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On 1 February 2023, the UK’s economic and finance ministry, HM Treasury (HMT), published its consultation and call for evidence on the future financial services regulatory regime for cryptoassets (the Consultation). This follows a previous consultation (published in April 2022) on the regulation of fiat-linked stablecoins which HMT refers to as “Phase 1.” The Consultation sets out further details of this Phase 1 as well as proposals to regulate certain other categories of cryptoassets, which HMT refers to as “Phase 2.” The UK government does not currently propose to bring portfolio management or investment advice in relation to cryptoassets within the scope of regulation as part of Phase 1 or Phase 2.
Responses to the Consultation must be submitted by 30 April 2023.
The UK government’s decision to introduce regulation in phases reflects an iterative approach to the regulation of cryptoassets. This is in contrast to the EU’s regulatory regime for cryptoassets under the Markets in Cryptoassets Regulation (MiCA), which is expected to be adopted during 2023. Although there is significant overlap between the UK proposals and MiCA, there are important points of difference, a number of which we discuss below. For further information on MiCA, see our Sidley Update, How Will the EU Markets in Crypto Assets Regulation Affect Crypto and Other Financial Services Firms? (November 2022).
Additionally, HMT published a response (the Response) to its July 2020 consultation on proposals to bring marketing of certain cryptoasset services within scope of the UK financial promotion rules set out in the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (the FPO). It also published a related statement on the outcome of that consultation (the Outcome) that includes clarifications on the scope of those requirements.
This Sidley Update focuses on Phase 2, the Response, and the Outcome. For more information on Phase 1, please see our Sidley Update, UK to Regulate Fiat-Linked Stablecoins (April 2022).
Cryptoassets that share the features of traditional financial instruments (e.g., shares, bonds, derivatives, units in a fund – so-called “security tokens”), and cryptoassets that satisfy the definition of “electronic money” under the UK Electronic Money Regulations 2011,1 are already generally within scope of the UK’s regulatory authorisation regime for financial services.
Additionally, firms that exchange cryptoassets for fiat currency or other cryptoassets, including issuers of cryptoassets (“cryptoasset exchange providers”) and certain firms that provide services to safeguard cryptoassets on behalf of customers (“custodian wallet providers”), must be registered with the UK Financial Conduct Authority (FCA) and comply with certain requirements under the UK Money Laundering, Terrorist Financing and transfer of Funds (Information on the Payer) Regulations 2017 (MLRs).
In the Consultation, HMT considers the impact of, and potential responses to, recent disruption in the crypto market as well as broader regulatory considerations. In particular the Consultation, referencing the work of the Financial Stability Board2 in this area, notes that recent market disruption has raised important questions around conflicts of interest, market conduct, operational resilience, and liquidity risks in the cryptoasset market. The concentration of risk is also highlighted as a key issue as some market players offer issuance, exchange, lending, and custody as well as other services. These risks can be exacerbated where a firm holds significant amounts of its own tokens on its balance sheet or as collateral.
In particular, the Consultation includes the following proposals:
- extending the existing regulatory authorisation regime for financial services under the Financial Services and Markets Act 2000 (FSMA) to cover a range of cryptoasset services;
- making use of the Designated Activity Regime (DAR), a new regime being legislated for in the Financial Services and Markets Bill (FSM Bill), to impose new regulatory requirements on cryptoasset firms without requiring full regulatory authorisation;
- introducing disclosure obligations for issuers of cryptoassets and the operators of venues where such assets are traded; and
- introducing a market abuse regime for cryptoassets.
HMT has ruled out the creation of a fully bespoke regime for cryptoassets and will instead extend the existing FSMA framework, which it argues will ensure a level playing field between crypto and traditional financial services firms. Under FSMA, authorisation is required to conduct a “specified activity” in respect of a “specified investment.” The list of specified investments is set out in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO). The UK government intends to add cryptoassets to the list of specified investments in the RAO.
Which cryptoassets are in scope?
The Consultation uses the same definition of “cryptoasset” as the FSM Bill, being:
Any cryptographically secured digital representation of value or contractual rights that – (a) can be transferred, stored or traded electronically, and (b) that uses technology supporting the recording or storage of data (which may include distributed ledger technology).
This is a broad definition that purposefully captures cryptoassets that use technology other than distributed ledger technology. This reflects the UK government’s intention to create a “technologically neutral” regime. In this regard, the definition is notably broader than the equivalent definitions in the MLRs, the FAO (as defined below), and MiCA.
