In our Alert Marketing Cryptoassets and Services in and Into the UK: Shifting Regulatory Sands (goodwinlaw.com) we mentioned the HM Treasury (HMT) consultation on the future financial services regulatory regime for crypto-assets TR_Privacy_edits_Future_financial_services_regulatory_regime_for_cryptoassets_vP.pdf (publishing.service.gov.uk) (the General Consultation) issued in February 2023.
On 30 October, HMT published its response Future_financial_services_regulatory_regime_for_cryptoassets_RESPONSE.pdf (publishing.service.gov.uk) to the Consultation (the Response).
At the same time, HMT published its stable-coins update Update_on_Plans_for_Regulation_of_Fiat-backed_Stablecoins_13.10.23_FINAL.pdf (publishing.service.gov.uk) (Stablecoins Update), updating its April 2022 consultation O-S_Stablecoins_consultation_response.pdf (publishing.service.gov.uk) (Stablecoin Consultation). A Bank of England (BoE) discussion paper Regulatory regime for systemic payment systems using stablecoins and related service providers | Bank of England (BoE DP) and Financial Conduct Authority (FCA) discussion paper DP23/4: Regulating cryptoassets Phase 1: Stablecoins | FCA (FCA DP) followed a week later on 6 November.
The Big Picture
The Response and Stablecoins Update confirm the core of HMT’s policy proposals in the General Consultation and Stablecoin Consultation, respectively, although they shine further light on the features of the regulatory regime. Unlike the approach in the EU under the Markets in Crypto Assets Regulation (MICA), HMT is not seeking to regulate all of the corresponding crypto activities all at once in one place.
That said, the UK regimes can be divided and examined in manner that is similar to the structure in MICA, as we do below, recognizing rules that govern:
- the activities of crypto service providers;
- the activities of the issuers of crypto-assets, with the proposals for issuers of fiat-backed stablecoins being the most developed;
- market abuse, which apply to anyone who abuses the market in exchange-traded crypto-assets; and
- the activities of decentralized finance (DeFI) providers and those involved in crypto staking, activities that have no clear analogue with traditional finance activities (although, MICA does not address staking and rules on DeFi have been deferred.)
Moreover, HMT’s comments on how it views the territorial scope of the regime — in or to the UK — are similar to those in MICA, albeit without recognizing a “reverse solicitation” concept. As we discuss below, they are not entirely coherent. (See our recent Alerts on MiCA: Marketing Crypto-Assets in and Into Europe: MiCAR, the EU’s New Uniform Crypto Code | Insights & Resources | Goodwin Procter (goodwinlaw.com); Doing Crypto Business in Europe: MiCAR, the EU’s New Uniform Crypto Code – Part 2 (goodwinlaw.com); Acquiring or Investing in EU Crypto-Asset Businesses: MiCA’s Impact | Insights & Resources | Goodwin Procter (goodwinlaw.com) and Crypto Regulation in Europe: ESMA Statement Clarifies process for the Transition to MiCA | Insights & Resources | Goodwin Procter (goodwinlaw.com).)
That said, unlike MICA, HMT does recognize the challenges of a strict and comprehensive onshoring regime, and there are indications both in the Stablecoins Update and in the Response, in the context of HMT’s concerns about liquidity fragmentation, that some non-UK unregulated activity into the UK may be inevitable.
In both the Response and Stablecoins Update, HMT confirms its proposals for a phased approach:
- Phase one would be for the regulation of fiat-backed stablecoins, which the Stablecoins Update addresses. HMT’s intention is to present secondary legislation for phase one “as soon as possible and by early 2024,” subject to Parliamentary availability.
- Phase two would be for the regulation of the other crypto-assets, which the Response addresses. HMT’s intention is to present secondary legislation for phase two in 2024, subject to Parliamentary availability.
More immediately, the period for responses to the BoE DP and FCA DP closes on February 6, 2024.
Expanding The Current Regime For Financial Services
Both the Response and Stablecoins Update indicate that HMT intends to expand the list of “specified investments” in the Regulated Activities Order (RAO) to include currently unregulated crypto-assets and identify the regulated activities in the RAO connected with those crypto-assets.
