UK Cryptoassets: HMT consultation and call for evidence on a future financial services regulatory regime

Background to the proposals for regulating cryptoassets

The HM Treasury (HMT) consultation and call for evidence published on 1 February 2023, builds on a series of publications on a regulatory approach to cryptoassets.   In April 2022, the government announced its ambitious plans for the UK to become a global hub for cryptoasset technology as part of the wider Fintech strategy and the Kalifa Review.  The initial approach taken towards the regulation of stablecoins when used as a form of payment and the financial promotion of cryptoassets are set out in legislative proposals in the Financial Services and Markets Bill (FSM Bill).  By expanding these proposals to a wider range of cryptoassets and cryptoasset activities in the consultation and call for evidence, the government has reiterated its commitment to developing a UK global hub for cryptoasset technology and investment.  With these proposals, the government aims to position the UK as a safe jurisdiction for cryptoasset activity to take place against a backdrop of fostering innovation and growth whilst providing firms with clarity over the planned regulatory framework.

Views from Hogan Lovells Global Digital Assets and Blockchain Practice

Commenting on the consultation, John Salmon, Co-Head of the Hogan Lovells Global Digital Assets and Blockchain Practice provided his views:

“John Glen, in his speech as Economic Secretary to the Treasury last year, called for an agile approach, and that is reflected in the core design principles of this consultation. The FCA will have powers to write tailored rules as opposed to applying the existing rules automatically to cryptoassets, this will be significant.

However, the decision to forego a bespoke regime seems to be a missed opportunity. The government said it considered this approach and discounted it on the basis that it would have not created a  level playing field and could have resulted in an overlapping regulatory regime and confusion. This seems misguided. Just as a bespoke regime for crowdfunding has provided clarity and boosted the activity in P2P lending, the same could have happened for cryptoassets. As well as clarity, proportionality will be key to attracting businesses to the UK and there will be a lot of work to be done to ensure that this is the case with the proposed approach. It is encouraging to see that HMT have put this as a core design principle, however, it will be important in this consultation to highlight the concerns around what could potentially lead to a weighty and onerous authorisation regime.

There is also concern around the Call for Evidence on DeFi. One option that HMT is considering is to define a set of DeFi-specific activities such as establishing or operating a protocol as a regulated activated and the person carrying out that activity would need to be authorised. This is worrying and does not apply the tech neutral approach that the government put forward in their core design principles. To do so would stymie innovation and push development of these protocols outside of the UK thereby not benefiting from the growth, innovation and competition that HMT are pursuing. It is imperative that we await the Law Commission report on the legal status of Decentralised Autonomous Organisation and use this as a basis for any approach.”

Lavan Thasarathakumar, Consultant in the Digital Assets and Blockchain Practice added:

“This much anticipated consultation paper has provided a comprehensive overview of how cryptoassets are treated as well as HMT’s vision around how it will address its next stage of cryptoasset regulation. Whilst the phased approach has drawn some criticism, it does seem to be a methodical approach that HMT are taking and they have provided a clear roadmap of what is to come.

It is encouraging to see thought being given as to how to reduce the burden on cryptoasset firms, to ensure that the regime is not overly onerous. An example of this is the attempt to reduce the duplication of what is required for submission for FSMA authorisation for firms who have already obtained MLR registration.

One thing to note is the notion of “same risk, same regulatory outcome”. An old adage that is often used, however not necessarily applied as such. The risk element has often been assumed as opposed to calculated when it comes to distributed ledger technology (DLT) and this consultation seems to suggest this is the case again. Whilst it considers whether the use of technology may bring additional risk, there is no consideration as to the risk mitigation that technology can bring. To have a truly competitive regime, one that will make the UK a global cryptoasset hub, there will need to be careful consideration of what novel risks there are but also what risks are mitigated by the use of DLT.

Overall, the devil will be in the detail as to how this will be applied however, these are very positive steps for the UK.”

