UK Treasury outlines future regulatory regime for crypto-assets

By John Bassilios and Max Ding

The UK’s HM Treasury has recently published a consultation paper revealing its plans for regulating crypto-assets in the UK.

The paper came shortly before the Australian Government revealed its own approach to crypto regulation in Australia. You can read our summary of the Australian Government’s ‘token mapping’ consultation paper in our previous article.

In this update, we outline the HM Treasury’s approach to crypto regulation, which seeks to be innovation-friendly, regulate crypto-asset ‘activities’, and achieve ‘phased’ regulatory goals in the near, medium, and long term.

You can read the full consultation paper on the UK Government’s website: ‘Future financial services regulatory regime for cryptoassets‘.

Regulatory approach to crypto and financial services in the UK

HM Treasury’s broad approach to regulating crypto-assets reflects the UK Government’s commitment to create a ‘global hub’ for crypto. In particular, the Government is seeking to provide regulatory standards for crypto-asset activities commensurate with standards expected of ‘traditional’ financial services activities, while harnessing the innovation and benefits of the technology behind crypto-assets.

The regulatory approach for traditional financial services in the UK is an ‘activities’-based approach, which regulates financial activities, rather than the financial assets themselves. In the UK, firms must be authorised by the UK’s Financial Conduct Authority (FCA) to carry out regulated financial services activities.

The regulatory perimeter of the FCA, which determines the financial service activities the FCA regulates, is set by the UK Government. In line with this approach, HM Treasury intends to regulate financial services activities related to crypto-assets, rather than crypto-assets themselves, and therefore expand the regulatory perimeter to include activities related to crypto-assets.

This differs from the ‘function’-based regulatory approach in Australia, where the regulatory trigger is not based on whether a certain activity is being performed, but on whether the financial product achieves certain functions.

Specifically, the regulatory perimeter for financial products in Australia captures financial products which are ‘facilities’ through which a person ‘makes a financial investment’, ‘manages financial risk’, and/or ‘makes non-cash payments’. In line with this approach, the Australian Treasury has proposed to regulate crypto products which are facilities through which one of those functions are performed.

Current regulatory landscape for crypto-assets in the UK

In the UK, although most crypto-assets activities are not currently subject to broad financial services regulation, the Government has already taken steps toward including crypto within the regulatory perimeter.

For example, in January 2020, the UK’s Anti-Money Laundering and Counter Terrorist Finance regulations (MLR) were amended to apply to crypto-assets businesses. Existing crypto-assets businesses must be registered with the FCA for MLR purposes, and demonstrate that their controls, policies, and procedures are adequate to deal with money laundering and terrorist financing risks.

Moreover, some types of crypto-assets already fall within the existing regulatory perimeter of the FCA, due to qualifying as ‘specified investments’, ‘financial instruments’ and ‘e-money’.

The terms ‘specified investments’ and ‘financial instruments’ include security tokens that provide rights and obligations similar to shares, debt instruments or other securities, which are investments specified under legislation to be within the regulatory perimeter.

Tokens that exhibit the following characteristics likely constitute ‘security tokens’ which fall within the current regulatory perimeter.

• Tokens that give holders similar rights to shares, like voting rights, or access to a dividend of company profits or the distribution of capital upon liquidation.
• Tokens that represent a right in a share, even where the token itself does not represent or have characteristics of a share.
• Tokens that create or acknowledge indebtedness by representing money owed to the token holder.
• ‘A’ tokens, where a firm issues the ‘A’ tokens which grant token holders the right to subscribe for ‘B’ tokens in the future, and the ‘B’ tokens are themselves ‘specified investments’ (eg shares or debentures).
• Tokens that confer rights in relation to tokenised shares or tokenised debentures.
• Tokens that act as vehicles through which profits or income are shares or pooled, or where the investment is managed as a whole by a market participant.