The Consultation sets out a non-exhaustive list of cryptoassets that could be in scope of Phase 2 if used in relation to a specified cryptoasset activity (see below). The Consultation’s non-exhaustive list includes:
- exchange tokens;
- utility tokens;
- non-fungible tokens (NFTs);
- asset-referenced tokens (ARTs);
- commodity-linked tokens;
- crypto-backed tokens;
- algorithmic tokens;
- governance tokens; and
- fan tokens.
We would note the following points of difference with MiCA:
- Whereas MiCA imposes unique requirements on ARTs (e.g., the establishment of a reserve and obligations in relation to the management of such reserve), this would not be the case in the UK under Phase 2.
- NFTs are in principle within scope of Phase 2, whereas they, broadly speaking, fall outside the scope of MiCA.
Which activities relating to cryptoassets are in scope?
For illustrative purposes, the Consultation also sets out the following types of activities relating to cryptoassets in respect of which HMT proposes to impose regulatory authorisation requirements under Phase 2.
- Exchange activities. Operating a cryptoasset trading venue would require authorisation. Notably, firms operating cryptoasset trading venues would likely require subsidiarisation (i.e., establishing a subsidiary rather than a branch) in the UK given what HMT describes as their “critical role” in the cryptoasset value chain. We also note that these proposals place responsibility on cryptoasset trading venues for defining the detailed content requirements of their admission and disclosure documents.
- Intermediation activities. Authorisation would be required for firms (i) dealing in cryptoassets as principal or agent, (ii) arranging (bringing about) deals in cryptoassets and/or (iii) making arrangements with a view to transactions in cryptoassets. Firms should note that under this framework, they could be subject to regulatory requirements even if they operate outside the flow of cryptoassets (i.e., authorisation could be required even where they do not come into possession or control of cryptoassets).
- Custody activities. Firms would need authorisation in order to safeguard, or arrange the safeguarding and/or administering, of cryptoassets and/or means of access to a cryptoasset (e.g., wallet or cryptographic private key). Currently, firms conducting such activities only need to be registered under the MLRs. Under this proposal, such firms would be subject to extensive additional requirements. For example, in-scope firms would be subject to regulatory capital and liquidity requirements, as well as bespoke custody rules based on those that apply to custodians of financial instruments under the FCA’s Client Assets Sourcebook (CASS).
We note that this will not apply to fiat-linked stablecoins which will be brought within the payment services regime as part of Phase 1.
- Lending activities. Authorisation would be required for firms operating a cryptoasset lending platform, which would cover a broad range of lending activities, including facilitating collateralised and uncollateralised borrowing of cryptoassets or borrowing of fiat currency with collateral provided in cryptoassets. This is another marked difference from MiCA, which does not address lending activities.
The UK government proposes to regulate cryptoasset activities provided “in or to the United Kingdom” (emphasis added). As such, non-UK providers would generally be in scope of the new requirements where they provide services to UK customers from outside the UK.
Although HMT states this approach is in line with other areas of the UK’s regulatory perimeter, the geographical scope of the proposed UK cryptoasset regime differs from how certain other regulated activities have to date been dealt with under FSMA. In particular, the “overseas person” exclusion in the RAO, or the general “characteristic performance” test, has not been mentioned in the proposed UK cryptoasset regime. This is also a departure from the approach for regulated payment services under the UK Payment Services Regulations 2017 (PSRs), which require authorisation when providing payment services “in the UK” and in respect of which the FCA has stated it “would not generally expect a payment services provider incorporated and located outside the UK to be within the scope of the regulations, if all it does is to provide internet-based and other services to UK customers from that location.”3
This could mean that the territorial scope of Phase 1 and Phase 2 could differ significantly as the former will be brought within the PSRs. It will be interesting to see if the government also begins to shift the existing approach to territorial application of UK financial services regulation more broadly, although there is no indication that is the case at present. Such a shift in approach, should it occur, could have significant implications for non-UK firms and international groups that provide services to UK customers on a cross-border basis.
The Consultation notes that HMT will endeavour to accommodate an exemption from authorisation for non-UK firms providing services to UK customers from outside the UK on the basis of “reverse solicitation,” i.e. where services are provided entirely at the initiative of the UK customer. However, HMT notes that any such exemption would be defined so as to prevent misuse and regulatory arbitrage, which suggests the exemption will be narrow.