Where a firm carries on those regulated activities by way of business in the UK, it will require authorization under the general financial services authorization regime in Part 4A of the Financial Services and Markets Act 2000 (FSMA) or rely on an exemption from authorization to avoid the criminal penalties for breaching the General Prohibition in FSMA.
A key aspect of the approach to the regulation of crypto-assets, which is consistent with the regulation of financial products in the UK, is the focus on the regulation of activities. Noting the broad definition of crypto-assets in the FSMA through amendments originating in the Financial Services and Markets Act 2023 (FSMA 2023)1, this is important because where a firm carries on an activity that is not identified in the RAO, it will not require authorization.
The Response identifies the regulated crypto activities under five categories:
- Issuance activities
- Exchange activities
- Investment and risk management activities, such as dealing in crypto-assets as principal or agent, arranging deals in crypto-assets, and making arrangements with a view to transactions in crypto-assets)
- Lending, borrowing and leverage activities
- Safeguarding and/or administration (custody) activities
The Response highlights HMT’s approach to integrating the crypto regime with the general financial services regime, as opposed to developing a regime outside of the FSMA or regulating crypto-asset activities as gambling as the Treasury Committee had recommended (Regulating Crypto: Government Response to the Committee’s Fifteenth Report (parliament.uk)). It will, therefore, seek to create a level playing field between crypto-asset firms and the traditional financial sector using an existing regime that is known and tested. This follows the approach to regulating financial promotion as noted in our most recent Alert on the topic Final Reminder: New UK Crypto Marketing Rules Less Than a Month Away | Insights & Resources | Goodwin Procter (goodwinlaw.com).
The Response notes that (a) crypto exchanges and crypto custodians currently registered with the FCA under the Money Laundering Regulations 2017 will require authorization under Part 4A and (b) financial services firms currently authorized under Part 4A that wish to carry on regulated crypto activities will have to vary their Part 4A permission to include crypto-asset activities. In the context of the use of existing regulatory principles, this is unsurprising.
Modifying The Territorial Scope of Regulated Activities For Crypto Businesses
As noted above, where a firm carries on those regulated activities by way of business in the UK, it will require authorization under Part 4A of the FSMA or need to rely on an exemption from authorization to avoid the criminal penalties for breaching the General Prohibition.
The Response confirms HMT’s approach in the Consultation that a person will “generally be required” to be FCA authorized if it undertakes one of regulated crypto activities by way of business and “they are providing a service in or to the UK.”
This approach is broader than that in the primary legislation in FSMA and the interesting question (for lawyers, at least) is how the introduction of secondary legislation, most likely in the form of modifications to the RAO, will narrow FSMA’s scope with any degree of certainty. Parliament recently made crypto related amendments to FSMA via the FSMA 2023: amendments to the territorial scope of the General Prohibition or the provisions on territoriality in section 418 were not amongst those amendments.
That said, the current “overseas persons exemptions” (OPEs) in the RAO and the connected FCA guidance have often created ambiguities as to the extent to which the General Prohibition does not extend to non-UK financial services firms. The Response confirms that HMT will not extend the OPEs to crypto businesses.
The Response qualifies this general refusal, however, by stating that “firms dealing directly with UK retail consumers should be authorized irrespective of the firms’ location.” This is broadly the effect of the OPEs already so it remains to be seen exactly how a regulatory regime for non-UK crypto activities will, in fact, differ from that for other non-UK financial services activities. In this respect, the role of the amendments to the financial promotion regime for crypto-assets discussed in our previous Alert Final Reminder: New UK Crypto Marketing Rules Less Than a Month Away | Insights & Resources | Goodwin Procter (goodwinlaw.com), which clearly applies to non-UK crypto businesses, is important: it already applies regulatory protections to UK retail investors with respect to crypto-assets, greater than those for UK retail investors in most other financial products.
The Response also addresses the issues with the proposed breadth of the territorial scope, stating that, with respect to market access, HMT is committed to working with international partners to work towards deference/equivalence type arrangements. However, it may create time limited exemptions to allow access to global liquidity pools and allow UK users to achieve satisfactory execution outcomes.
Defining Crypto-assets: Non-fungible Tokens (NFTs) and Utility Tokens
As FSMA now contains a broad legislative definition of “cryptoasset,” the RAO will seek to qualify that definition in a way that is likely to be very similar to the Financial Promotion Order’s definition of a “qualifying cryptoasset,” as discussed in our Alert Final Reminder: New UK Crypto Marketing Rules Less Than a Month Away | Insights & Resources | Goodwin Procter (goodwinlaw.com).