Other types of crypto-asset may also be subject to the existing regulatory perimeter by virtue of being classified as ‘e-money’ under UK legislation.

Tokens that exhibit the following characteristics likely constitute ‘e-money tokens’ which fall within the current regulatory perimeter.

• The token has electronically stored monetary value that represents a claim on the issuer of the token.
• The token is issued on receipt of funds for the purpose of making payment transactions.
• The token is accepted by a person other than the issuer of the token.
• The token is not excluded by certain e-money regulations.

Firms carrying on specified activities today involving security tokens and e-money tokens therefore need to ensure that they have the correct FCA permissions and are abiding by the raft of existing regulations that apply to traditional financial products.

Proposed approach for future crypto-asset regulation

HM Treasury intends to pursue a phased approach to regulating crypto-assets in the future, which is prioritised according to what HM Treasury perceives to be the greatest risk and opportunity in the crypto space. The proposed phases are as follows.

• Currently: the UK Government will shortly regulate the promotion of crypto-assets to ensure promotions are clear, fair and not misleading.
• Phase 1: in the near-term, the UK Government will introduce a regime to regulate fiat-backed stablecoins and address issuance, custody and payment-related activities.
• Phase 2: in the medium-term, the UK Government intends to introduce a regime to regulate broader crypto-assets activities.
• Beyond: in more nascent areas of the market, such as Decentralised Finance (DeFi) and crypto mining, the Government is actively seeking views and evidence from industry, consumers and regulators to inform future policy development.

We provide a broad overview of each phase in the following sections.

Regulating the promotion of crypto-assets

The UK Government will shortly introduce legislation in 2023 allowing the FCA to regulate the promotions of crypto-assets, to ensure the promotions are clear, fair and not misleading. Subject to parliamentary approval, the ‘Financial Promotion Order’ will make it a criminal offence to promote crypto-assets to UK consumers unless:

• the promotion is communicated by an FCA-authorised person;
• the promotion is made by an unauthorised person but approved by an FCA-authorised person;
• the promotion is communicated by a crypto-assets business registered under the MLR; or
• the promotion otherwise complies with the conditions of an exemption in the Financial Promotion Order.

The UK Government has clarified that non-fungible tokens (NFTs) will not be within the scope of the Financial Promotion Order, as NFTs can represent a range of assets which may not constitute financial services products.

Phase 1: defining ‘crypto-assets’ and regulating fiat-backed stablecoins

As a first step in introducing a regulatory regime for crypto-assets, the UK Government is legislating a bill to amend the Financial Services and Markets Act 2000 (FSMA), a key piece of legislation within the UK’s legal framework for financial services. Importantly, the bill introduces the concept of ‘crypto-asset’ into the FSMA, which is defined as:

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 definition is put broadly in order to capture crypto-assets beyond those which use distributed ledger technology to future-proof the regime against changes in technology and mitigate against regulatory arbitrage.

Under the current FSMA, HM Treasury has powers to bring activities into the regulatory perimeter by specifying them under the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO). The introduction of the definition of ‘crypto-asset’ into the FSMA creates a power for HM Treasury to specify regulated crypto-assets activities into the regulatory perimeter.

This means that persons who are carrying out certain activities involving crypto-assets ‘by way of business’ would be performing regulated activities and therefore require authorisation from the FCA under the FSMA. Crypto firms already registered under the current MLR regime would also need to seek authorisation under the new FSMA-based regime.

However, new crypto firms not yet registered under the MLR would not need to separately register under the MLR if they obtain FSMA authorisation. Moreover, for newly included crypto-assets activities in regulatory perimeter, firms which are already FSMA-authorised and intending to undertake the newly regulated crypto-assets activity will generally need to apply for a variation of their permission from the FCA.

The introduction of ‘crypto-assets’ into the FSMA paves the way for the UK Government to carry out its regulatory goals. This includes the Government’s Phase 1 goal to bring issuance, custody and payment-related activities in relation to fiat-backed stablecoins into the current regulatory perimeter as part of the FSMA Bill. At a minimum, GBP and other fiat-backed stablecoins which are issued in the UK are expected to be within the scope of this reform.

