After years of anticipation, the Financial Services and Markets Bill (when it finally achieves Royal Assent), underpinned by the regulatory priorities announced by the Government as part of the Edinburgh Reforms, will finally create the detail for how the UK will regulate those who issue, trade and distribute crypto-assets.

In this article, Emma Radmore of Womble Bond Dickinson looks at HM Treasury's consultation on the future financial services regulatory regime for crypto-assets and related initiatives.

Where are we currently?

At the moment, the UK is only in the very initial stages of regulation of crypto-related activities. Regulation currently broadly takes one of two forms:

  • Firms that require to be registered under anti-money laundering requirements (the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs), and
  • Firms that provide services relating to crypto-assets that are structured such that they constitute "specified investments" (securities such as security tokens or derivatives) for the purposes of the current Financial Services and Markets Act 2000 (FSMA) and FSMA (Regulated Activities) Order 2001 (RAO).

What do the MLRs require?

Under the MLRs, any business that acts as a cryptoasset exchange provider or a custodian wallet provider in the course of business in the UK must register with the Financial Conduct Authority (FCA) before they may start relevant business. The application, while falling short of the onerous application for authorisation under FSMA, nevertheless requires not only that the applicant's owners and controllers be vetted for fitness and propriety, it also requires firms to provide their regulatory business plans, with programmes of operations, details of IT systems and governance and control frameworks as well as the detailed anti-money laundering (AML) policies required to evidence compliance with the MLRs. FCA has been very exacting in its assessments and many applicants have either been rejected or have withdrawn their applications. The latest FCA data has only 41 firms registered.

What does the Government propose?

The Government now proposes to use powers to be introduced when the Financial Services and Markets Bill (FSMB), currently going through the legislative process in the House of Lords to:

  • Include cryptoassets within the financial promotion restrictions in s21 FSMA
  • Include cryptoassets within the scope of the regulated activities regime under s22 FSMA
  • Introduce a new definition of cryptoasset which will be "any cryptographically secured digital representation of value or contractual rights that (a) can be transferred, stored or traded electronically, and (b) that uses technology supporting the recording or storage of dad (which may include distributed ledger technology".

Separately, the Bill will allow Treasury to make regulations in connection with the regulation of payments that include digital settlement assets, and their providers. Various legislative amendments will operate to bring significant providers under the Bank of England's remit, and amend e-money and payment services legislation to enable the regime to be effective, including when fiat-backed stablecoins are used in retail payment activities. Meanwhile, the Bank of England is seeking views on how the UK central bank digital currency might operate, with a view to taking the decision on whether to go ahead in a couple of years' time, for issue of the "Britcoin" by the end of the 2020s.

In anticipation of the passing of the FSMB, Treasury published several papers at the beginning of February, comprising the start of a consultation on expansion of the RAO, and confirmation of the Government's plans for promotions of cryptoassets.

Expansion of the Regulated Activities regime

The consultation, which also includes a call for evidence, says the Government wants to take a proportionate approach to regulation of the sector which will both protect consumers and encourage innovation. The plan is to consult using the overarching principles of “same risk, same regulatory outcome”, “proportionate and focused” and “agile and flexible”. It proposes a phased approach to regulation, to address the most urgent areas of risk first. The phased approach involves legislation that will bring digital settlement assets into the regulatory perimeter for systemic payment systems and service providers, enable issuance and custody of fiat-backed stablecoins to be brought within the regulatory perimeter and allow a system of dual regulation. Treasury is aware of the need to make the delineation and interaction between the regime for fiat-backed stablecoins and the broader cryptoassets regime clear.

In principle, Treasury believes that cryptoassets and the activities that underpin their use should follow the standards expected of other similar financial services activities. The consultation focuses on the future regulatory regime for cryptoassets used within financial services, rather than the wider application of distributed ledger technology in financial services or the use of crypto outside the sector.

