The UK’s House of Commons Treasury Committee (Committee) published a report (Report) on September 12, 2018, in relation to the current and future regulation in the UK of crypto-assets. The Report finishes by setting out the Committee’s conclusions and recommends that UK government urgently brings forward legislation for the regulation of crypto-assets.
The Committee considers that:
- crypto-currencies are not suitable for sale to most retail investors due to their volatility;
- investors in conventional assets may not be familiar with risks particular to crypto-assets, such as hacking and loss of passwords causing the loss of the asset. These risks are not covered by investor compensation schemes;
- most ICOs will fall outside the FCA’s remit because they are structured as utility tokens, rather than security tokens, and are thereby exploiting a regulatory loophole, to the detriment of ordinary investors;
- many advertisements for crypto-assets are misleading, but the Financial Conduct Authority (FCA) is restricted in the actions it can take;
- the Committee will press the UK government to introduce legislation urgently to regulate activities related to crypto-currencies and related transactions, such as initial coin offerings and the provision of crypto-asset exchange services;
- the legislation should cover consumer protection and anti-money laundering issues, at a minimum, and it is hoped it could lead to positive outcomes for the crypto-asset industry; and
- the next step is for the UK government to decide whether to propose legislation and in what form.
Terminology and Features of Crypto-Assets
In the Report, the Committee has throughout referred to crypto-currencies as “crypto-assets”, due to the inherent differences between crypto-currencies and traditional currencies. During their hearings, the Committee received evidence from the Head of Note Operations at the Bank of England that crypto-currencies currently do not perform all of the functions that are generally understood to be implicit in the term “currency”, i.e., acting as a medium of exchange, a store of value and a unit of account.
Although crypto-assets, and the distributed ledger technology (or “blockchain”) underlying crypto-assets, were originally designed as an alternative system of making payments for goods and services, even Bitcoin (the most widely used crypto-asset) is not widely accepted as payment. In addition, the Committee heard evidence that the underlying blockchain technology is not currently able to process anything like the volumes of transactions that would be required for it to be considered a mass-market payment system, and it would involve prohibitive energy costs in order to verify the transactions.
It concluded that the extent to which crypto-assets and blockchain can replace conventional payment systems is currently limited by the slow, costly and energy-intensive verification process for transactions, and such assets and technology are not considered to present a risk to the stability of the financial system.
The Committee is supportive of good innovation in terms of blockchain being deployed in the financial services industry and supply chain management, but considers that the UK government and industry should identify existing problems and consider whether blockchain is the most appropriate solution, rather than blockchain being pursued for its own sake. Having said that, it recognizes that the blockchain technology may improve trust in data integrity and, for certain types of data, may be a more efficient method of management and offer higher levels of security than centralized databases.
Crypto-assets display far higher volatility than other asset classes, giving rise to potentially larger gains but also potentially larger losses than other classes. The Committee considers that the use of blockchain as a payments system for crypto-asset transactions may exacerbate the risks of loss, since in the time it takes to settle a transaction with blockchain, the exchange rate of the crypto-asset being transacted (for other crypto-assets or conventional currency) can fluctuate significantly.
Due to their volatility alone, the Committee considers that crypto-assets are particularly risky for inexperienced retail investors.
Although there is no recorded incidence of anyone successfully managing to hack the underlying blockchain technology, there have been instances of crypto-asset exchanges (where individuals can convert crypto-assets into conventional currency and vice-versa) and platforms being hacked and customers losing significant amounts of money.
Currently, there is no deposit insurance scheme to compensate investors in this event, and individual exchanges do not provide such coverage. The Committee is concerned that investors in conventional assets may not be well-placed to judge the risk of hacking that is associated with crypto-assets, or be aware of the lack of any deposit insurance scheme to compensate them in such an event. This reinforces the view of the Committee that crypto-assets are ill-suited to retail investors.
The Committee also highlights the difference in treatment between a customer of a bank who forgets their account details, but would always be assisted by the bank in retrieving their assets, compared to the case of an investor who loses their password to their crypto-exchange account and finds themselves permanently locked out of their account when the crypto-exchange is unable to recover the customer’s details.
Initial Coin Offerings
Whether an initial coin offering (ICO) is regulated in the UK will depend upon how it is structured and what the token will subsequently represent. When a token represents a transferable security, such as a share, bond or a unit in a fund, the ICO will fall within the regulatory powers of the FCA. However, when tokens are utility tokens, i.e., they represent a claim for prospective services or products, they do not amount to transferable securities or other regulated products and will fall outside the FCA’s regulatory perimeter. As such, the issuer of such tokens would not be required to comply with the FCA’s principles and rules, and the FCA is not required to ensure appropriate protection for investors.
Nevertheless, the FCA, in September 2017, published a consumer warning about the risks of ICOs, stating that they are “very high risk, speculative investments” and highlighting to consumers the absence of regulatory protections. The Committee noted that, beyond drawing attention to the risks of ICOs, the FCA is currently powerless to protect individuals from fraud or investment loss in connection with ICOs, since most ICOs do not promise financial returns, but instead offer future access to a service or utility.
