An extract from The Virtual Currency Regulation Review, 3rd Edition

Introduction to the legal and regulatory framework

In the United Kingdom, the term 'cryptoasset' is defined 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).

At present, some (but not all) types of virtual currencies are regulated in the UK. In general, the structure and substantive characteristics of a virtual currency will determine whether or not it falls within the UK regulatory perimeter, and if so, which regulatory framework or frameworks will apply. In its Guidance on Cryptoassets,2 the UK Financial Conduct Authority (FCA) identifies three broad categories of virtual currencies, with the following features:

  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, meaning that they fall within the UK regulatory perimeter as 'specified investments' under the Financial Services and Markets Act 2000 (FSMA).
  2. E-money tokens: virtual currencies that meet the definition of electronic money (or e-money) under the Electronic Money Regulations 2011 (EMRs). Again, they fall within the UK regulatory perimeter as specified investments under the FSMA.
  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 (other than 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', which grant holders access to a current or prospective service or product but exhibit features that would make them akin to securities. Utility tokens may be the same as or similar to reward-based crowdfunding.

In its Guidance, the FCA states that although it recognises these three broad categories of cryptoassets 'they may move between categories during their lifecycle' 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'. More generally, the Guidance sets out the FCA's views on when virtual currencies fall within the current UK regulatory perimeter. This Guidance is not binding on the courts but may be persuasive in any determination by the courts, for example when enforcing contracts.

i Questions to consider when identifying potentially applicable regulatory regimes

There are various ways in which market participants' activities relating to virtual currencies might be regulated in the UK. When analysing whether, and if so how, activities relating to a particular virtual currency may be regulated, it is helpful to consider the following questions:

  1. Might virtual currencies be transferable securities or other types of regulated financial instruments or investments?
  2. Might arrangements relating to the issuance of virtual currencies involve the creation of a collective investment scheme?
  3. Might virtual currencies give rise to deposit-taking, the issuance of electronic money or the provision of payment services?
  4. Might the issuance of virtual currencies or the operation of an exchange for virtual currencies be regulated as crowdfunding?
  5. Might the relevant activities concerning virtual currencies fall within the scope of the UK anti-money laundering legal and regulatory regime?
ii Interaction with EU financial services regulation and the impact of Brexit

The UK ceased to be a Member State of the European Union (EU) on 31 January 2020. The withdrawal agreement concluded by the UK and EU provides for a transition period scheduled to end on 31 December 2020, during which period EU-wide rules regulating the provision of financial services continue to apply in the UK. At the end of the transition period, the European Union (Withdrawal) Act 2018 (EUWA) provides for the 'onshoring' of EU financial services legislation that applies at that date into UK domestic law. The EUWA also grants the UK government powers to make statutory instruments remedying deficiencies in this retained EU legislation, with the aim of ensuring that the UK has a functioning statute book at the end of the transition period reflecting the fact that the UK is not (and will no longer be treated as) an EU Member State.

The 'onshored' versions of EU regulations (and UK legislation implementing the requirements of EU directives) will form part of domestic law in the UK after the end of the transition period. Therefore, the analysis of whether virtual currencies are regulated in the UK (including under applicable EU-wide regulatory frameworks) should not be affected by Brexit, at least in the short term.

Banking and money transmission

In the UK, a number of banking activities should be considered in the context of virtual currencies, including whether any activities performed in connection with virtual currencies might give rise to the acceptance of deposits, the issuance of electronic money or the performance of payment services.

i Accepting deposits

Accepting deposits in the UK is a regulated activity for the purposes of the FSMA if money received by way of deposit is lent to others or any other activity of the person accepting the deposit is financed wholly, or to a material extent, out of the capital of or interest on money received by way of deposit.34

For these purposes, a deposit is defined as a sum of money paid on terms:

  1. under which it will be repaid, with or without interest or premium, and either on demand or at a time or in circumstances agreed by or on behalf of the person making the payment and the person receiving it; and
  2. that are not referable to the provision of property (other than currency) or services or the giving of security.

Typically, virtual currencies would not give rise to deposit-taking activity, as issuing virtual currencies does not usually involve the deposit of a sum of money to the issuer (assuming there is an issuer); virtual currencies would often be issued on receipt of other cryptocurrencies. Even if the other cryptocurrencies were to be treated as money, they are rarely issued on terms under which they would be repaid to the holder.

ii Electronic money

The issuance of electronic money is also a regulated activity in the UK.35 It is a criminal offence to issue electronic money without the appropriate authorisation.

