HMT publishes its response to the consultation on future financial services regulatory regime for cryptoassets

No time for a leisurely Monday morning for the cryptoasset (crypto) world last week, as HM Treasury (HMT) published its long awaited response document (the Response Paper) to the consultation paper on the future financial services regulatory regime for cryptoassets, published in February of this year. In no less than 94 pages, HMT confirmed its final proposals for crypto regulation in the UK, including its intention to bring a number of cryptoasset activities into the financial services regulatory perimeter.

In response to the February consultation paper, HMT received a total of 131 responses from a wide range of stakeholders, including: blockchain network providers, crypto exchanges, crypto compliance firms, companies specialising in web3 gaming, crypto fund managers, as well as traditional banks, asset managers and payment providers. Among other things, prominent themes from the consultation feedback centred on:

• Non-Fungible Tokens (NFTs) and Security Tokens;
• Geographical scope;
• Phase 1 Vs Phase 2 activities;
• Wholesale Vs retail lending activities;
• Carving out staking from lending and borrowing activities; and
• Disclosure liability.

In general, the government intends to proceed in the same way as was proposed in the consultation. However, as ever with crypto, there is plenty to unpack from the detailed Response Paper. We have set out below some of the key takeaways.

 

FSMA is friendly and familiar

Cryptoasset activities will be regulated under the umbrella of the existing financial services regime, with businesses needing Financial Conduct Authority (FCA) authorisation.

The government will expand the list of “specified investments” in Part III of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO). Firms undertaking relevant activities involving cryptoassets by way of business will have to be authorised by the FCA under Part 4A of the Financial Services and Markets Act 2000 (FSMA).

HMT notes that FSMA is “well-established and understood by firms” and that developing a fully bespoke regime outside of the FSMA framework would “risk creating an unlevel playing field between cryptoasset firms and the traditional financial sector”. HMT pinpoints that this direction is also in line with the approach taken in other jurisdictions and is likely to be welcomed by the market.

The government does not plan to expand the definition of “financial instrument” in the RAO to include presently unregulated cryptoassets and agrees with the majority of respondents that “retrofitting” the existing financial instruments regime to cryptoassets would “likely result in unsuitable and potentially onerous regulation”.

 

Definition of cryptoasset

Despite receiving a “high volume” of feedback to the effect that the definition of “cryptoassets” in the consultation was “overly broad”, HMT notes that this is its intention. The government wishes to “capture all current types of cryptoasset” and ensure the powers are future proofed to cover those cryptoassets which may not yet exist. As laid out in Financial Services and Markets Act 2023 (FSMA 2023), which received Royal Assent in June 2023, the definition of “cryptoasset” is as follows: 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 data (which may include distributed ledger technology).

The Response Paper confirms that the future financial services regulation of cryptoassets will typically apply to a particular subset of cryptoassets depending on the “matter being regulated” and so a narrow definition will apply. The Response Paper states that the precise legal mechanism for distinguishing between tokens that are in and out of scope will be set out in secondary legislation and FCA rules.

Under this futuristic, “innovation-forward” approach, the government has acknowledged in the Response Paper that the decentralised finance (DeFi) market, although currently small, may play an important role in financial services as the crypto world grows. The government envisions the potential for fully decentralised DeFi service models, and if achievable, to play a role in financial services in the future. This is with the caveat of careful consideration on the management of risk and extensive international legislation.

NFTs will not be regulated within the financial services cryptoasset framework. The government states in the Response Paper that generally these are “more akin”, to digital collectibles or artwork than a financial services product. In the same way that the sale of art is not regulated as a financial services activity, the government considers that in general activities in connection with NFTs are “not appropriate for regulation as a financial service”. However, the government acknowledges that a range of tokens currently offered in the market are described as NFTs but perform other functions, and it is possible this may become more common in the future, thereby possibly bringing them within scope of regulation. In this regard, the government confirms that it will focus on whether the token is used for a regulated activity within financial services markets or as a financial services instrument (in the general sense) or product, rather than how it describes itself.

HMT also rejects calls for crypto to be regulated in the same way as gambling.

 

Authorisation process for regulated cryptoasset activities

The new authorisation regime will be “broader in scope” than the current Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLR) registration regime and will include aspects of regulatory compliance that will not have previously been assessed by the FCA under the MLR registration process. Authorisation will not be automatically granted to MLR registered firms – so firms wishing to operate in this space will need to apply to the FCA for authorisation.

Mirroring the consultation paper's proposals, HMT states that the expectation is for firms that have an existing authorisation under Part 4A of FSMA (including, for example, those authorised to operate a Multilateral Trading Facility (MTF)) to apply for a Variation of Permission (VoP), rather than having automatic permissions or exemptions to enable them to undertake newly regulated cryptoasset activities.

The regulation of activities related to stablecoins (phase 1) is currently underway (with information set out in the StableCoins Update). All other cryptoassets activities (phase 2) will become regulated separately, with phase 2 legislation expected during 2024 (subject to the parliamentary timetable). Firms carrying out phase 1 and phase 2 activities will need to apply for a subsequent VoP or for unregulated firms, authorisation, as the regulatory scope expands to cover more activities.

 

In or to the UK

Crypto firms should be mindful of the broad geographical reach of these proposals.

