The FCA said that customers cannot "reliably" value crypto-derivatives, citing a number of concerns:

• the underlying assets have "no reliable basis for valuation";
• the prevalence of market abuse and financial crime in the secondary market;
• the "extreme volatility" of prices;
• lack of understanding among retail consumers about this products; and
• lack of legitimate investment need for retail consumers to invest in these products.

"These features mean retail consumers might suffer harm from sudden and unexpected losses if they invest in these products," the FCA said.

Sheldon Mills, interim Executive Director of Strategy & Competition at the FCA, said that the ban reflects how seriously the FCA views "the potential harm to retail consumers in these products", and added:

"Significant price volatility, combined with the inherent difficulties of valuing cryptoassets reliably, places retail consumers at a high risk of suffering losses from trading crypto-derivatives. We have evidence of this happening on a significant scale. The ban provides an appropriate level of protection."

The FCA also published two instruments:

• FCA 2020/34: conduct of business (cryptoasset products) instrument 2020; and
• FCA 2020/46: conduct of business (cryptoasset products) (amendment) and associated existing the European Union amendment instrument 2020.

Following a consultation published in January, the FCA received 92 responses seeking clarification of the policy intentions, and this guidance looks to address these concerns.

The guidance does not vary too greatly from the initial consultation, but it does provide greater clarity on some areas, including when certain type of cryptoassets would fall under the regulator's remit.

Different categories

The FCA guidance separated tokens into three categories:

• Security tokens: the January consultation set out that security tokens fall within the FCA's regulatory perimeter, meaning that if a firm was carrying out activities akin to specified investments as defined in the Regulated Activities Order (RAO) it would need to obtain the relevant permissions. As a result of the consultation, the guidance removed e-money from the definition of a security token and created a separate category to make the classification of tokens clearer.
• E-money tokens: the consultation had stated that, in some instances, utility tokens would meet the criteria of e-money and while utility tokens are not regulated by the FCA, e-money is. The regulator has now further clarified this and created a separate e-money category. The guidance also notes that certain stablecoins may meet the definition of e-money. It acknowledges that as stablecoins vary in structure and arrangement they cannot have one uniform classification. If a stablecoin is an electronically stored monetary value that: is issued on receipt of fiat currency for the purpose of payment; is accepted by other users; and is not excluded by regulation 3 of the E-Money Regulations, it will fall within the e-money token category.
• Unregulated tokens: the guidance noted that a number of cryptoassets have been used to facilitate regulated payments, such as international money remittance. Firms using cryptoassets in that way will continue to be regulated as normal and would have to obtain the correct permissions and follow the relevant rules and regulations. However, the tokens themselves remain outside the FCA's perimeter. This is also the case with cryptocurrencies, which are defined as exchange tokens. The FCA noted that the courts and the legislature need to address this matter and therefore it is outside the scope of this guidance. It does, however, acknowledge that the Treasury is working on an approach to unregulated cryptoassets and the regulatory perimeter could therefore change at some stage.

Other considerations

While not expanding the FCA's perimeter, it is worth noting that the Government has assigned the FCA to be the supervisor for the fifth Anti-Money Laundering Directive (5AMLD).

The 5AMLD will introduce an anti-money laundering regime for cryptoassets, and will bring within its remit virtual currency exchange platforms and wallet providers. This will therefore allay some consumer protection and market integrity fears that had arisen through exposing the identity of users and the source of the funds.

The guidance also comments on proposals to ban crypto-derivatives for retail investors (ie, derivatives with an underlying cryptoasset).

Last month, the FCA set out plans to prohibit the sale, marketing and distribution of crypto-derivatives to retail consumers and has put this out for consultation with a deadline for comments of 3 October.

The consultation states that cryptocurrencies could not be valued as easily as other more traditional assets and their price fluctuation was more akin to gambling than technological or economic development and therefore should not be made available to retail investors.

What happens now?

The next steps will be interesting.

Communications from public authorities have intensified in recent months with the view to some significant changes on the horizon.

The prospects of new crypto regulation from the Treasury could see a change to the regulatory perimeter and bring more cryptoassets within the regulated space.