The definition will, therefore, exclude:
- NFTs, which HMT views as more akin to (for instance) digital collectibles or artwork than a financial services product. Thus, in the same way the sale of art is not regulated as a financial services activity, NFTs are not appropriate for regulation as a financial service. HMT will, nevertheless, keep this under consideration and, where an NFT is used for a regulated activity, the person carrying on that activity will require authorization.
- Utility tokens, which HMT describes by example as tokens designed to provide digital access to a specific service or application and use technology such as distributed ledger technology to support the recording and storage of data. For HMT, a utility token that could potentially be traded on a crypto-asset trading venue could have an investment purpose and, therefore, fall within the future financial services regulatory regime. HMT will focus on how the token is used, rather on than a hypothetical application of the technology. If HMT’s approach is consistent with that under the financial promotion regime as noted in our previous Alert Final Reminder: New UK Crypto Marketing Rules Less Than a Month Away | Insights & Resources | Goodwin Procter (goodwinlaw.com), the ability for a utility token to be transferred or sold other than by way of redemption with the issuer is likely to tip it into the regulatory regime.
Asset-Referenced Token and Algorithmic or Crypto-backed Stablecoin Activities
In discussing the definition of crypto-assets, the Response not only focuses on the qualification or narrowing of the term and, therefore, activities subject to the regime but also identifies some crypto-assets that the regime will definitely capture. In this respect:
- To the extent that an asset referenced token does not meet the definition of an existing specified investment (e.g., a share or a unit in a collective investment scheme) but falls within the legislative definition of a crypto-asset, it will be regulated under the wider regime for unbacked crypto-assets.
- Because algorithmic or crypto-backed stablecoins are not backed by fiat currency, they will not fall within the scope of the forthcoming regulatory regime for fiat-backed stablecoins but will be regulated under the wider regime for unbacked crypto-assets (assuming the stablecoins in question fall within the legislative definition of a crypto-asset).
In the Stablecoins Update, HMT confirmed the definition of “fiat-backed stablecoin” will not include and the regime will not, therefore, regulate non-fiat backed stablecoins, unbacked stablecoins, algorithmic stablecoins, commodity-linked tokens, tokenized deposits or e-money.
The Payment Services Regulations 2017 will be amended to cover mixed and pure stablecoin payments and will apply if:
- The transaction involves UK customers; or
- A UK firm facilitates the transaction(s).
The Stablecoins Update, as an apparent qualification of the extension of the territorial scope in the Response noted above, discusses an “arranger” structure as a possible avenue for non-UK issued stablecoins to be used in UK payment transactions. Payment arrangers would be required to report the number of transactions to the BoE and the FCA.
As to regulatory rules that would apply to fiat-backed stablecoins, the FCA and BoE could require backing assets to be held in a statutory trust.
Staying with the protection of assets backing fiat-backed stablecoins, the Stablecoins Update seeks to apply the Insolvency Act 1986 to fiat-backed stablecoin firms and the Financial Market Infrastructure Special Administration Regime will apply in the event of a failure of a systemic digital settlement asset issuer, on which the HMT issued a consultation response CR_Managing_the_failure_of_systemic_dsa__including_stablecoin__firms.pdf (publishing.service.gov.uk).
The Stablecoins Update also addresses the role of the BoE and Payment Systems Regulator (PSR), which will set requirements for operators of and service providers to systemic digital settlement asset (DSA) payment systems and service providers. The PSR will have powers to regulate DSA payment systems. The BOE will be charged with regulating systemic fiat-based stablecoin firms, with the FCA regulating the conduct of those firms, and, in certain cases, the PSR will be responsible for regulating the firms for competition, innovation, and access purposes.
