The FMLC highlighted a number of legal uncertainties concerning a regulatory framework for cryptoassets and stablecoins, for example identifying what a 'token' is, as well as difficulties around interpreting definitions under existing financial regulation in the context of token arrangements.

The issue of possible overlap of the new regime for stablecoins with the existing regime under the E-Money Regulations was also noted.

The Committee also drew attention to the difficulties arising from the application of concepts present in financial services regulation which reflect the traditional market infrastructure of intermediated securities, most of which cannot readily be applied to a DLT context.

This publication was borne out of the Chancellor’s March 2020 budget where, in response to the rapid growth of cryptoasset markets in recent years, the Chancellor committed to:

• consulting on bringing cryptoassets within the scope of financial promotions regulations; and
• consulting on broader regulatory approaches to cryptoassets and stablecoins.

Earlier this year, HMT published the consultation paper on cryptoasset promotions which concluded on 25 October 2020. This paper now addresses the second commitment.

The paper is made up of two parts:

• the consultation paper, which discusses the current regulatory landscape for cryptoassets, and puts forward a policy with specific proposals regarding the regulation of cryptoassets for payments purposes; and
• a call for evidence covering a broad range of questions in relation to cryptoassets.

HM Treasury’s proposed approach will see future legislation in this area define the objectives and scope of the regulatory perimeter, as opposed to mandating specific requirements.

The consultation paper proposes:

• a policy approach; and
• an expansion of the regulatory perimeter.

Policy approach

The suggested approach will involve specific requirements being implemented by independent regulators (e.g., via rules or codes of practice) within a wider framework of objectives and considerations set out by HM Treasury. HM Treasury currently seeks to define the scope, objectives and principles of the regulatory approach, rather than pinning down precise requirements.

The paper identifies the following key objectives:

• protecting financial stability and market integrity;
• delivering robust consumer protections to the same level as other regulated instruments used for the same purposes (e.g. payments); and
• promoting competition and innovation in the UK.

Additionally, the paper suggests a number of guiding principles including:

• ensuring a level playing field (i.e. applying the concept of “same risk, same regulatory outcome” and of technology-neutrality);
• maintaining the delineation of UK regulator responsibilities and applying existing regulations where appropriate;
• taking a proportionate approach and focusing on urgent risks and opportunities;
• taking an agile approach that is able to reflect international discussions and standards.

The paper requests feedback regarding the approach, objectives and principles as outlined above, as well as views on the extent to which the UK’s approach should be in line with other jurisdictions.

Expansion of regulatory perimeter and new regime for “stable tokens”

Under the proposed approach, activities associated with unregulated tokens primarily used for speculative investment purposes will remain outside the perimeter of conduct and prudential regulation. However, such activities will be subject to financial promotions regulations and AML/CTF requirements. Utility tokens will also remain outside the scope of conduct and prudential regulations.

The paper further sets out a regulatory framework for “stable tokens” (i.e., tokens which maintain a stable value by referencing asset(s)). The regime would seek to draw on existing e-money and payments legislation.

In terms of scope, the proposed regime intends to cover tokens which can reliably be used for retail or wholesale transactions by being linked to or collateralised by stable reference assets. Algorithmic stablecoins will not be covered.

It is proposed that the Financial Conduct Authority will authorise and supervise relevant entities (e.g., issuers, exchanges and custodian wallets) carrying out certain activities in the UK, and the CP suggests a list of activities and high level requirements. A number of activities and requirements bear similarities to those under existing payments regulation (such as the activity of transmitting funds, and requirements relating to risk management and financial crime). However the list also sets out activities and requirements which are more specific to stable tokens. These include, in particular, activities involving issuance, creation and destruction of tokens, value stabilisation and reserve management; and requirements in relation to quality of reserve assets, safeguarding of tokens and private keys, and custody of client assets.