HMT also intends to pursue equivalence arrangements whereby firms authorised in other jurisdictions could provide cryptoasset services in the UK as long as such firms are subject to equivalent standards in their home jurisdiction and suitable cooperation mechanisms exist between the relevant UK and overseas regulators.
In addition to requiring authorisation under FSMA, firms conducting cryptoasset activities would also be subject to extensive regulatory requirements including in relation to the maintenance of own funds, liquidity management, governance, operational resilience, data reporting, consumer protection, and other conduct of business requirements (e.g., managing conflicts of interest and mandatory disclosures to customers).
Firms that are already authorised under FSMA (e.g., banks and investment firms) and intend to undertake a newly defined RAO cryptoasset activity would first need to apply for a variation of their permission from the FCA (and the Prudential Regulation Authority for dual-regulated firms). HMT notes that such authorisation will not be automatically granted to already authorised firms. This differs from MiCA which allows certain authorised firms, most notably banks, to conduct cryptoasset activities on the basis of their existing regulatory authorisations (albeit subject to other requirements).
In addition to the proposal to bring certain cryptoasset activities within the RAO (which would impose an authorisation requirement), HMT is proposing to include other cryptoasset activities under the new DAR. This would mean that direct requirements, or even bans, could be imposed on firms carrying on such activities, even though they would fall outside of the authorisation regime. One example which is under consideration is a requirement for certain public offers of cryptoassets to be conducted via a regulated platform.
Obligations for issuers and trading venues
HMT has proposed to establish an issuance and disclosures regime for cryptoassets based on the approach taken in the forthcoming Public Offer and Admissions to Trading Regime. This will be tailored to accommodate the specific attributes of cryptoassets. Firms will be subjected to disclosure requirements when (i) admitting a cryptoasset to a trading venue and/or (ii) making a public offer of cryptoassets (including initial coin offerings).
The UK government will seek the following outcomes:
- a minimum standard of information enabling investors to make informed investment decisions based on a “necessary information” test;
- appropriate liability and compensation arrangements for untrue or misleading statements made in disclosure/admission documents;
- an appropriate level of due diligence of the contents of disclosure/admission documents;
- an appropriate level of investor protection in relation to marketing materials and advertisements and for trading venues to have in place rules governing marketing materials/product appropriateness; and
- controls or procedures to prevent a harmful offer from being made (e.g., to detect fraud).
Trading venues will be required to prescribe detailed requirements for disclosure documents for the admission of cryptoassets in accordance with principles established in the FCA’s rulebook. The issuer or the trading venue will be required to produce the disclosure documents in accordance with such requirements.
Trading venues will be required to reject the admission of cryptoassets should they consider that they may result in investor detriment.
Other cryptoasset activities
The Consultation also discusses the potential regulation of several other activities relating to cryptoassets.
Vertically integrated business (e.g., exchanges): Trading venues that also perform other regulated activities, such as issuing their own native cryptoassets, are referred to in the Consultation as “vertically integrated businesses.” HMT expects such businesses to follow the rules governing each of the relevant cryptoasset activities they may undertake, instead of only following the rules specifically applicable to one of the undertaken activities, such as, operating as an exchange. In practice, this could mean that cryptoassets firms with multiple business lines will be subject to multiple sets of regulatory requirements. Such firms will need to consider carefully how this affects their legal, operational and governance structures.
ART-activities: There are two ART-related activities addressed in the Consultation: (i) activities involving commodity-linked tokens, and (ii) activities related to, crypto-backed tokens. HMT has indicated that the former could be covered by existing regimes governing specified investments or collective investment schemes and that the latter should be regulated in the same way as unbacked cryptoassets (e.g., Bitcoin) given the volatility of the underpinning token. This differs from the approach under MiCA, which creates specific requirements in relation to ARTs.
Algorithmic stablecoins: Activities related to algorithmic stablecoins (e.g., TerraUSD token) will be regulated as unbacked cryptoassets instead of fiat-linked stablecoins under Phase 1. In other words, the category of “stablecoins” will be limited to those tokens that are backed by fiat funds. Given the extension of financial promotion rules to cryptoassets, firms involved in activities relating to such non fiat-backed stablecoins may no longer be able to refer to such cryptoassets as being “stablecoins” or use similar terms in their marketing or other customer-facing materials.
