An extract from The Virtual Currency Regulation Review, 5th Edition

Introduction to the legal and regulatory framework

In response to the question What are cryptoassets?, the principal UK regulator in the area, the Financial Conduct Authority (FCA) tells us that 'Cryptoasset is a broad term and covers many different types of products. The most popular forms of cryptoassets include tokens like Bitcoin, Ether and Litecoin'. True indeed, it is most definitely a broad term and attempts to define and pin down run up against an ever changing environment for virtual currency. In a chapter (and publication) such as this it makes sense to start with what is in front of us; that is, the law and regulations that are there. From that base, we look at where law and regulation are going in the future and potential changes that are coming down the tracks.

i Cryptoassets in law and regulation

In legislation we come across the definition of 'cryptoasset' in the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs) as 'a cryptographically secured digital representation of value or contractual rights that uses a form of distributed ledger technology (DLT) and can be transferred, stored or traded electronically'. Similarly, other UK regulatory rules and guidance generally use the term cryptoasset (rather than virtual currency) and so, where we refer in this chapter to virtual currencies, this should be understood as a reference to all types of cryptoassets (as well as e-money tokens).

Similar to any regulatory regime, the regulation of cryptoassets has a perimeter. For cryptoassets, that regulatory perimeter is somewhat blurred. Certainly there are types of cryptoassets that are regulated, with the perimeter being determined through the structure and substantive characteristics. Those characteristics (falling into three broad categories identified by the FCA in its Guidance on Cryptoassets,2) determine the three following applicable regulatory frameworks.

  1. security tokens: virtual currencies with characteristics that mean they provide rights and obligations akin to traditional instruments, such as shares, debentures or units in a collective investment scheme. Consequently, they fall into the UK regulatory perimeter as 'specified investments' under the Financial Services and Markets Act 2000 (FSMA);
  2. e-money tokens: virtual currencies meeting the definition of electronic money (or e-money) under the Electronic Money Regulations 2011 (EMRs). They also fall within the UK regulatory perimeter as specified investments under the FSMA; and
  3. unregulated tokens: virtual currencies that are neither security tokens nor e-money tokens. They are not specified investments under the FSMA and so fall outside the UK regulatory perimeter (save in relation to anti-money laundering-related requirements; see Section IV). They include virtual currencies that are not issued or backed by any central authority and are intended and designed to be used directly as a means of exchange, which the FCA refers to as exchange tokens but are often called cryptocurrencies. Unregulated tokens also include 'utility tokens'. Utility tokens could be securities under the FSMA if they both granted holders access to a current or prospective service or product and also exhibited features similar to security tokens as described above. Alternatively, they could be the same as or similar to reward-based crowdfunding with simple access to products or services (sometimes at a discount).

In its Guidance on the cryptoassets regulatory perimeter, the FCA states that although it recognises these three broad categories of cryptoassets 'they may move between categories during their lifecycle'3 and assessing whether a particular virtual currency falls within the UK regulatory perimeter 'can only be done on a case-by-case basis, with reference to a number of different factors'. FCA Guidance is not binding on the courts but may be persuasive in any determination by the courts, for example when enforcing contracts.

ii Questions to consider when identifying potentially applicable regulatory regimes

The following questions may be helpful in determining how a particular cryptoasset might be regulated in the United Kingdom:

  1. Is the cryptoasset a type of transferable security or other type of regulated financial instrument or investment under the FSMA?
  2. Are the arrangements relating to the issuance of the cryptoasset such that they may create a collective investment scheme under section 235 of the FSMA?
  3. Could the cryptoasset give rise to deposit-taking, the issuance of electronic money or the provision of a payment service under the FSMA or Payment Services Regulations 2017?
  4. Could the issuance of a cryptoasset or the operation of an exchange for cryptoassets be regulated as crowdfunding under the FSMA?
  5. Would activities concerning cryptoassets fall within the scope of the UK anti-money laundering legal and regulatory regime (under the MLRs or otherwise)?

Securities and investment laws

The FSMA forms a cornerstone of the UK regulatory regime for financial services. Under Section 19 FSMA, a person must not carry on a regulated activity in the United Kingdom or purport to do so unless he or she is authorised or exempt.4 This is known as the general prohibition, breach of which is a criminal offence (see Section VIII.i).

