In February 2018, the House of Commons Treasury Select Committee (“TSC”) issued an inquiry into digital currencies. The initial inquiry sought to examine the role of digital currencies in the UK, including the opportunities and risks that digital currencies may bring to consumers, businesses and the Government. Another aim of the inquiry was to analyse the potential impact of blockchain technology on financial institutions and financial infrastructure and assess the regulatory response to digital currencies from the Government, the FCA and the Bank of England (“BoE”) and determine how the industry can be regulated in order to offer protection to consumers and businesses.
Following the launch of the initial inquiry in February 2018, the Committee held three oral evidence sessions that involved numerous parties giving evidence relating to the application of blockchain, the development of crypto-assets and the current crypto-asset landscape and the regulation of crypto-assets. Based on the oral evidence sessions and the written evidence submitted to the Committee, the TSC was able to publish its 22nd report on crypto-assets. This report focuses on the advantages, limitations and risks that are attached to crypto-assets and Initial Coin Offerings (“ICOs”) and it provides recommendations on how to mitigate these from a regulatory perspective.
The crypto-asset landscape is explained at the outset of the paper and it includes an introduction relating to what crypto-assets are, the purpose of blockchain technology and the meaning of ICOs.
The crypto-asset industry and most of the ICOs are not regulated. The TSC outlines the current position in its report by explaining what ICOs are and why they may be used by companies to raise capital instead of the traditional ways of raising money. In summary, funds can be raised from the public where the issuers accept a crypto-asset or fiat currency in exchange for a ‘coin’ that is related to a specific service or a project. The coin issued can represent for example a share in a company (regulated) or a pre-payment voucher for future services (not regulated) or other future rights.
David Raw, Deputy Director of Banking and Credit at HM Treasury, stated that the growth of ICOs has been significant and that in the first four months of 2018, approximately $10 billion was raised through ICOs globally.
The TSC reminds us that most ICOs are not regulated and therefore the investors have no protection under the financial services regulation and the FCA rules. The report states that advertisements often do not include risk factor statements and seem to present the investment as being one sided, in that the value will go up and investors can make money very easily. The TSC stated that this leaves potential unsophisticated investors open to high risks and no protection.
The FCA published a consumer warning about the risks of ICOs; the warning states that ICOs are “very high risk, speculative investments” and that there is no regulatory protection. As most ICOs fall outside the FCA’s remit, the warning posted on its website in 2017 is as far as the FCA had gone to date in terms of protecting the investors. However, it is the TSC’s opinion that the “FCA’s consumer warnings are a feeble corrective to advertisements”.
Risks Identified by the TSC Report
Bitcoin and Ethereum are well known crypto-assets as they have been the subject of significant media attention in the last few years. As mentioned in the TSC’s report, although intended to be used as a means of payment for goods and services, crypto-assets cannot be described as currencies because they do not serve as a store of value, a medium of exchange and a unit of account.
TSC focuses on the risks of the crypto-assets and one of the risks mentioned numerous times throughout the paper is the high price volatility. The TSC reports that Bitcoin has suffered significant hikes and dips in its value in a relatively short amount of time with the price of Bitcoin reaching $19,206 in December 2017 and by the end of February 2018 falling to $8,732.71, a decline of over 54% in its value. The TSC argues that on account of their volatility alone, crypto-assets are especially risky and that risk is higher for inexperienced retail investors.
The TSC identified another risk associated with crypto-assets - the hacking of crypto-asset exchanges and losing access to the accounts. A crypto-asset exchange is technically an intermediary or a business which enables customers to trade crypto-currencies or to use fiat money (conventional money) to purchase crypto-assets. Numerous custodial crypto-asset exchanges have been hacked. Mt. Gox, a Japanese Bitcoin exchange filed for bankruptcy in February 2014 after it was hacked and lost all of its investors’ virtual coins that were worth nearly half a billion dollars. The report acknowledges that at present there is no compensation scheme to deal with this risk and to indemnify those that suffer loss as a result of a hack.
Furthermore, the TSC also stated that there is evidence that in some circumstances, if a customer loses his/her password for the exchange account, he/she may no longer be able to access it as exchanges may not be able to recover the customers’ details.
Another danger posed by the non-regulated crypto-asset industry is that the lack of regulation aids to the anonymity within the crypto-assets’ sphere and in turn can contribute to facilitating money laundering and terrorist financing. At the moment, crypto-asset exchanges and related technology are not covered by any Anti-Money Laundering legislation. However, the fifth Anti-Money Laundering Directive will cover the aforementioned when transposed into UK regulation. The TSC urges the Government to treat the implementation of the Directive into UK legislation as a priority and to expedite the consultation process, which is not currently planned to finish until the end of 2019.
In terms of market manipulation risks, the FCA mentioned that the relatively immature market infrastructure that covers the crypto-asset market could lead to more serious forms of market manipulation, such as insider trading. Crypto-asset markets currently also fall outside the market abuse regime.
Advantages and Limitations of Blockchain Technology
The BoE noted that the use of blockchain could increase the efficiency of managing data by reducing data replication and associated reconciliation processes. Furthermore, it added that transparency and auditability are enhanced through the creation of instant, permanent and immutable records of transactions.
In addition, the FCA added that blockchain technology could lead to “cost and time reductions arising from the removal of intermediaries required for processing a transaction”.
The report also mentions evidence given by Dr Kotsialou, a researcher of blockchain at King’s College London who argued that another advantage of the blockchain technology is the resilience and the security that it can offer and that it is much more difficult to hack than a traditional database because the data is replicated multiple times.
Although the blockchain technology has clear advantages, the report has also highlighted some limitations of such a system. The BoE drew attention to the fact that crypto-assets and the blockchain have capacity limits. A comparison was drawn between payments through Bacs and Faster Payments (more than 30 million electronic payments are made through these payment systems daily), whereas Bitcoin’s global maximum capacity is currently at 0.6 million per day.
The information that is recorded on a blockchain is shared and updated over the network in real time. In essence, the blockchain database is not stored centrally like the ledger of a bank, but instead it is distributed across the network of multiple connected computers, which have a copy of the ledger file. The BoE stated that further consideration should be given on how a distributed system is controlled and governed.
Certain ICOs fall within the remit of the FCA (for example, when they relate to a security and are therefore regulated). However, the majority of ICOs and other crypto-assets activities fall outside the FCA’s regulatory perimeter. Therefore, the TSC strongly suggested in the report that regulation should be introduced to cover all types of ICOs.
The TSC recommends that consideration should be given to two options, where regulation could either be introduced by incorporating crypto-assets activity under the current framework or design a new framework of regulation specifically for crypto-assets.
However, if regulation would be introduced under the Financial Services and Markets Act 20000 (Regulated Activities) Order (RAO), then the government should consider how to best define activities related to crypto-assets and consider the potential implications. MPs are of the opinion that the FCA should oversee the sector as a matter of urgency and that “bringing crypto-assets into the scope of existing regulation rather than creating a new framework just for the crypto-assets would be the quickest way of doing this.” The report mentioned that this approach has been taken before, in April 2014 when peer-to-peer lending was added to the RAO and became a regulated activity.