The Consultation proposes a dedicated market abuse regime for cryptoassets. This will be based on, but is stated to be separate from, the UK Market Abuse Regulation (UK MAR) for financial instruments (e.g., shares, bonds, and derivatives traded on certain trading venues). The proposed cryptoassets market abuse regime will also be narrower in scope. Amongst other things, the regime would only apply to cryptoassets that are traded on a UK cryptoasset trading venue, whereas UK MAR applies to financial instruments traded on UK as well as EU trading venues. The cryptoassets markets abuse regime would impose obligations on in-scope trading venues, and offences would apply regardless of where the person is based or where the trading takes place.
The following obligations will also apply to other market participants:
- persons professionally arranging or executing transactions will be required to establish systems and controls to prevent and detect market abuse, and
- all regulated firms undertaking cryptoasset activities will be required to disclose inside information and maintain a list of persons with access to such information.
These obligations are similar to those that already apply to certain investment firms and issuers under UK MAR.
HMT requested additional evidence from stakeholders to better understand areas that could potentially be regulated at some point following Phase 2. The Consultation calls for evidence on the following:
- Decentralised finance: HMT states that it does not currently have sufficient information to determine how certain aspects of decentralised finance (DeFi), such as Decentralised Autonomous Organisations, should be regulated. However, it notes that, in principle, regulators should be able to apply rules to persons who maintain significant control or influence over a DeFi arrangement or protocol providing cryptoasset services and activities.
- Whether to regulate other cryptoasset activities: The Consultation explains why HMT has not yet decided whether to regulate: (i) cryptoasset investment advice and portfolio management; (ii) post-trade activities in cryptoasset transactions (e.g. clearing and settlement); or (iii) crypto mining and validation. Notably, the Consultation suggests that although there may not be justification for broadly regulating cryptoassets mining activities, there is likely a stronger argument in favour of specifically regulating staking activities.
- Sustainability: HMT has requested information from stakeholders on sustainability-related aspects of cryptoasset activities. In particular, it is seeking further views on whether the existing sustainable disclosure requirements could be modified to cover cryptoasset activities.
In addition to the Consultation, HMT published the Response and the Outcome on 1 February 2023. The Response and the Outcome set out HMT’s latest proposals to bring “qualifying cryptoassets” within scope of the financial promotion rules set out in the FPO.
The Response proposes to define “qualifying cryptoasset” as “any cryptographically secured digital representation of value contractual rights which is fungible and transferable.” This proposed definition removes the reference to “distributed ledger technology” included in the earlier proposed definition. However, the newly proposed definition contains the unique requirements that a cryptoasset must be “fungible.” NFTs would therefore generally fall outside the proposed definition depending on their specific features.
Generally, the FPO prohibits in-scope promotions unless these are made or approved by a firm authorised under FSMA. However, HMT has noted that many cryptoasset firms are not currently subject to such authorisation requirements and that there is evidence of a lack of suitable authorised persons in the market willing and able to approve cryptoasset promotions. As such, it became clear that certain requirements proposed in the initial consultation would amount to an effective ban on cryptoasset financial promotions. HMT explained in the Outcome Statement that this was not its intention, so it now proposes to introduce a time-limited exemption to the FPO enabling cryptoasset businesses that are registered with the FCA under the MLRs (but not authorised under FSMA) to promote their own services. This exemption will be in place while the UK’s broader cryptoasset regulatory regime is introduced.
Firms that provide, or are planning to provide, services relating to cryptoassets in the UK or to UK customers should consider how the proposed reforms could affect their businesses and consider responding to the Consultation directly and/or through a trade association.
Firms that provide cryptoasset services in the UK and EU will need to assess the differences between the HMT proposals and the approach taken under MiCA and consider how they will satisfy their obligations in both jurisdictions.
1 Under those regulations, “electronic money” is defined as “electronically (including magnetically) stored monetary value as represented by a claim on the electronic money issuer which (a) is issued on receipt of funds for the purpose of making payment transactions; (b) is accepted by a person other than the electronic money issuer; and (c) is not excluded by regulation 3 [of the Regulations].”
2 A key international body that monitors and makes recommendations about the global financial system.
3 Section 15.6 of Chapter 15 of the FCA’s Perimeter Guidance Manual (PERG).
Leonard Ng, Partner
Max Savoie, Partner
Martin Dowdall, Senior Managing Associate
Arash Dashtgard, Managing Associate
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