Issuance and Disclosures
Returning to the Response: although it deals with rules on the offer of crypto-assets together with those for regulated activities carried on by way of business, the nature of these rules is different, falling more within the financial markets’ jurisdiction of the FCA rather than its financial services jurisdiction. It is then unsurprising that HMT is looking to establish an issuance and disclosures regime for crypto-assets based on the proposed Public Offers and Admissions to Trading Regime (POATR) for securities. The POATR regime is different to that for the authorization and regulation of firms that carry on regulated activities, with the latter falling within the financial services jurisdiction of the FCA. That said, the Response does refer to prudential/capital requirements for issuers, which is relevant, at least, to any crypto-backed stablecoin. Such requirements are more typically associated with regulated financial services firms that issue financial instruments for sale to customers. The precise content and application of these requirements for issuers of crypto-assets remain unclear.
HMT’s application of a modified POATR to crypto-assets can be divided as follows:
- For admission of crypto-assets to a UK crypto-asset trading venue (CATV), HMT will adapt the regime for Multilateral Trading Facilities MTF and give CATVs the responsibility for writing the disclosure rules for admission.
HMT states that it supports the principle of a centralized coordinating body (i.e., industry association) to coordinate, with FCA oversight, the efforts to define detailed content requirements for admission disclosure documents in order to ensure consistency across the industry. It also supports the principle that disclosure requirements should be less prescriptive for CATVs that only admit institutional investors.
- For public offers of crypto-assets (e.g., via Initial Coin Offerings or other similar issuances) which are not securities, disclosure requirements and exemptions will likely be similar to those in the POATR and include offers of free crypto-assets (e.g., via an airdrop or similar distribution mechanism) or offers made only to professional / sophisticated investors.
For “well-established tokens” that have already been issued, HMT acknowledges that sufficient transitional time periods are needed between laying the legislation and the regime becoming effective to reduce the risks of “cliff edges” and removals from trading.
HMT maintains the position that all firms required to publish crypto-asset disclosure documents should be liable for their accuracy, except that crypto-asset exchanges, which choose to take responsibility for disclosure document, should not be held liable for all types of losses arising from events relating to a token, provided they have taken reasonable care to identify and describe the risks.
As is the case with the regime for the issuers of crypto assets, the proposed market abuse regime is one that is classified more as a financial markets, rather than a financial services, regulatory regime, which explains HMT’s approach to the market abuse regime for crypto-assets. HMT confirmed its proposals in the consultation to introduce a crypto-assets market abuse regime (CAMAR) based on elements of the Market Abuse Regulation (MAR) which applies to financial instruments. The market abuse offences of market manipulation and those related to inside information would apply to all persons committing market abuse on a crypto-asset that is admitted (or requested to be admitted) to trading on a UK CATV. As is the case with MAR, CAMAR is a regime with general application and will not be limited to FCA regulated firms.
As is the case with MAR, CAMAR will also have financial services regulatory features in that it will impose obligations for market participants, such as CATVs, who will be FCA authorized under Part 4A of FSMA, as noted below. These obligations will include the detection and disruption of market manipulation. CAMAR will also place obligations on crypto-asset market intermediaries, who will have obligations connected with the handling of inside information.
HMT indicates its support in the Response for a central organization, with FCA oversight, to coordinate and harmonize information sharing.
The Crypto Business Activities in Summary
1. Crypto-asset trading venues
HMT intends to establish a regulatory framework for persons operating a CATV. This will be based on the existing RAO activities connected with regulated trading venues (i.e., operating a multilateral trading facility [MTF] and operating an organized trading facility [OTF]). HMT indicates that decentralized trading venues will fall within the consideration of DeFi, addressed elsewhere in the Response. HMT does reiterate, however, the need to take into consideration specific characteristics and risks of crypto-asset trading activities.
The response also clarifies that HMT does not intend to explicitly endorse or prohibit specific business models or execution protocols in legislation — e.g., OTF and matched principal trading and proprietary trading. Its expectation will be for firms to be able to demonstrate that they are managing appropriately conflicts of interests and any risks to market integrity within the context of their business models when the firms seek authorization from the FCA.
The Response notes that a number of other issues, such as operational resilience requirements, will require treatment through future regulator consultations and firm-facing rules. It also sets out HMT’s intention to make CATVs subject to an insolvency regime that will ensure that the assets of CATV users receive the same type of treatment under FSMA and protection that the users of MTFs and OTFs would receive.
2. Crypto-asset intermediation activities
The Response confirms HMT’s intention to adapt analogous existing regulated activities in the RAO, such as “arranging deals in investments” and “dealing in investments as agent,” for crypto-asset market intermediation activities, taking into account specific aspects of crypto markets. HMT will also seek to distinguish between rules for retail and for wholesale customers.
