of cryptoasset derivatives. The FCA has previously published guidance on firms offering cryptoasset derivatives (see our blog post on that guidance).
The FCA is considering various actions to protect consumers from cryptoassets, including prohibiting the sale of cryptoasset derivative products to retail consumers and strengthening the financial promotion rules to ensure financial products are marketed in a manner that is clear, fair and not misleading, possibly by expanding the scope of the prospectus directive. The UK Treasury is also in the process of consulting on a potential expansion of FCA regulation to cover more types of cryptoassets.
The anonymity of cryptoassets represents an opportunity for criminals to move money surreptitiously. This raises the risk of cryptoassets being used for money laundering and terrorist financing. Thus, the implementation of the 5th AMLD is of great importance. The 5th AMLD will be incorporated into UK law in 2019 and will cover the exchange, safekeeping and transfer between cryptoassets and fiat currencies and between different types of cryptoassets.
The FCA Guidance expresses concern that the lack of transparency and the volatility in the prices of cryptoassets increase the risk of market manipulation and illegal insider trading. These risks are particularly acute on cryptoasset exchanges or trading platforms that do not have adequate controls to detect and prevent suspicious behaviour. For example, malicious actors may engage in a “pump and dump” scheme for a particular cryptoasset at the expense of investors. These risks make it more difficult for legitimate cryptoasset projects to move forward.
The FCA has taken several steps to address risks to market integrity in the cryptoasset space. For example, cryptoassets have been incorporated into the ScamSmart Warning List. In addition, the FCA Guidance notes (but does not discuss) the potential application of the EU Market Abuse Regulation to the cryptoasset space.
Scope of the “Regulatory Perimeter”
The second major element of the FCA Guidance is an examination of the “regulatory perimeter”. The FCA defines the regulatory perimeter as “the boundary between regulated and unregulated financial services activities”. Understanding how the FCA can expand the regulatory perimeter requires examining how the agency categorizes different types of cryptoassets. The FCA groups cryptoassets into three token categories: exchange tokens, security tokens and utility tokens.
Security tokens are cryptoassets whose characteristics meet the FCA’s definition of a “Specified Investment”, and thus are subject to securities regulation like shares or bonds. Consequently, security tokens fall within the current scope of the regulatory perimeter.
The FCA provides that a cryptoasset may be a security token on the basis of:
- the contractual rights and obligations of the cryptoasset holder;
- contractual entitlements to profits, revenues or other payments or benefits of any kind, such as dividends;
- contractual entitlements to ownership or control over the cryptoasset issuer (like voting rights);
- language used in whitepapers and other relevant documentation suggesting the cryptoassets are intended to function as an investment;
- whether the cryptoasset is transferable and tradeable on cryptoasset exchanges or any other type of exchange or market; or
- whether there is a direct flow of payments from the issuer to cryptoasset holders and whether this flow of payments is a contractual obligation.
It is important to note that the FCA Guidance is concerned with substance and not language. This means that a whitepaper referring to a cryptoasset as a utility token does not necessarily make it so in the eyes of the FCA.
Exchange tokens are intended to be used as a means of exchange or payment without intermediaries such as banks or clearinghouses. A prominent example of an exchange token is Bitcoin. Exchange tokens are not currently regulated by the FCA and exchanges providing a platform for buying and selling these cryptoassets are not subject to FCA regulation. The FCA Guidance equates purchasing exchange tokens to participating in the foreign exchange market – risky, but not subject to FCA regulation directly.
Nevertheless, market participants should be aware that the 5th AMLD will create regulations applicable to exchange tokens. As noted above, the 5th AMLD will govern the exchange, safekeeping and transfer between cryptoassets and fiat currencies and between different types of cryptoassets.
Utility tokens are cryptoassets which give holders some rights, such as being first to use a new product, but do not give holders other rights characteristic of the rights provided to security holders. Utility tokens do not have the same features as securities, and consequently are not covered by FCA regulation. For example, a firm could issue tokens granting holders early access to a new product at a discounted rate. The FCA equates this activity to rewards-based crowdfunding and would consider the tokens to be utility tokens. Similarly, if a car manufacturer were to issue tokens giving holders the right to test drive a new vehicle and no other rights, the FCA would consider these tokens to be utility tokens even if they traded freely on secondary markets and could fluctuate in value.
The FCA Guidance notes that all classes of cryptoassets may be classified as e-money, and thus covered by payment services regulations. E-money is an electronic store of value issued for the purpose of making payment transactions upon the receipt of funds and accepted by persons and entities other than the e-money issuer. While exchange tokens such as Bitcoin and Ether are not centrally issued, and therefore are unlikely to be considered e-money, the FCA Guidance notes that other cryptoassets could be classified as e-money. The FCA will evaluate whether cryptoassets constitute e-money on a case-by-case basis.
The FCA Guidance is an initial step in an ongoing consultation process. Market participants should monitor the FCA’s categorization of security tokens, exchange tokens and utility tokens and the degree to which the FCA anticipates each to be regulated. Regulators in other jurisdictions will likely be paying close attention to the FCA’s regulation of cryptoassets, particularly in Europe given the need to avoid regulatory gaps as a result of Brexit.
Interested parties have until April 5, 2019 to submit their feedback on the FCA Guidance.
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