The FCA may still remain cautious in its approach to cryptoassets, but this guidance is an important starting point to the coming discussions on what it has called a "small, complex, and evolving market covering a broad range of activities".

In its consultation, the FCA noted that although the UK cryptoasset market has grown, it remains small compared with other jurisdictions, with limited traded volumes.

However, the regulator added that "there is growing evidence that cryptoassets are causing harm to consumers", who cannot reliably assess the value and risks of derivatives (such as contracts for difference (CFDs), options and futures) or ETNs that reference certain cryptoassets.

The FCA said that this is because of:

• the inherent nature of the underlying assets, which have no reliable basis for valuation;
• the prevalence of market abuse and financial crime in the secondary market for cryptoassets (eg cyber theft);
• the extreme volatility in cryptoasset prices movements; and
• an inadequate understanding by retail consumers of cryptoassets and the lack of a clear investment need for investment products referencing them.

"We think these issues have and will cause retail consumers harm from potentially sudden and unexpected losses if they purchase these products", the FCA said.

It added:

"We estimate the potential benefit to retail consumers from banning these products to be in a range from £75 million to £234.3 million a year."

The FCA is therefore consulting on banning the sale, marketing and distribution to all retail consumers of all derivatives and ETNs that reference unregulated transferable cryptoassets by firms acting in, or from, the UK.

However, it is not proposing to extend the ban to professional or eligible counterparty clients; derivatives or ETNs that reference other tokens; or collective investment undertakings (funds).

Christopher Woolard, Executive Director of Strategy & Competition at the FCA, said:

"As with our work on the wider CFD and binary options markets, we will act when we see poor products being sold to retail consumers. These are complex contracts built on top of complex assets.

Most consumers cannot reliably value derivatives based on unregulated cryptoassets. Prices are extremely volatile and as we have seen globally, financial crime in cryptoasset markets can lead to sudden and unexpected losses. It is therefore clear to us that these derivatives and exchange traded notes are unsuitable investments for retail consumers."

The consultation will be of particular interest to firms issuing or creating products referencing cryptoassets; firms distributing products referencing cryptoassets; including brokers and investment platforms, and financial advisers; firms marketing products referencing cryptoassets; operators of trading venues and platforms; and retail consumers and consumer organisations.

In October 2018, the UK Cryptoassets Taskforce issued a report on the UK's policy and regulatory approach to distributed ledger technology and cryptoassets, setting out some of the potential risks and benefits they present, and making various commitments.

The FCA's guidance consultation comes as a response to one of those commitments, namely providing firms with additional clarity about the current 'regulatory perimeter', which "separates regulated and unregulated financial services activities".

As such, the guidance focuses on the FCA's regulatory perimeter.

Specifically, it looks at where cryptoassets would be considered specified investments under the Regulated Activities Order (RAO), financial instruments under MiFID II or captured under the Payment Services Regulations or the E-Money Regulations.

In line with the Taskforce, the guidance categorises cryptoassets into three main types: exchange, security and utility tokens, explaining whether each falls within the FCA's remit and, if so, what this means for market participants.

The FCA warned:

"Assessing whether a cryptoasset is within the perimeter can only be done on a case-by-case basis, with reference to a number of different factors… Ultimately, it is a firm’s responsibility to make sure that it has the correct permissions for the activities it intends to engage in and we encourage market participants to obtain independent advice if they think the position remains unclear."

Exchange tokens

"This means that the transferring, buying and selling of these tokens, including the commercial operation of cryptoasset exchanges for exchange tokens, are activities not currently regulated by the FCA."

So, exchanges or any organisation that facilitate transactions of bitcoins, ether, litecoin or other exchange tokens between participants are not carrying a regulated activity.

Security tokens

For those cryptoasset activities involving cryptoassets that meet the definition of a specified investment as set out in the RAO (and possibly also a financial instrument under MiFID II), an authorisation or exemption will be required.

However, the FCA noted that determining whether a token is a specified investment is not always easy, especially for those that are securities, such as shares, debt instruments warrants, certificates representing certain securities, units in collective investment schemes, rights and interests in investments.

