On 31 July 2019, the FCA published its final Policy Statement, PS 19/22 ‘Guidance on Cryptoassets’ (PS).
Substantively, the most important development since the FCA’s original consultation back in January is the departure from the previous taxonomy used for cryptoassets. Instead of a focus on security, exchange and utility tokens, the FCA has sought to improve the clarity and accuracy of its guidance by setting out two broad categories of cryptoassets, being regulated and unregulated tokens. The former includes security tokens and e-money tokens, while the latter includes all other tokens not covered by those two sub-categories i.e. utility tokens and exchange tokens that are not security or e-money tokens. In this article we look at these categories in a little more detail.
A point to note is that the FCA avoids making direct reference to “hybrid” tokens as it considers it important to look at the intrinsic characteristics of a token throughout its lifetime. As such, the FCA promotes a substance over form and case-by-case approach. Indeed, the FCA expressly states in several occasions in the PS that a token could potentially fall within the regulated category even if it started its digital life as an unregulated token (see also case study 7 of the PS).
Within the regulated tokens category the FCA has included both security tokens and e-money tokens.
Security tokens are treated as “as those tokens that provide rights and obligations akin to specified investments as set out in the [regulated activities order], including those that are financial instruments under MiFID”.
Considering whether something is a security token will depend on several factors that can bring the token within the definition of a specified investment for the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO). Such factors include but are not limited to (i) the contractual rights and obligations the token-holder has by virtue of holding or owning that cryptoasset, (ii) any contractual entitlement to profit-share or (iii) whether the token is transferable and tradeable on cryptoasset exchanges. The most pertinent specified investments under the RAO include shares, debt instruments, warrants, units in collective investments, certificates representing certain securities, and rights and interests in investments.
The second category of regulated token is the e-money token. This new category of cryptoasset is based on the definition of e-money under the Electronic Money Regulations (EMR); i.e. electronically stored monetary value as represented by a claim on the issuer which is:
- issued on receipt of funds for the purpose of making payment transactions
- accepted by a person other than the electronic money issuer, and
- not excluded by regulation 3 of the EMR.
Issuers of e-money tokens will also fall under Financial Services and Markets Act 2000 if they are credit institutions, credit unions, and municipal banks by virtue of 9B of the RAO.
In its discussion of regulated tokens, the FCA identified a number of token types that were queried by respondents as being potentially regulated but which, ultimately, the FCA disagreed with. Included within the list of unregulated tokens were ‘settlement tokens’, which are used for “back-office efficiency” by the issuer in the settlements process.
In this way the FCA has rather helpfully avoided overcomplicating the taxonomy relevant to cryptoassets by introducing a technologically neutral approach within the current regulatory perimeter.
Naturally, the FCA moves on in the PS to state that tokens that are neither security nor e-money tokens will not be regulated. For parties engaged in cryptoassets therefore, the key question is whether their tokens fall within those two sub-categories (per the above discussion).
One such example that does not fit within the security/e-money sub-categories is exchange tokens, which are those types of cryptoasset that are usually decentralised and primarily used as a means of exchange, such as Bitcoin and Litecoin.
An important consideration underlined by the FCA in this context is that, while activities involving such exchange tokens will, for the most part, be unregulated, a regulated firm, and in particular senior managers therein, may still be caught under FCA scrutiny in relation to PRIN and SMCR rules.
A trickier category of token to be classified, but one which is usually unregulated is the utility token. In line with most respondents, the FCA noted that utility tokens are most likely to fall within the perimeter if they fall within the definition of e-money and hence are caught by EMR. Utility tokens, therefore, will not appear to be regulated unless they fall within the security or e-money definition (for some practical examples please see case studies 1 to 8 of the PS).
Other Matters – From Secondary Markets to Payment Services
The FCA also took time in the PS to touch on some residual matters relating to cryptoassets. These include stablecoins, airdrops, payment services, prospectus and listing transparency requirements, and guidance on exchange platforms:
- Stablecoins: These are cryptoassets where attempts are made to stabilise their value using a variety of mechanisms. With these it will be necessary to consider whether their structure and features mean that they fall within the e-money definition as prescribed under EMR. That being said, the FCA did not preclude the possibility that such stablecoins may be correctly categorised as security tokens if they are, for example, backed by securities or could be better described as representing units in a collective investment scheme. As such, a case by case analysis is recommended.
- Airdrops: Airdropping is the process by which a token issuer provides tokens either to the general public or certain token holders, usually for free. On this unique feature of cryptoassets, the FCA confirmed that, “whether a token is sold at value, or distributed for free via an airdrop will not factor into deciding whether a token is a security token or not”.
- Payment Services: While the FCA recognised that exchange tokens may be used to facilitate payment services such as international remittances, it has not proposed to expand its guidance to such an effect as to deliberately bring such tokens in the perimeter. We can therefore, expect cryptoassets to interact with payment services rules in two instances. The first is where the token is described, or acts as, as e-money. That is because some services in Schedule 1 Part 1 of the Payment Services Regulations 2017 include the transfer of ‘funds’ the definition of which by extension includes e-money. The second situation is where cryptoassets are used to facilitate payment services although not used as e-money themselves. The FCA gives an example of a Sandbox company, which used an otherwise unregulated token to bridge the exchange between two fiat currencies (see Sandbox case study 1 in the PS). In such circumstances, the company would have to receive the relevant authorisations for the payment services aspect of the business. In addition, unregulated activities would still fall under the general SMCR and PRIN rules of the FCA Handbook if the firm were an authorised firm, as noted above.
- Prospectus and Listing Rules: For prospectus rules to apply, the token itself must be a transferable security under MiFID II and be offered to the public or admitted to a regulated market. Currently, the regulated markets operating in the UK do not appear to have admitted cryptoassets directly on their exchange, despite there being steps by some with blockchain technology. This could of course change in the future. In the meantime a prospectus will be necessary, even if not listing in a regulated market, whereby the token is treated as a security token akin to a transferable security. The FCA notes that in such cases, the relevant exemptions e.g. for offers made entirely in the UK for less than €8m in the last 12 month period would be available to crypto related offers in the same fashion as for normal offers.
- Exchange platforms: The FCA concludes on exchange platforms by noting that platforms wishing to provide infrastructure for the buying, selling or transferring of security tokens will have to receive the relevant permissions as appropriate on each case. For example, a platform may have to be authorised as a multi-lateral trading facility when providing for the trading of security tokens that are treated as transferable securities for purposes of MiFID II.
The FCA does not appear to have intentions to amend the FCA handbook directly for the time being to create specific provisions for cryptoassets. At the same time, while it recognises that the PS does not expand on distributed ledger technology in general, it noted that it intends to monitor developments in these areas and engage with market participants as the market matures. In the meantime the FCA will remain engaged with the Treasury to consider the development of bespoke rules for unregulated tokens, discuss whether banning the sale of derivatives linked to certain types of unregulated cryptoassets is necessary, and the furtherance of the transposition of AMLD5 into domestic law.