On 15 December 2017, the Financial Conduct Authority (FCA), following the publication of its Discussion Paper on Distributed Ledger Technology (DLT) (Discussion Paper) (DPI 7/3) in April 2017, published a Feedback Statement (FS 17/4) (Feedback Statement) summarising the feedback received and providing its own response and views on recent developments.
Not long after its consumer warnings about the risks of investing in cryptocurrency CFDs and the risks of Initial CoinOfferings (ICOs), the FCA has returned to the subject of innovative technologies in the context of financial markets and has begun to clarify its position on the regulatory implications of DLT. In the Feedback Statement, the FCA reiterated its "technology-neutral" philosophy and openness to all forms of deployment of DLTs, both permissioned and permissionless. However, it also called for all operational risks to be properly identified and mitigated, with the expected extension of the Senior Managers and Certification Regime (now in 2019) from banks and insurers to virtually all regulated firms helping to facilitate that objective. The FCA, aiming to strike a balance between its role as the financial services regulator and its statutory objective to promote competition, stated that it will continue to monitor DLT-related developments, but clarified that, for the moment, the existing FCA rules are flexible enough to capture the use of DLT by regulated firms and no legislative or Handbook changes are proposed at this stage.
Key Points in the Feedback Statement
The FCA received 47 responses from a wide range of market participants including trade associations, regulated firms, technology providers and law firms. The Feedback Statement highlights the following:
1. Operational risk
Despite the risks, DLT has the potential to enhance operational soundness of firms and is not inherently incompatible with the regulatory regime when used in outsourcing. The FCA recognised the security benefits that DLT networks may bring, but reminded firms that it expects them to actively manage the operational and security risks arising from the implementation of this new technology.
2. Digital currencies - no current systemic risk
Due to the relative size of the digital currencies market compared to traditional financial markets, the FCA took the view that digital currencies do not, at this point, pose systemic risks to financial stability. It stated that digital currencies could improve the delivery of financial services in the UK as an alternative, or supplement, to traditional payment mechanisms. The FCA nevertheless repeated its warnings about ICOs (in September 2017) and digital currency-related products (in November 2017), and in particular, CFDs.
3. Digital asset trading and smart contracts
The FCA noted that DLT can help to eliminate settlement risk and lead to greater disintermediation in the securities markets. The FCA stated that it is unclear whether the broader adoption of DLT across securities markets will follow and highlighted the lack of clarity regarding the enforceability of "smart contracts".
4. Regulatory reporting
The FCA acknowledged the risks associated with the adoption of DLT in regulatory reporting, but stated that it can reduce costs for firms and regulators, improve the FCA's access to data and allow it to identify the areas of emerging risk more effectively, enabling a quicker and more accurate response.
5. Financial crime
The FCA expressed its belief that DLT can provide a better record of transactions and improve data quality at the same time as reducing the likelihood of fraud. However, the FCA has found that a number of firms leveraging DLT were denied banking services and stated that deploying this technology, on its own, should not lead to the loss of access to traditional banking.
6. General data protection regulation
Some respondents had doubts about the compatibility of permissionless DLT networks with the provisions of the General Data Protection Regulation (GDPR) and the UK legislation supplementing it. In this regard, the FCA encouraged firms to follow the guidance from the Information Commissioner's Office. It also noted that it had not identified any substantial incompatibilities between the Handbook and GDPR, and that no further guidance was required for firms to comply with both regimes.
Initial Coin Offerings
The FCA concluded that for a well-functioning ICO market which contributes to the development of DLT, issuers must remain sensitive to their regulatory obligations, but also take appropriate steps to manage the risk of harm to the public and to markets themselves. With a limited number of ICOs having engaged with the Innovation Hub, the FCA sets out the consumer benefit criterion in the context of ICOs under which the ICO must fall within the FCA regulatory perimeter and be fully compliant with UK and other relevant regimes, or if outside the FCA regulatory perimeter, designed, promoted and governed in line with best practice, so that potential acquirers of tokens are properly informed about the proposition that is being marketed to them.
The FCA commits to observe, engage, gather evidence on ICOs and collaborate both internationally and domestically. The FCA will conduct a deeper examination of the fast-paced developments in the ICO area. The FCA's findings will then help to determine whether there is a need for further regulatory action.
Given the volume and breadth of responses received, the FCA not only did not question the significance of the issues, but also recognised the necessity of a co-ordinated approach, both at national and international level. It is worth noting that the FCA Feedback Statement comes only a few days after the US Securities and Exchange Commission's (SEC) statement on the rising phenomenon of ICOs, with SEC raising similar concerns to the FCA. This suggests that the FCA and the SEC have coordinated their approach and their published views.
Meanwhile, also on 15 December 2017, ESMA, with the FCA's subsequent support, issued a statement expressing its concerns about the provision of speculative products such as CFDs, including rolling spot forex, and binary options to retail clients and announced that it is considering the possible use of its product intervention powers to address these investor protection risks. ESMA responded to the wider concern about ICOs as being voiced by various national regulators, including the German Federal Financial Supervisory Authority who issued a consumer warning on 9 November 2017.