The consultation addresses:

  • A definition of “cryptoasset”: noting the deliberately broad definition in the current draft of the FSMB, which is similar to the MLRs definition but references a wider range of underlying technology. It is intended also broadly to align with EU and Financial Action Task Force standards, and the FSMB contains a power to amend the definition by secondary legislation
  • The intention to bring “cryptoasset” within the list of specified investments in the RAO, such that any person carrying out certain activities involving cryptoassets “by way of business” will need authorisation – which will be by FCA and FCA will have power to design an appropriate regulatory regime, which it will of course consult on at a later stage
  • While a "cryptoasset" will be a specified investment in its own right, Treasury’s does not intend to expand the RAO definition of “financial instrument” to include cryptoassets but rather to put in place equivalent or similar safeguards where cryptoassets present similar risks to financial instruments (although some types of cryptoasset already meet the definition, and will continue to – specifically security tokens and also some crypto derivatives), or may be e-money
  • The potential for Treasury to use the Designated Activities Regime being created under the FSMB to regulate any crypto-related activities which it feels should be subject to regulation but for which the RAO regime is not suitable
  • The fact that all activities that are currently within the MLR registration requirement will fall within the FSMA requirements, and relevant firms will of course be required to continue to comply with the MLRs as well as FCA's wider financial crime prevention requirements as part of becoming fully authorised firms. This also means that firms that are registered with FCA will need to complete an authorisation application, and FCA will need to consider the most proportionate way to achieve this without unnecessarily duplicating information already requested and received
  • That supporting legislation (which we discuss below) will extend the financial promotions perimeter to cover crypto asset promotions
  • The need to capture relevant activities carried on both in and into the UK – so would catch any activities of overseas firms provided to UK persons whether natural or legal. This is seen as critical for consumer protection and so as not to create an unlevel playing field for UK-based providers. There may be exceptions to this, such as a potential exception for “reverse solicitation”, and FCA will need to consider whether overseas firms will be required to have a physical presence in the UK. Firms that operate crypto trading venues would be likely to have to have a UK incorporated entity through which to trade
  • An initial indicative proposed list of activities – showing the intention to regulate activities rather than actual assets. The consultation also includes a table showing in which phase various activities will fall to be regulated. Some of the list below will take the form of new regulated activities, while in other cases crypto-related activities can slot into existing regulated activities:
    • Issuance activities
      • Issuance and redemption of a fiat-backed stablecoin
      • Admitting a cryptoasset to a cryptoasset trading venue
      • Making a public offer of a cryptoasset
    • Payment activities
      • Payment activities such as execution of payment transactions or remittances involving fiat-backed stablecoins
    • Exchange activities
      • Exchange activities involving operating cryptoasset trading venues supporting exchange of cryptoassets for other crypto, fiat currency, other assets and
      • Post trade activities;
    • Investment and risk management activities (similar to the current dealing and distribution activities for financial instruments and other products)
      • Dealing in cryptoassets as principal or agent,
      • Arranging or making arrangements in relation to transactions in cryptoassets,
      • Advising on cryptoassets and
      • Managing cryptoassets
    • Lending, borrowing and leverage activities
      • Operating a cryptoasset lending platform
    • Safeguarding and/or administration (custody) activities
      • Safeguarding and/or administration services for cryptoassets other than fiat-backed stablecoins and/or means of access to the cryptoasset
    • Validation and governance activities 
      • Mining or validating transactions or operating a node on a blockchain
      • Using cryptoassets to run a validator node infrastructure on a proof-of-stake network
  • Treating “non-algorithmic stablecoins” in the same way as unbacked cryptoassets – and unbacked cryptoassets and crypto-backed tokens may or may not be specified investments depending on the analysis of the particular instrument
  • Similarly, including non-fungible tokens (NFTs) and utility tokens within the scope of regulation only where they meet the relevant definitions
  • Creating an issuance and disclosure regime for cryptoassets based on the UK prospectus regime, establishing a regulatory framework for trading based on the RAO activities of regulated trading venues including multilaterals trading facilities – and additionally considering using the Designated Activities Regime to prohibit public offers of cryptoassets which are not security token offerings unless they are conducted via a regulated platform
  • Applying a market abuse regime broadly based on MAR.