A regulated activity is an activity of a specified kind that is carried on by way of business and relates to an investment of a specified kind.5 The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO) sets out activities and investments specified for this purpose. In general, a case-by-case analysis of the substantive features of the cryptoasset under consideration is needed to determine whether it is a specified investment under the RAO and, if so, which category of specified investments. However, Section II.i sets out some broad principles about how different types of cryptoasset are likely to be categorised under the UK regulatory regime. At a high level, the FCA has indicated exchange tokens (i.e., cryptocurrencies) and utility tokens are not regulated types of financial instruments, whereas activities relating to cryptocurrency derivatives and securities tokens are regulated. We also consider in Section II.ii whether arrangements relating to the issue of virtual currencies could involve the creation of a collective investment scheme (CIS) under Section 235 of the FSMA. Even if virtual currencies are not specified investments under the RAO, firms carrying on activities relating to virtual currencies may be subject to regulatory requirements discussed in the subsequent sections of this chapter.

i Categories of virtual currencies and specified investmentsExchange tokens (cryptocurrencies) and cryptocurrency derivatives

The FCA has made various statements indicating that it does not consider exchange tokens (also referred to as cryptocurrencies or digital currencies) to fall within the UK regulatory perimeter for financial services, provided that they do not form part of other regulated products or services.6 In general, this means that cryptocurrencies are not considered to be specified investments under the FSMA.7

However, in April 2018, the FCA indicated that cryptocurrency derivatives may be financial instruments within the scope of the recast Markets in Financial Instruments Directive (MiFID II),8 even though cryptocurrencies themselves are not regulated financial instruments in the UK.9 In this statement, the FCA indicated that cryptocurrency derivatives include futures, options and contracts for difference referencing cryptocurrencies. This means that firms would most likely need to be authorised under the FSMA to deal in, advise on or arrange transactions in cryptocurrency derivatives, or provide any other regulated services relating to cryptocurrency derivatives in the United Kingdom. On 6 January 2021, the FCA imposed a ban on marketing, distribution and sale to retail clients of derivatives and exchange traded notes referencing unregulated transferable cryptoassets, such as cryptocurrencies.10

Additionally, the FCA announced on 11 March 2022 that it had not authorised any crypto ATM under the MLRs and consequently all crypto ATMs operating in the United Kingdom were acting illegally.11

In its April 2018 statement, the FCA also indicated that it does not consider cryptocurrencies to be currencies or commodities for regulatory purposes. This is relevant for assessing which regulatory rules would apply to cryptocurrency derivatives, as specific rules apply to certain categories of derivatives, such as commodity derivatives or derivatives where the underlying is a currency or a regulated financial instrument.

Security tokens

In its Guidance on Cryptoassets, the FCA describes security tokens as virtual currencies that constitute specified investments under the RAO, excluding e-money tokens (see Section III.ii for a discussion of e-money tokens). Security tokens are generally likely to fall within the definition of securities under the RAO, which are a subset of specified investments under the RAO. Further regulatory requirements also apply to virtual currencies constituting transferable securities, such as the UK prospectus regime (see Section VII.i).

The FCA has indicated that at least some types of virtual currencies may be transferable securities. In particular, it identifies that traditional shares issued on a public blockchain may be transferable securities, and that some security tokens may 'amount to a transferable security more akin to regulated equity-based crowdfunding'.12

Meaning of securities

The RAO defines securities as including:13

  1. shares;14
  2. bonds, debentures, certificates of deposit, and other instruments creating or acknowledging indebtedness;15
  3. warrants and other instruments giving entitlements to investments in shares, bonds, debentures, certificates of deposit, and other instruments creating or acknowledging indebtedness;16
  4. certificates representing certain securities: that is, certificates or other instruments that confer contractual or property rights in respect of certain types of securities held by another person and the transfer of which may be effected without the consent of that other person;17
  5. units in a CIS (see Section II.ii for further detail on CIS);18
  6. rights under a stakeholder or personal pension scheme;19 and
  7. greenhouse gas and other emission allowances.20

The definition of securities also includes rights or interests in these types of investments (with some exceptions, such as in relation to occupational pensions schemes, which are not generally relevant to virtual currencies).21

In its Guidance on Cryptoassets, the FCA provides a non-exhaustive list of factors that are indicative of a security token, including any contractual entitlement that holders may have to share in profits or exercise control or voting rights in relation to the issuer's activities. Other factors may include the language used in relevant documentation, although the FCA notes that labels are not definitive and it is the substantive analysis that would determine whether or not a virtual currency is a security token.

Persons who carry on specified activities relating to securities tokens by way of business in the United Kingdom would therefore need to be authorised and have appropriate permissions under the FSMA. Potentially relevant specified activities may include dealing (i.e., buying, selling, subscribing for or underwriting) as principal or as agent,22 arranging transactions or making arrangements with a view to transactions.23

Meaning of transferable securities

If the features of the virtual currency are such that it is a security, it is also necessary to consider whether the security is transferable to identify the applicable regulatory requirements.

