SMART MONEY - UK
Digital Asset Regulation in the UK: new tech, old rules?
The rise in the use of digital assets has presented regulators around the world with a number of unique challenges. Regulators and law makers in different jurisdictions are considering their options to more effectively regulate these novel assets in ways that protect consumers and the market, but also foster innovation to support the benefits this technology could bring. Our digital asset regulatory experts in the UK, Germany and the US have each provided their views regarding current developments in their respective jurisdictions. In this article, we focus in on the UK. The UK’s framework for regulated digital assets is currently based on rules that existed prior to the rise of digital assets. That may, however, be slowly changing, as the appropriateness of more bespoke standards is explored.
In the post-Brexit world, the UK is likely to take a more bespoke and supportive approach to the regulation of digital assets.
The manner in which digital assets based on Distributed Ledger Technology (“DLT”) (i.e. Cryptoassets based on blockchain) are currently regulated (or not regulated) in the UK remains largely determined by the framework that existed prior to the development and rise of these assets. However, in the post-Brexit world, the UK is likely to take a more bespoke and supportive approach to the regulation of digital assets.
Current Taxonomy and Regulatory Status
The concept of a digital asset is broad, and encompasses a wide variety of potential applications of DLT. While other types of technology can form the basis of a digital asset, the focus in this article is on DLT given its prevalence in this space at this time. From a policy perspective, it may not be desirable for all of these applications of DLT to fall within the ambit of financial services regulation. Even for those applications that should be regulated, it is often necessary to apply different regulatory requirements to different categories of digital asset. Accordingly, a threshold challenge in regulating digital assets is to develop an appropriate taxonomy to distinguish between the different applications of DLT before determining the regulatory standards that should be applicable to each.
As seen from its Guidance on Cryptoassets issued in July 2019, the FCA has adopted a functional characterization approach to the regulation of digital assets. Essentially, one looks at how the particular application of DLT under consideration is being used (including its purpose(s)) and assesses the nature of the rights and obligations that attach to that digital asset. The outcome of that functional characterization then determines whether or not it falls within the scope of the regulatory perimeter.
The table below provides a high-level summary of the UK’s current taxonomy and regulatory treatment of digital assets from the perspective of whether FCA authorization is required to engage in activities in relation to the digital asset in question:
In addition to the above taxonomy, it is important to bear in mind the following key issues:
- The characterization of a digital asset is a question of fact and degree in each case.
- While dealing with, or providing custody for, exchange and utility tokens does not require a person to become FCA-authorized, pursuant to the implementation of MLD5 in the UK, cryptoasset exchange providers and wallet providers are required to register with the FCA for AML purposes.
- The FCA deliberately did not create a separate category of digital asset for “stablecoins”. A stablecoin is a digital asset which has some mechanism built into its operation and functionality that seeks to stabilize its value (i.e. by removing excessive pricing volatility). This is often achieved by pegging the stablecoin to an underlining fiat currency, a basket of fiat currencies, or other assets. In the FCA’s view, depending on the precise circumstances, a stablecoin is capable of falling within any one any of the above digital asset categories. However, the consultation paper published by HMT 6 January 2021, entitled “UK regulatory approach to cryptoassets and stablecoins”, proposes to create an additional category of regulated cryptoasset specifically for stablecoins that satisfy particular conditions.
- It is possible for the manner in which a whole token ecosystem operates to amount to the provision of a regulated payment service. In these circumstances, the token itself may not amount to a regulated product, but the manner in which the token is used and the overall nature of the system in which it is used could give rise to the provision of a regulated payment service, or even the creation of a payment system.
- Critically, while utility tokens and exchange tokens may themselves be unregulated, the creation of derivatives (eg. CFDs and futures) that reference these as underlying assets will be regulated as investment products under the UK regulatory regime. In this regard, the FCA has issued a ban on the sale, marketing and distribution to retail clients of derivatives and exchange-traded notes that reference unregulated transferrable cryptoassets as the underlying asset, with the ban due to commence in January 2021.
The future of digital asset regulation in the UK?
On 4 November 2020, the UK Chancellor put forward his vision for the future of the UK financial services sector in which the innovative use of technology is to play a key role. This vision, amongst other things, included:
- an announcement that HMT will be consulting on the creation of an appropriately bespoke regulatory regime for stablecoins. As mentioned above and discussed during our Emerging Themes webinar on 19 January 2021, HMT has now published its consultation on this subject, which closes on 21 March 2021. The proposals in this paper would bring certain types of stablecoin within the regulatory perimeter and require authorization for firms undertaking various types of activities in relation to such stablecoins; and
- an indication that the Bank of England and HMT will continue to explore the potential for the creation of a digital currency to be issued by the central bank.
We may well see novel or more tailored forms of regulation developed to help promote the use of certain types of digital asset as well as the underlying DLT on which they are based.
These and other related developments (including the Law Tech Delivery Panel’s Statement on Cryptoassets and Smart Contracts from November 2019), make it clear that the UK sees the development and innovative use of technology in financial services as critical to the success and wellbeing of the UK’s financial services sector. The potential role of digital assets is no exception to this. On this basis, we may well see novel or more tailored forms of regulation developed to help promote the use of certain types of digital asset as well as the underlying DLT on which they are based.
In the consultation paper on stablecoins, HMT also called for evidence on how other digital assets for wholesale and investment uses ought to be regulated and stated that the objective of regulation in this area is to ensure that the UK maintains its position as a world leader in the development and use of fintech. According to the paper, this is to be achieved by creating a regulatory environment which fosters innovation but also maintains the highest regulatory standards to promote strong market and consumer confidence in the use of fintech solutions. HMT has also made it clear that it will develop regulation in the digital assets space using a flexible and risk based approach, applying the principle of technological neutrality while also following the concept that the same type of risk should be regulated in the same way. Accordingly, the position in relation to how consumers (i.e. retail clients) are exposed to digital assets will likely result in a more restrictive regulatory regime.
As evidenced by the ban on cryptoasset derivatives, the UK regulators will take action where they feel consumers may be exposed to significant risks from a particular asset class. Given the importance placed on protecting consumers, it may be that the FCA and HMT seek to bring crypto exchanges and wallet providers within the scope of the UK’s authorization regime in the future. Whether that happens or not will depend largely on the outcome of the call for evidence built into HMT’s consultation on stablecoin regulation.
The road ahead for digital asset regulation appears to be a little mixed in the UK. It seems that fostering the development and use of digital assets in wholesale markets will be encouraged and facilitated where possible by sensible and proportionate regulation. In the retail space, however, there may be less facilitation and more restraints imposed on the market in order to protect consumers.
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This document provides a general summary and is for information/educational purposes only. It is not intended to be comprehensive, nor does it constitute legal advice. Specific legal advice should always be sought before taking or refraining from taking any action.