For each of these categories, the regulator gave examples of some factors that may show that a token qualifies as a security.

Utility tokens

As utility tokens do not typically show features that would make them the same as securities, they will not be captured in the regulatory regime, unless they meet the definition of e-money or are "used to facilitate regulated payments services".

The FCA concluded:

"Where a person is engaged in activity by way of business in the UK, that relates to a security token, or to a token that constitutes e-money, or is involved in payment services, they should consider whether those activities require authorisation," the FCA said.

This will determine which permissions are needed from the FCA.

Her Majesty’s Treasury is set to publish a consultation in 2019 that considers the options for bringing further cryptoasset-related activity within the regulatory perimeter.

It will also consult on the transposition of the EU’s Fifth Anti-Money laundering Directive and the broadening of anti-money laundering/counter terrorism financing regulation in relation to cryptoassets.

“Any legislative change will require the FCA to consult on the new activities to be brought into the regulatory perimeter, and the FCA will work with HMT on this”, the guidance states.

The FCA will consult later in the year on banning the sale of derivatives linked to certain types of cryptoassets to retail investors and the government is also planning to consult on whether to expand the regulatory perimeter to include further cryptoassets activities.

First announced in March as part of the UK's FinTech Sector Strategy, the Cryptoasset Taskforce consists of the Financial Conduct Authority (FCA), HM Treasury and the Bank of England (BoE) and is tasked with developing an approach to cryptoassets and DLT.

In its final report released yesterday, the taskforce concluded that while DLT is at an early stage of development, it could deliver "significant benefits in both financial services and other sectors".

For example, DLT could enhance system resilience, improve the efficiency of end-to-end settlement processes and reporting, auditing and oversight, and enable greater automation.

As an emerging leader in the DLT space, the UK should therefore capitalise on these opportunities, even if some challenges to wider adoption remain, including issues around the interoperability of systems, banking relationships, settlement finality as well as competition, governance and civil law (such as, the enforceability of smart contracts and data protection).

"The Taskforce does not consider there to be regulatory barriers to the adoption of DLT. The [Prudential Regulation Authority] and FCA will continue to take a technologically neutral approach to regulation, as well as providing a platform for innovation," the report said.

The report added:

"Both the FCA and the Bank of England will continue to explore whether there are any unintended consequences of regulation to the innovations of new technologies, including DLT."

Noting that cryptoassets (defined as exchange, security and utility tokens) are not widely used in the UK and that the country is not a major market even though interest is growing, the taskforce concluded that there is "limited evidence of the current generation of cryptoassets delivering benefits".

This may change in the future, but in the meantime, the taskforce said that existing cryptoassets pose a variety of risks, notably harm to consumers (who may face large losses), market integrity (owing to manipulation and other market abuse strategies) and financial crime.

Risk mitigation

The taskforce said that HM Treasury, the FCA and the BoE "will take action to mitigate the risks that cryptoassets pose to consumers and market integrity; to prevent the use of cryptoassets for illicit activity; to guard against threats to financial stability that could emerge in the future; and to encourage responsible development of legitimate DLT and cryptoasset-related activity in the UK".

To deliver these actions, the three authorities will consult on:

• guidance to clarify which cryptoassets fall within the existing regulatory perimeter and which outside (by the end of 2018);
• whether the regulatory perimeter should be extended in relation to cryptoassets that are similar to specified investments but that currently fall outside the perimeter (by the end of 2018);
• potentially banning the sale to retail consumers of derivatives referencing certain types of cryptoassets (for example, exchange tokens), including contracts for differences, options, futures and transferable securities (by Q1 2019);
• implementing one of the most comprehensive responses globally to the use of cryptoassets for illicit activities by applying and going further than the fifth EU Anti-Money Laundering Directive (consultation in 2019 with legislation in 2019); and
• revised guidance on the tax treatment of cryptoassets (by early 2019).

A consultation will also be issued in early 2019 to explore whether and how exchange tokens and related firms such as exchanges and wallet providers could be regulated effectively.

The three authorities will also continue to warn consumers of the risks of investing in cryptoassets; monitor market developments and financial stability risks; and work with international counterparts to consider appropriate domestic and international responses.