Transferable securities are defined as 'those classes of securities which are negotiable on the capital market, with the exception of instruments of payment'.24

The UK regulators continue to take into account interpretive guidance on this definition published by the European Commission prior to the United Kingdom's withdrawal from the European Union. The Commission has indicated that the concept of being negotiable on the capital market is to be interpreted broadly and that '[i]f the securities in question are of a kind that is capable of being traded on a regulated market or MTF, this will be a conclusive indication that they are transferable securities, even if the individual securities in question are not in fact traded' but conversely '[i]f restrictions on transfer prevent an instrument from being tradable in such contexts, it is not a transferable security'.25

The term 'capital market' is not defined for this purpose, but the Commission has indicated that the concept is broad, and is intended to include all contexts where buying and selling interests in securities meet.26 This could therefore include a cryptocurrency exchange. This means that those types of virtual currencies that are classed as securities are also likely to qualify as transferable securities where they are traded or capable of being traded on cryptocurrency or other exchanges. They would therefore fall within the prospectus regime (discussed in Section VII.i) and other regulatory requirements that apply specifically to transferable securities.

If security tokens are not negotiable on the capital market, for example because of contractual restrictions on transfer, they may nonetheless fall within the UK crowdfunding regime for non-readily realisable securities (see below and Section V.ii).

Non-readily realisable securities

In 2014, the FCA introduced regulatory rules relating to the promotion of non-readily realisable securities. The FCA defines a non-readily realisable security as a security that is not:

  1. a readily realisable security: this term includes government and public securities, and securities that are listed or regularly traded on certain exchanges – note that this concept is narrower than that of a transferable security;
  2. a packaged product: this includes units in a regulated CIS as well as certain insurance, pension and other products;
  3. a non-mainstream pooled investment: this includes units in an unregulated CIS, certain securities issued by a special purpose vehicle, and rights or interests to such investments; or
  4. certain types of shares or subordinated debt issued by mutual societies or credit unions.27

It is possible that some types of virtual currencies may be both transferable securities and non-readily realisable securities.

Utility tokens

Utility tokens are not regulated financial instruments in the United Kingdom. The FCA describes utility tokens as 'tokens representing a claim on prospective services or products' and explains that they are 'tokens that do not amount to transferable securities or other regulated products and only allow access to a network or product'.28 For example, this would include tokens that entitle the holder to access office space or to use certain software.

ii Arrangements relating to the issue of virtual currencies that involve the creation of a CIS

Additional regulatory requirements will apply if arrangements relating to the issue of a virtual currency involve the creation of a CIS. Units in a CIS are specified investments under the RAO, and establishing, operating or winding up a CIS is a regulated activity under the FSMA (subject to the exclusions discussed below in 'Collective investment undertakings and alternative investment funds').29

Collective investment schemes

A CIS is defined as 'any arrangements with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements (whether by becoming owners of the property or any part of it or otherwise) to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income'.30

In addition, the participants in a CIS must not have day-to-day control over the management of the property; and the arrangements must provide for the contributions of the participants and the profits or income to be pooled, or for the property to be managed as a whole by or on behalf of the operator of the scheme, or both.31

Virtual currency structures that do not involve an investment in underlying assets (such as cryptocurrencies) or that do not provide for participants to participate in or receive profits or income from a pool (such as utility tokens) would not generally fall within the definition of a CIS.

In some cases, it is possible that the issuer of a virtual currency will itself be a CIS, albeit that the virtual currency is not a unit, and holders of the virtual currency will not be unitholders in the CIS. This may arise, for example, where the issuer raises funds from issuing virtual currency and uses the funds raised to acquire assets or make other investments for the benefit of unitholders in the issuance vehicle (but not the holders of the virtual currency).

Collective investment undertakings and alternative investment funds

If a virtual currency is a CIS, it may also be a collective investment undertaking (CIU), an alternative investment fund (AIF), or both.

A CIU is similar but not identical to a CIS.32 The European Securities and Markets Authority (ESMA) has issued guidelines on the characteristics of a CIU, which provide that an undertaking will be a CIU where:

  1. the undertaking does not have a general commercial or industrial purpose;
  2. the undertaking pools together capital raised from its investors for the purpose of investment with a view to generating a pooled return for those investors; and
  3. the unitholders or shareholders of the undertaking – as a collective group – have no day-to-day discretion or control.

The fact that one or more but not all of the aforementioned unitholders or shareholders are granted day-to-day discretion or control should not be taken to show that the undertaking is not a collective investment undertaking.33

An AIF is a CIU that raises capital from a number of investors with a view to investing it in accordance with a defined investment policy for the benefit of those investors, and that does not require authorisation as an undertaking for collective investment in transferable securities.34

In general, a substantive analysis would be required to determine whether a particular virtual currency may be an AIF. If so, the virtual currency would need an authorised or regulated manager (AIFM) who would be responsible for compliance with the UK regulatory requirements applicable to AIFs and AIFMs. Managing an AIF is a regulated activity under the FSMA.35