Nevertheless, the Committee’s conclusion is that, despite there being no explicit promise of a financial return, ICO investors will typically expect such a return and are usually intending to sell the token in the future for a profit, rather than utilizing it to receive the promised service or utility.
As part of the hearings, the Committee considered the December 2017 public statement of the Chairman of the U.S. Securities and Exchange Commission (SEC) as to the SEC’s approach to whether an ICO involves the issuance of a security. In particular, that statement highlighted the approach of the SEC that the analysis should be based on the application of long-standing securities law principles, rather than a focus on the precise form that a token may take. Those principles have led to the SEC concluding that merely calling a token a utility token, or structuring it to provide some utility, does not prevent it from being a security, because where it incorporates features that emphasize the potential for profits, based upon the entrepreneurial or managerial efforts of others, these will continue to be considered the features of a security under U.S. law.
The Committee also heard evidence from the Director of Policy of the FCA that highlighted the differences between the UK and the U.S. in their approach to regulating utility tokens. In his view, the SEC applies tests on the basis of case law, focusing on whether the particular asset behaves like an investment, in the sense of hoping for a speculative return. In contrast, under UK legislation, the definition of a “financial instrument” is laid down very prescriptively.
In the Committee’s view, the issuers of ICOs are currently exploiting a loophole in UK regulation to the detriment of ordinary investors.
Money Laundering and Terrorist Financing
The Committee also noted the possibility of crypto-assets facilitating trade in illicit goods and services and laundering the proceeds of crime and funds for terrorism, and considers the current lack of regulation of crypto-asset exchanges is a particular problem. However, it notes that the UK is due to adopt the EU’s Fifth Anti-Money Laundering Directive, under which crypto-asset exchanges will be compelled to comply with anti-money laundering and counter-terrorist financing rules. Currently, the UK’s transposition of that directive into its national laws is undergoing a consultation process, which is currently not planned to finish until the end of 2019, whereas the United Kingdom is due to leave the European Union (Brexit) by the end of March 2019. Therefore, the Committee will urge the UK government to replicate the directive’s provisions into UK law, whether or not it is obliged to do so after Brexit takes place.
The Committee also notes that crypto-asset markets, though being particularly vulnerable to market manipulation, currently fall outside the scope of UK market abuse rules, and the Committee has requested the FCA to outline the approach it would take to market manipulation if future legislation were to bring these markets within the FCA’s remit.
A further specific concern of the Committee in relation to crypto-assets is the current irresponsible attitude of certain promoters in their use of advertisements for investments in crypto-assets, particularly on social media, billboards, trains and taxis. Frequently, such advertisements can be clearly misleading to consumers, yet the FCA is severely restricted in the actions it can take in relation to such advertisements, given that crypto-asset activities fall outside the current remit of the FCA. It therefore proposes to give the FCA more powers to control how crypto-asset exchanges and ICO issuers market their services, and also to provide investors with better protections against “mistreatment”, including loss of deposits through fraud and hacking or losing access to funds due to the loss of passwords.
In conclusion, the Committee urges the UK government to clarify the current ambiguity surrounding its position on regulation of crypto-assets and related activities. The Report describes the current situation in this regard as akin to the “Wild West”. It considers the current system of self-regulation within the crypto-asset industry to be insufficient and recommends the introduction of formal regulation to allow relevant regulators to “hold the industry to account”. In its view, regulation should, at a minimum, address consumer protection and anti-money laundering. It also expresses the view that the introduction of regulation could lead to positive outcomes for the crypto-asset market, by enabling it to move to a more mature business model that improves consumer outcomes and enables it to grow sustainably.
It considers that, if the UK is able to develop an appropriate and proportionate regulatory environment for crypto-assets, then, assuming that future innovations in crypto-assets prove to be beneficial to society and industry, the UK could be well-placed to become a global center for this activity.
In terms of the manner of implementing new regulation for crypto-assets and associated activities, the Committee considers that the quickest and simplest method of introducing this would be to amend the existing Regulated Activities Order to include these assets and activities, and it noted that, in recent years, this precise approach has been taken to the regulation of peer-to-peer lending. It considers that this method is preferable to designing a new framework of regulation that specifically targets crypto-assets. It recommends that the UK government consider which activities related to crypto-assets should be specified in the Regulated Activities Order and considers that, at a minimum, this should cover the issuance of ICOs and the provision of crypto-asset exchange services.
The Committee also recognized the importance of international co-operation in relation to regulation of crypto-assets and related activities, and it encouraged UK regulators to continue engaging with international bodies to ensure that the UK adopts best practice from other regulators.
The next step will be for the UK government to consider whether to act on the recommendations of the Committee and propose legislation to Parliament. However, the timing of any such step is currently highly uncertain, due to the current distraction to the UK government caused by the crucial negotiations with the European Union on the terms of Brexit.