In a report issued by the UK Cryptoassets Taskforce, authorities break down the key concepts of cryptoassets; consider application of the current regulatory perimeter to different cryptoassets; and discuss the impact, risks, and benefits of cryptoassets as well as next steps for regulating this developing sector.
The United Kingdom’s Cryptoassets Taskforce, comprising representatives from the UK government, Financial Conduct Authority (FCA), and Bank of England, issued a report on 29 October 2018 paving the way for settlement of the UK policy and regulatory approach to cryptoassets and distributed ledger technology (DLT). The report explains key concepts; describes how the current regulatory perimeter applies to different types of cryptoassets, and how it might apply in future; and discusses the impact of DLT in financial services, the risks and benefits of cryptoassets, and next steps.
The Taskforce was established in March 2018 in response to the growing use of cryptoassets, the application of DLT, and the risks that these developments bring to consumers and the UK financial market. It forms part of the UK government’s wider Fintech Sector Strategy, which aims to promote the UK as the most innovative global economy, whilst maintaining its reputation as a transparent and reliable financial regime. One of the Taskforce’s key objectives is to ensure a robust regulatory structure within which innovative technologies, including DLT and cryptoassets, can prosper.
The report—part of a well-established and continuing endeavour by each Taskforce authority to support and prioritise the UK as a leading innovative economy and maintain its position as a leading global financial centre—makes clear that disruptive market technologies call for a dynamic regulatory response. The report concludes the following:
- DLT has the potential to deliver significant benefits in financial services in the future.
- Whilst evidence that the current generation of cryptoassets does deliver benefits is scant, the market is rapidly developing and that might change.
- There are substantial potential risks associated with cryptoassets.
- The immediate priorities for each authority are to mitigate the risks to consumers and market integrity and to prevent the use of cryptoassets for illicit activity.
- Whilst certain cryptoassets do fall within the current UK regulatory perimeter, the authorities will engage with international bodies on those cryptoassets that do not in order to ensure a comprehensive response and help prevent a patchwork of differing regulatory regimes from proliferating.
For comparative context, cryptoassets are still fledging in scale: even at their peak market capitalisation of $830 billion in January 2018 (which had plummeted to $191 billion by August 2018), the combined global market capitalisation of the cryptoasset market was less than 0.3% of global financial assets and the total value of cryptoassets worldwide was less than 1% of world gross domestic product (GDP). By contrast, at the peak of the dot-com bubble in March 2000, the combined market capitalisation of US technology stocks was almost one-third of world GDP, and prior to the 2008 financial crisis the notional value of credit default swaps was 100% of world GDP.
Key Concepts Explained
Early on, the report sets the scene by usefully unpacking and explaining some challenging concepts:
- “Blockchain” is not co-extensive with DLT but instead refers to a specific way of structuring data on a DLT platform.
- Bitcoin is the leading example of a DLT platform that has no central, trusted authority, and is open to anyone to participate, aka “permissionless.”
- In contrast, most of the DLT platforms being developed for use in financial services are “permissioned,” both in terms of who can access and who can update the network. The FCA considers the most promising areas for development to be bespoke private versions of blockchain on permissioned distributed ledgers.
- Cryptoassets are one application of DLT and are neither currency nor money.
- DLT can “tokenise” existing financial or tangible assets by recording an existing asset on a DLT platform and representing it as a token in order to enhance processes around trading and transfer of the asset.
Categories and Uses of Cryptoassets
The report divides cryptoassets broadly into three main categories:
- Exchange tokens that (1) are used for exchange or investment; (2) are often referred to as cryptocurrencies (such as Bitcoin) that use DLT; and (3) are not issued or backed by a central bank or other central body
- Security tokens that (1) provide certain rights such as ownership, repayment of a specific sum, or entitlement to a share of future profits; (2) qualify as a specified investment under the Financial Services and Markets Act 2000 (Regulated Activities) Order (RAO); and (3) may also be transferable securities or financial instruments for the purposes of the Markets in Financial Instruments Directive (MiFID)
- Utility tokens that can be redeemed for access to specific products or services
The report sets out three different uses of cryptoassets:
- As a means of exchange, i.e., the buying or selling of goods and services and the facilitation of regulated payment services
- As a direct or indirect investment
- To support capital raisings and the creation of decentralised networks through initial coin offerings (ICOs)
Due to the fast-paced market and opaque nature of cryptoassets, the Taskforce recognises the difficulty in assessing whether a specific cryptoasset falls within the regulatory perimeter. If regulated, a certain cryptoasset may fall under several categories within the regulatory framework, all of which need to be considered. Regulation of security tokens is particularly complex, and the FCA is expected to consult on this soon.
The Treasury Select Committee of the UK Parliament published its report on cryptoassets on 18 September 2018, equating the area with the “wild west” and calling for each of the issuance of ICOs and the provision of crypto-exchange services to be rendered a regulated activity under the RAO. The Taskforce welcomes that committee’s work and indicates that the government will issue its formal response soon.
The Taskforce makes clear that the question of whether cryptoassets fall within the current regulatory perimeter—and if so, what regulation applies—should be determined on a case-by-case basis, and this determination is the responsibility of the firm engaging in the cryptoasset-related activities. The report notes that the FCA has been active in investigating whether unauthorised firms require authorisation relating to their cryptoasset activities, and it should be noted that wider legal frameworks may also come into play, such as general criminal and civil antifraud laws; contract, consumer, and advertising laws; and the UK financial promotions regime. Other provisions under the FCA Handbook may also affect regulated firms carrying out currently unregulated cryptoasset-related activities.
The report recognises that while cryptoassets (which currently number around 2,000) remain at the early stages of development and have minimal evidence of success to date, there is the potential for future benefits. At the same time, the report emphasises that cryptoassets bring significant risks due to their complex nature, including potential risks to market stability and integrity, the fostering of illicit activity and financial crime, and potential absolute loss to consumers. Thus, the Taskforce notes that in many cases, “the risks posed by the current generation of cryptoassets outweigh any potential benefits.”
The report outlines various responses for tackling these concerns. The Taskforce authorities will consult by the end of 2018 on potentially prohibiting the sale to retail consumers of derivatives relating to certain cryptoassets, including contracts for differences (CFDs), futures, and options, which clearly fall within the current regulatory perimeter. Although the proposed measures do not extend to derivatives referencing cryptoassets that qualify as securities, the report notes that the FCA supports the European Securities and Markets Authority (ESMA) restriction on sale of CFDs referencing cryptoassets, which was renewed on 1 November 2018.
Further government consultation is expected in early 2019 to explore whether the regulatory perimeter requires an extension to capture those cryptoassets comparable to security assets, but which fall outside the current regulatory framework, and whether the regulation of exchange tokens, exchanges, and wallet providers could be tightened.
In addition, the government intends to develop regulatory provisions during 2019, which will go significantly beyond the EU’s fifth Anti-Money Laundering Directive in order to tackle financial crime concerns. Proposed changes could extend the requirements to firms outside the UK that provide services to UK consumers.
The Bank of England and the Prudential Regulation Authority are working to maintain financial stability through monitoring risks and assessing whether current prudential regulations are sufficient. For example, measures have been taken to include non-interbank payment systems within the regulatory perimeter, thereby potentially bringing those systems within the bank’s supervision.
We are monitoring this developing area of regulation closely and will report further as the Taskforce authorities deliver their next steps. In the meantime, read our All Things FinReg blog, and in particular the 23 October 2018 post, Cryptoassets: The Current State of Financial Regulation of EU, UK, and US Levels.