Expanding its comments on the territorial scope of the regime, noted above, HMT makes the point that it would be problematic if all overseas crypto-asset exchanges were to seek authorization in the UK as intermediaries rather than CATVs, as this would take them outside the issuance and market abuse regimes that are linked to the “regulatory trigger points,” which the CATVs control. HMT, therefore, intends to require any CATV to lodge a disclosure / admission document for a crypto-asset on the National Storage Mechanism before any UK intermediary is able to deal or arrange deals in that crypto-asset.
3. Crypto-asset custody
The Response confirms HMT’s intention to apply and adapt existing frameworks for traditional custodians — specifically, a new regulated activity for custody covering the (i) safeguarding, (ii) safeguarding and administration, or (iii) the arranging of safeguarding or safeguarding and administration — of a crypto-assets. The Response notes that the government will consider the Law Commission’s Final Report on Digital Assets, which provides recommendations to clarify the concept of “control” of crypto-assets, in its forthcoming work on custody.
HMT has also confirmed that it will not seek to impose full, uncapped liability on crypto custodians in the event of a malfunction or hack that was not within the custodian’s control.
The Response also clarifies that HMT does not expect the provision of self-hosted wallets to fall within the new regulated activity for custody. However, the FCA should continue to monitor this matter and consider whether FCA rules should address aspects of those services, especially the rules governing operational resilience and critical outsourcing.
The Response also confirms HMT’s view that, although the custody of security tokens that meet the definition of existing specified investments, will, for the most part, continue to be regulated in line with existing rules and regulations, the rules may need to change to take account of the fundamental differences between how crypto-asset custody and traditional custody operate.
4. Crypto-asset lending platforms
The Response conforms HMT’s intention to create a regulated activity of “operating a crypto-asset lending platform” (CLP) and to establish a tailored set of rules for CLPs. CLPs would be subject to requirements to put in place adequate risk warnings, adequate financial resourcing, and clear contractual terms of ownership. The Response clarifies HMT’s intention to prioritize regulation of retail-facing lending business models, noting its concerns around retail consumer risks.
HMT’s Call For Evidence in Summary
1. Decentralized finance (DeFi)
The Response explicitly states that HMT does not intend to ban DeFi, although HMT reiterates that it would be premature and ineffective to regulate DeFi activities currently.
Instead, the government will support efforts at the international level, such as through work which the Financial Stability Board is undertaking. HMT also agrees with respondents to the Consultation that a spectrum of decentralization needs to be recognized within the DeFi ecosystem rather than a binary split between centralized or decentralized activities.
The regulation of DeFi, including the perhaps unintended reach of the financial promotion regime in this regard, will remain an area of focus.
2. Crypto-asset activities kept out of scope
The Response clarifies HMT’s position on crypto-asset activities, including crypto-asset investment advice and portfolio management, which HMT will continue to keep under review. HMT does not also intend to bring mining within scope of the perimeter as a regulated activity at this stage.
HMT intends to accelerate its work in clarifying the regulatory treatment of staking in the UK due to industry concerns. This will include:
- Developing a clear definition of crypto-asset staking on a Proof of Stake (PoS) blockchain and distinguishing this from other activities that may be referred to as “staking”
- Establishing a taxonomy of the different PoS staking business models currently in the market
- Identifying how to mitigate the associated risks and take advantage of the potential benefits of a permitted form of staking in the UK
HMT states that it does not intend to ban staking, noting that many activities that intermediaries perform in pool staking present risks for consumers that should be addressed by regulation. Other regimes, including the financial promotion, custody, lending, and intermediation, already address these risks, thus removing the need for further regulation.
HMT also notes that existing rules for collective investment schemes (CIS) may capture on-chain staking services, which may require certain types of staking to be excluded from the CIS regime, provided that the risks are appropriately captured in other crypto-asset regulatory regimes. Alternatively, a new regulatory regime for “operating a staking platform” outside of the CIS framework may be introduced.
HMT will address sustainability issues primarily through disclosures. The Response also highlights the government’s intention to develop international and interoperable metrics through existing international forums, such as the International Organization of Securities Regulators.