A firm located overseas conducting crypto activities with a customer located in the UK will fall within the scope, as will UK providers servicing customers located overseas. A person will generally be required to be authorised by the FCA under Part 4A of FSMA if:

1. they are undertaking one of the regulated activities;
2. by way of business; and
3. they are providing a service in or to the UK.

The government is not minded to extend the overseas persons exclusion to cover cryptoasset activities.

 

Disclosure requirements

The government intends to establish an issuance and disclosure regime for cryptoassets. In the Response Paper, the government states that there should be disclosure documents in place for all cryptoassets which are made available for trading on a UK crypto trading venue. This would cover both well-established tokens, and those without a clearly identifiable issuer, for example Bitcoin.

The paper states that in order to reduce the risks and impacts of “cliff edges” and products being removed from trading (e.g., back book of tokens already in circulation), there will need to be “sufficient transitional arrangements for bringing activities into the regulatory regime”.

Venues only admitting institutional investors would be subject to less prescriptive disclosure requirements compared to those that cater to retail customers.

Public offers (e.g. ICOs), airdrops and tokens earned via reward mechanisms (rather than those admitted to trading through a regulated platform) may be subject to some exemptions, depending for example on whether they are free or offered solely to professional and/or sophisticated investors.

 

Intermediation activities

The consultation proposed that regulatory rules (e.g. conduct of business) applying to analogous persons engaged in regulated activities, such as ”dealing in investments as agent” and ”dealing in investments as principal”, would be adapted for those conducting cryptoasset market intermediation activities. This will be taken forward through legislation and changes to the FCA rules.

 

Crypto custody

In line with its February proposals, the Response Paper states that the government will legislate to define a new regulated activity for custody covering: (i) safeguarding; (ii) safeguarding and administration; or (iii) the arranging of safeguarding or safeguarding and administration, of a cryptoasset. It is likely that this will be consistent with the existing framework for traditional finance custodians under Article 40 of RAO.

The Response Paper states that the government intends to apply a “proportionate approach” in relation to rules regarding custodian liability. For example, it will not impose a full, uncapped liability on the custodian in the event of a malfunction or hack that was not within the custodian's control.

 

Market abuse

Proposals in the consultation also introduced a cryptoasset market abuse regime based on elements of the Market Abuse Regulation (MAR) regime for financial instruments covering insider dealing, market manipulation and unlawful disclosure of inside information. The Response Paper states that market abuse offences would apply to all persons committing market abuse on a cryptoasset that is admitted (or requested to be admitted) to trading on a UK cryptoasset trading venue. The Response Paper clarifies that this would apply regardless of where the person is based or where the trading takes place. The regime would entail obligations for certain market participants, for example cryptoasset trading venues (who would be expected to detect and disrupt market abuse behaviours) and cryptoasset market intermediaries. The Response Paper highlights that the government “disagrees” with the position put forward by respondents that the overall scope of the regime should be more narrowly defined.

 

Operating a cryptoasset lending platform

The Response Paper confirmed the government approach to introduce a new regulated activity of operating a cryptoassets lending platform. The precise scope of regulation and the rules that will apply will depend on whether the participants are retail or wholesale. As would be expected, protection of retail customers will be a particular focus for this regime.

The regulation of investment advice and portfolio management will be kept under review for now.

 

Further clarity on staking

The penultimate chapter of the Response Paper sets out HMT's comments on the regulation of staking. The government considers that it has insufficient data to conclude whether and how to regulate staking activities. Therefore, the regulation of staking will be considered separately from this current initiative.

Bearing in mind that this is a key area of concern for industry participants and stakeholders, HM Treasury will accelerate exploratory work, which will entail extensive engagement with stakeholders and will consist of working on: “(i) developing a clear definition of cryptoasset staking on a PoS blockchain and distinguishing this from other, riskier, activities which may be referred to, or marketed as ‘staking’; (ii) establishing a taxonomy of the different PoS staking business models currently in the market; and (iii) identifying how to mitigate the associated risks and take advantage of the potential benefits of a carefully defined, permitted form of staking in the UK”.

 

Sustainability

Whilst recognising that there is a “robust debate” around the impact that the cryptoasset sector has on the environment, the government confirmed its view that disclosure will continue to be a key tool in tackling sustainability issues.

In the Response Paper, HMT draws parallels between cryptoassets and the securities markets and in doing so, confirms that applying similar ESG-related reporting requirements is a “proportionate way of achieving [the] same risk, same regulatory outcome” principle.

The government indicated that it will work with its international peers to develop specific metrics including through IOSCO.

 

Closing remarks (for now)…

More detail and certainty is welcome. The “familiarity” of the FSMA regime will, HMT anticipates, work to firm’s favour. This could be the case for those already familiar with this landscape.

Looking ahead, in response to requests for clarity on timelines, and to accelerate the overall implementation programme, the government intends to publish phase 2 secondary legislation in 2024, subject to Parliamentary time. The government will work with the FCA to provide specific rules for those operating in the crypto space. To that end, the FCA published guidance on 2 November 2023 relating to “qualifying cryptoassets” with the intention to help crypto firms comply with the cryptoasset financial promotion rules. Although this may not be fast enough for some, crypto is definitely making its way up the legislative agenda with force.