Phase 2: regulating other crypto-assets activities beyond fiat-backed stablecoins

Looking beyond the regulation of fiat-backed stablecoins, HM Treasury intends to create a number of new regulated or designated crypto-asset activities, where the activities closely resemble traditional financial services activities which are currently regulated. The sorts of crypto-asset activities HM Treasury intends to regulate in Phase 2 include:

• issuance activities;
• exchange and market abuse activities;
• intermediation (dealing, arranging, making arrangements) activities;
• custody activities; and
• lending activities.

HM Treasury proposes to capture activities provided by UK firms to persons based in the UK or overseas, as well as those provided by overseas firms to UK persons.

We provide a brief overview of HM Treasury’s intended regulatory approach for each of these activities below.

Phase 2: issuance activities

HM Treasury intends to regulate the admission of crypto-assets to crypto-asset trading venues, as well as the making of public offers of crypto-assets (including initial coin offerings). For these activities, HM Treasury proposes to establish an issuance and disclosure regime based on incoming reform to the UK prospectus regime (the Public Offer and Admissions to Trading Regime), tailored to the specific attributes of crypto-assets. HM Treasury is intending to achieve the following broad regulatory outcomes:

• a minimum standard of information regarding a crypto-asset should be available so investors are able to make informed investment decisions;
• appropriate liability and compensation should be available for untrue or misleading statements made in disclosure/admission documents;
• an appropriate level of due diligence should be performed over the content of disclosure/admission documents;
• an appropriate level of investor protection should be offered around marketing materials and advertisements, and trading venues should have in place rules governing marketing materials/product appropriateness; and
• there should be controls or procedures to prevent a harmful offer from being made (eg to detect fraud).

Phase 2: exchange and market abuse activities

HM Treasury intends to regulate the operation of crypto-asset trading venues. For this activity, HM Treasury considers that many of the risks associated with crypto-asset exchanges are comparable to those of traditional exchanges and is proposing to establish a regulatory framework based on existing regulation around traditional trading venues.

Accordingly, persons operating crypto-asset trading venues would be subject to prudential rules and various other requirements related to consumer protection, operational resilience and data reporting. HM Treasury intends to achieve the following broad regulatory outcomes:

• there should be orderly, open and resilient conditions for trading on crypto-asset trading venues;
• venues should have transparent and fair access and operating rules;
• persons operating crypto-asset trading venues should have the people, processes, systems and controls to facilitate fair, orderly and efficient trading, and address conflicts of interest; and
• persons operating crypto-asset trading venues should have the systems and processes for ensuring accurate market data is available in real time where appropriate.

Moreover, HM Treasury has broadly sketched out a regulatory approach to counter market abuse on crypto-asset exchanges. It has proposed a market abuse regime based on elements of the current market abuse regime in the UK, while recognising that market abuse on crypto-asset exchanges present unique risks that may fail to be captured by the current regime.

For example, some requirements under the existing regime are grounded upon the concept of a traditional issuer. This concept does not easily translate to crypto-asset exchanges, where there may not be a clearly identifiable issuer of crypto-assets. This creates difficulties such as placing obligations on ‘issuers’ to control insider information. As a result of these challenges, HM Treasury has proposed a model that places primary responsibility on crypto exchanges to prevent, detect and disrupt market abuse, where the FCA is then responsible for supervising exchanges to ensure they have appropriate systems and controls to do so.