Under the EMRs, electronic money is defined as electronically (including magnetically) stored monetary value as represented by a claim on the electronic money issuer that is issued on receipt of funds for the purpose of making payment transactions; is accepted as a means of payment by persons other than the issuer; and is not otherwise excluded under the EMRs.

A key characteristic for a product to be electronic money is that it must be issued on receipt of funds (i.e., it is a prepaid product whereby a customer pays for the spending power in advance).

In general, cryptocurrencies are unlikely to give rise to the issuance of electronic money as they do not typically give rise to stored monetary value (the value of cryptocurrencies is often highly volatile, determined by market forces, and is not related to any specific currency). Furthermore, most cryptocurrencies do not give holders a contractual right of claim against an issuer of the relevant cryptocurrency, are not issued on receipt of funds and (with some exceptions) are not usually issued for the purpose of making payment transactions.

However, there are some types of virtual currencies that do function much like electronic money. The FCA refers to virtual currencies that meet the definition of electronic money under the EMRs as e-money tokens in its Guidance on Cryptoassets. In particular, stablecoins are specifically designed to maintain value and are often pegged to underlying assets, including currencies such as the US dollar. If a stablecoin is issued on receipt of fiat currency, such as US dollars, and represents a claim on the issuer such that a holder may be entitled to redeem that stablecoin for fiat currency, this may well constitute the issuance of electronic money by the issuer.

However, in its Guidance on Cryptoassets, the FCA notes stablecoins may be structured and stabilised in different ways, which may impact their regulatory characterisation. For example, some types of stablecoins may be crypto-collateralised, asset-backed or algorithmically stabilised. The FCA notes that, depending on how it is structured, a stablecoin 'could be considered a unit in a collective investment scheme, a debt security, e-money or another type of specified investment. It might also fall outside of the FCA's remit. Ultimately, this can only be determined on a case-by-case basis.'

iii Payment services

The provision of payment services in the UK is regulated under the Payment Services Regulations 2017 (PSRs). It is a criminal offence to provide payment services without the appropriate authorisation or registration.36

Payment services comprise the following activities when carried out as a regular occupation or business activity in the UK:37

  1. services enabling cash to be placed on a payment account and all of the operations required for operating a payment account;
  2. services enabling cash withdrawals from a payment account and all of the operations required for operating a payment account;
  3. the execution of payment transactions, including transfers of funds on a payment account with a user's payment service provider or with another payment service provider, including:
    • execution of direct debits, including one-off direct debits;
    • execution of payment transactions through a payment card or a similar device; and
    • execution of credit transfers, including standing orders;
  4. the execution of payment transactions where the funds are covered by a credit line for a payment service user, including:
    • execution of direct debits, including one-off direct debits;
    • execution of payment transactions through a payment card or a similar device; and
    • execution of credit transfers, including standing orders;
  5. issuing payment instruments38 or acquiring payment transactions;39
  6. money remittance;40
  7. payment initiation services;41 and
  8. account information services.42

There are, however, a number of exclusions listed in Part 2 of Schedule 1 PSRs (activities that do not constitute payment services), including exemptions similar to the limited network exclusion and the electronic communications exclusion described above in relation to the issuance of electronic money.

The PSRs define 'funds' for these purposes as including banknotes and coins, scriptural money and e-money. Therefore, provision of payment services (such as execution of payment transactions) with respect to virtual currencies that qualify as e-money would be regulated under the PSRs. Other types of virtual currencies (such as cryptocurrencies) would not qualify as funds under the PSRs.

Nevertheless, transactions or remittance services involving both fiat currency (or e-money) and cryptocurrencies may involve the provision of regulated payment services under the PSRs. One such example may be where a cryptocurrency is used as an intermediary currency in money remittance, for instance, converting fiat currency into a digital currency and then back into a different fiat currency to transmit to the recipient (e.g., pounds sterling to Bitcoin to US dollar transactions).

As noted above, money remittance is a regulated payment service, and the interposition of a cryptocurrency in the remittance process would not mean that such a service ceases to be characterised as a regulated payment service; rather it will continue to be treated as a regulated payment service. That said, however, the interposition of a cryptocurrency into a money remittance process does not necessarily make the cryptocurrency itself a regulated financial product or mean its exchange for fiat currency would always constitute a regulated payment service. In its draft Guidance on Cryptoassets,43 the FCA explained that '[t]he PSRs cover each side of the remittance, but do not cover the use of cryptoassets in between which act as the vehicle for remittance.' In general, the arrangements and services offered by persons using such cryptocurrencies need to be considered holistically to determine whether, notwithstanding the use of a cryptocurrency, those persons may be engaging in regulated payment services.