Where stable token arrangements function similarly to a payments system, it would also be subject to regulation by the Payment Systems Regulator. Furthermore, in a stable token arrangement, issuers and system operators which reach systemic status and critical service providers as defined under the Banking Act 2009 would be regulated by the Bank of England and by enhanced requirements (which would be grounded in the Principles for Financial Market Infrastructures). Other core entities within the stable token chain (e.g. wallets) may also fall within scope of systemic regulation.

The proposed regime may additionally impose location requirements on entities which actively market to UK customers (e.g. obligation to have a UK establishment).

The paper requests feedback on the proposed framework for stable tokens, including:

• whether existing payments regulation should be used as a basis for regulating stable tokens, and if the listed functions and requirements are sufficiently comprehensive;
• the extent to which “single-fiat tokens” (i.e. where the value is linked to a single fiat currency) should be subject to requirements under the Electronic Money Regulations 2011;
• the classification of unbacked tokens which seek to maintain a stable value through the use of algorithms;
• views on proposed location requirements; and
• the application of existing legislation relating to e-money, payment systems and systemic payments systems.

Call for evidence

HM Treasury has also issued a call for evidence which specifically looks into:

• the application of existing regulation to security and investment tokens;
• DLT-based financial market infrastructures, including the potential benefits of adopting DLT for trading, clearing and settlement, and the adequacy of existing legislation;
• the extent to which other unregulated tokens and Decentralised Finance (DeFi) should be brought within the regulatory perimeter, and the risks and opportunities presented by DeFi.

The deadline for responding to the CP is 21 March 2021. HM Treasury will additionally undertake a programme of stakeholder engagement (e.g., roundtables and workshops) before setting out a final response.

The regulator said that it takes a technology neutral approach, looking at the "substance" of the activity in question, rather than "the form". As such, certain activities related to tokens are already captured by existing regulatory framework.

 The guidance said:

"In the Isle of Man, any person carrying on regulated activity, or any business which requires registration under the Designated Business (Registration and Oversight) Act 2015 must comply with the Anti-Money Laundering and Countering the Financing of Terrorism Code 2019."

 The guidance covers:

• Security tokens.
• E-money tokens.
• Unregulated token activities and anti-money laundering/combating the financing of terrorism requirements.

On 10 January 2020, the FCA became the anti-money laundering and countering terrorist financing supervisor for some types of cryptoasset businesses, meaning that the latter need to register with the regulator and explain, among other things, how they will meet a host of requirements, such as applying "enhanced due diligence" when dealing with higher-risk customers.

The regulator said that the 30 June date will allow it to review applications and raise any follow-up questions in time for the process to be completed before next year's deadline.

"Any businesses that started carrying on business in the UK immediately before 10 January 2020 and are not registered by the FCA by the 10 January 2021 deadline will have to cease carrying on business," the FCA warned.

New businesses that began operating after 10 January 2020 must be registered with the FCA before carrying out any business.

"Firms authorised or registered under the Financial Services and Markets Act 2000, Electronic Money Regulations 2011 or Payment Services Regulations 2017 but undertaking cryptoasset activity subject to the [the amended Money Laundering, Terrorist Financing and Transfer of Funds Regulations 2017] will also be required to apply for registration," the FCA said.

The FCA added that it will "proactively supervise firms’ compliance with the new regulations, and will take swift action where firms fall short of desired standards".

The paper says that a CBDC could provide households and businesses with a new form of central bank money and a new way to make payments. It could ensure that the public has continued access to a risk-free form of money issued by the central bank, which may be especially important in the future as cash use declines and new forms of privately issued money become more widely used in payments. CBDC could also be designed in a way that contributes to a more resilient, innovative and competitive payment system for UK households and businesses.

While a CBDC poses a number of opportunities, it could raise significant challenges for maintaining monetary and financial stability. A CBDC therefore has relevance to almost everything the BoE does, and would need to be very carefully designed if it were to be introduced.

The BoE has not yet made a decision on whether to introduce CBDC. It said that it needed to consider the questions carefully and in good time, alongside the government.

This paper is intended to be the basis for further research and dialogue between the bank and the payments industry, technology providers, payments users, financial institutions, academics, other central banks, and public authorities.

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 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.