Phase 2: intermediation (dealing, arranging, making arrangements) activities

HM Treasury intends to regulate investment and risk management activities in relation to crypto-assets, such as dealing in crypto-assets as an agent and arranging deals in crypto-assets. There are already various rules in relation to analogous activities in traditional financial services in the UK relating to conflicts of interest, acting in clients’ best interest and prudential requirements. HM Treasury proposes that these rules may be used and adapted for crypto-asset market intermediation activities. HM Treasury intends to achieve the following broad regulatory outcomes:

• there should be fair and transparent conditions for any trades executed for, or on behalf of, a third party;
• trades should be executed in a way that serves the best interest of the client;
• persons offering crypto-asset market intermediation should have effective controls and arrangements to manage conflicts of interest;
• persons offering crypto-asset market intermediation should have sufficient financial resources to conduct business in a prudent manner; and
• persons operating crypto-asset trading venues should have systems and processes to be able to detect market abuse and submit suspicious transaction and order reports.

Phase 2: custody of crypto-assets

HM Treasury intends to regulate the safeguarding and administering of crypto-assets (other than a fiat-backed stablecoin) and/or the means of access to crypto-assets (eg wallets or cryptographic private keys).

HM Treasury is proposing to apply and adapt existing regulatory frameworks applying to traditional finance custodians, with suitable modifications to accommodate unique crypto-asset features. For example, HM Treasury considers that the existing framework is not adequate to regulate the safeguarding of wallets and cryptographic private keys. HM Treasury is intending to achieve the following broad regulatory outcomes:

• custodians should ensure adequate arrangements to safeguard investors’ rights to their crypto-assets such that, if and when the custodian becomes insolvent, those assets are returned to investors promptly and as whole as possible;
• custodians should have sufficient financial resources to conduct business, wind down and, where applicable, fail without causing significant harm to consumers and market participants;
• custodians should establish clear processes for redress in the event that crypto-assets held in custody are lost;
• custodians should maintain adequate systems, controls and governance arrangements to help minimise risk of misuse or loss to investors’ crypto-assets; and
• authorities would retain the ability to put in place more comprehensive reporting requirements in future, including regular and wider reporting over time.

As discussed above, ‘security tokens’ may already subject to existing financial services regulation, including in relation to custody. To the extent that the existing framework currently applies to security tokens in relation to custody, the existing framework will be replaced by the new custody regime once it comes into place.

Phase 2: crypto-asset lending services

HM Treasury intends to regulate the operation of crypto-asset lending platforms, including the facilitating of collateralised and uncollateralised borrowing of crypto-assets, and the borrowing of fiat currency with collateral provided in crypto-assets. It is intending to achieve the following broad regulatory outcomes:

• lending platforms should have adequate risk warnings for consumers lending to said platform;
• lending platforms should have adequate financial resources – capital and liquidity – and wind down arrangements to carry out their business; and
• lending platforms should have clear contractual terms on ownership and, if applicable, ringfencing of retail funds in case of insolvency.

Future of regulation in the UK

The broad vision of the reforms set out in the paper for Phase 1 and 2 is to have clear regulatory outcomes for a wide range of crypto-asset financial services related activities, much of which is being carried out by crypto exchanges today. This includes activities relating to the promotion, custody, issuance, exchange and dealing of crypto-assets.

Beyond Phase 2, HM Treasury is looking for feedback and evidence concerning regulating areas of the crypto market which may not so easily map onto existing regulatory frameworks. This includes Decentralised Finance, crypto-asset advice and portfolio management, and crypto mining, validation and staking activities.

Although the UK’s ‘activities’-based approach differs from Australia’s ‘function’-based approach, both jurisdictions are taking the first step toward regulating crypto by attempting to map existing regulatory frameworks onto unregulated crypto-asset activities/functions. Beyond this first step, both jurisdictions are grappling with some of the unique risks posed by crypto-assets and considering bespoke regulation for those risks.

You can read our overview of the Australian Government’s ‘token mapping’ consultation paper in our previous article.

We encourage you to read the Australian chapter of the Lexology Getting The Deal Through Fintech 2023 publication, which is also written by Partner John Bassilios, our Fintech and Blockchain Lead (and Blockchain Australia Director).