In relation to each element of the proposal, the consultation looks at the desired outcomes, and the basis of the regulatory regime – for instance, using the "investment" regulation regime as a starting point wherever possible.

The consultation also calls for evidence on Decentralised Finance (DeFi) – financial services offered without the use of traditional financial intermediaries. There has been a noticeable increase in use of these in the cryptoasset financial services markets, and Treasury is seeking views on the best way to regulate these. It is considering defining a set of DeFi-specific activities, such as “establishing or operating a protocol”, which would require those operators to be authorised either under the RAO or rgw Designated Activities Regime. The Government is not sure there is justification to regulate mining in and of itself, but seeks views on whether any other regulatory outcomes should be pursued.

Finally, the consultation calls for views on sustainability. Proof of Work consensus mechanisms can have a high environmental impact, and the Government is considering the possibility of applying similar ESG reporting requirements as apply to securities markets to cryptoasset markets.

Consultation closes on 30 April 2023.

Financial promotions

Treasury has also updated its policy statement and decision on bringing promotions of cryptoassets within the scope of the financial promotion regime, which it announced it had decided to do back in January 2022. The regime is designed to promote responsible innovation and will bring promotions of “qualifying cryptoassets” within the scope of the financial promotion regime, such that any promotion falling within the definition and not within an exemption would need to be approved by an authorised person – and that any authorised person, when approving a promotion, would need to comply with FCA rules in doing so. At the moment, as noted above, very few crypto firms are actually authorised under FSMA, and therefore are not in a position to make their own promotions (unless the promotion is exempt). There was concern that few authorised firms would be willing to provide regulatory approval. As a result, there will be some changes to the financial promotion regime, which will:

  • Use the basic definition of "cryptoasset" in the FSMB, and work from that to produce a definition of "qualifying cryptoasset" for financial promotion purposes
  • Amend several of the “controlled activities” for the purposes of the FSMA (Financial Promotion) Order 2005 (FPO) to include cryptorelated activities (specifically dealing, arranging, managing, advising and agreeing to carry on the relevant activity) but will not add any additional activities (such as operating exchange or ATMs)
  • Apply the FPO exemptions consistently to cryptoassets as to other controlled investments. In principle, all the exemptions in Part IV of the FPO will apply, but in relation to those in Part VI (including those for high net worth and sophisticated individual investors), the Government says these will only apply where relevant given their existing scope – so for instance, those individual exemptions will not apply, given that their application is limited only to specific types of investment, of which crypto will not be one
  • Introduce a new exemption (which is intended to be temporary), that will permit crypto firms registered under the MLRs to communicate their own promotions.

Treasury and FCA will work together on the new FPO regime, and will include a transitional period of four months (previously the Treasury had indicated this would be six months) from finalisation to application. The draft order amending the FPO which is currently before Parliament will both introduce this new exemption for MLR registered firms, and also extend the other exemptions as appropriate.

FCA will be publishing its own rules once the relevant legislation has been made.

What can we expect?

The FSMB is now at Report stage in the House of Lords, so negotiations are far from over. However, the provisions in the Bill that will be the enabling powers for regulation of crypto activities have not been the subject of great debate, so Treasury is probably safe to proceed on the basis they will be passed in current or near-to-current form. The devil will then be in the detail of the timing. Clearly the priority is to get the financial promotion amendments in place, and FCA will be poised quickly to put its regulatory overlay on those restrictions once finalised. As to timings on the changes to the RAO (and otherwise), it’s hard to imagine we will see even the Phase 1 changes finalised in short order. Like everything, Treasury will need to consider the responses to consultation, discuss with the FCA, and then there will need to be consultations on the specific RAO amendments, the authorisation process (including whether there will be any form of temporary permission), and tweaks to existing FCA rules together with entire new parts of its rulebook.