A phased approach - policy objectives and principles for regulating cryptoassets

The consultation focuses specifically on the future UK regulatory framework for cryptoassets used within financial services, rather than the wider application of distributed ledger technology (DLT) in financial services or the use of cryptoassets outside of financial services. There are currently a number of UK government and regulator initiatives in the wider DLT space, such as the UK’s Financial Market Infrastructure (FMI) Sandbox and the DLT-supported debt issuance initiative.

In establishing a regulatory framework for cryptoassets in the UK, HMT is pursuing four overarching policy objectives:

1. Encouraging growth innovation, and competition in the UK
2. Enabling consumers to make well-informed decisions, with a clear understanding of the risks involved
3. Protecting UK financial stability
4. Protecting UK market integrity

HMT will continue to be guided by a set of core design principles as set out in the consultation:

• “Same risk, same regulatory outcome”. The government will remain technology agnostic while also considering whether the technology, or its use, gives rise to additional risks. HMT intends to take an activities-based approach to regulation, although there may be specific cases where systemic risk may warrant further regulation.
• “Proportionate and focused”.  The government intends to focus efforts on where the risks and opportunities are most urgent or acute. HMT intends to avoid applying disproportionate or overly burdensome regulation on entities.
• “Agile and flexible”.  The regulatory framework should accommodate evolving markets and products.

In line with these design principles, the government intends to continue to pursue a phased approach to regulating cryptoassets prioritised according to the areas of greatest risk and opportunity.

Phase 1 includes the following:

• Since January 2022, an Anti-Money Laundering and Counter Terrorist Financing (AML/CTF) registration regime has been in place for businesses undertaking cryptoasset exchange or custoday wallet services in the UK to regulate compliance with the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLR).
• The government will shortly introduce legislation to require the regulation of cryptoassets by the FCA to ensure promotions are clear, fair and not misleading.
• The government is also currently legislating in the FSM Bill to introduce a regime that will allow for the regulation of fiat-backed stablecoins when used for payments similar to that for other payment methods given that stablecoins have the potential to become widely used as a form of payment.

In Phase 2, the government’s intention is to introduce a regime to regulate broader cryptoasset activities, such as the trading of and investment in cryptoassets. Phase 2 will be focused on targeting the activity areas associated with (i) a higher degree of risk from a consumer and overall market perspective and (ii) greater opportunities to support the UK’s growth agenda. As a consequence, not all cryptoasset activities are proposed to form part of Phase 2 as addressed further in chapter 4 of the consultation.

In emerging areas of the cryptoassets market, the government is seeking views to inform future policy development in the call for evidence part of the consultation. 

Definition of cryptoassets and legislative approach

Whilst there is currently no universal definition of a “cryptoasset”, the consultation sets out that an increasing consensus is emerging on the basic elements of a definition of cryptoassets in the UK and internationally. The UK FSM Bill contains a definition of “cryptoasset” which will be introduced into the Financial Services and Markets Act (FSMA):

““cryptoasset” means 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 definition has been drawn widely to capture different types of cryptoasset.  It is similar to the definition of “cryptoasset” used in the MLR although the new definition references a wider range of underlying technology.  The FSM Bill definition is also similar to that used in the EU’s Markets in Cryptoassets legislation (MiCA) and shares some features with the definition “virtual asset” in FAFT’s recommendations.   The government anticipates that the future financial services regulation of cryptoassets created using HM Treasury’s powers will typically apply to a particular subset of cryptoassets depending on the matter being regulated which it will need to specify in any future rules or regulations.

The consultation (in Box 2.A) sets out a glossary of commonly used terms for different types of cryptoassets (including exchange, utility and security tokens, NFTs, stablecoins, asset-referenced tokens, commodity-linked tokens, crypto-backed tokens, algorithmic tokens, governance tokens and fan tokens)  which could in the future be subject to financial services regulation when they are being used for certain financial services activities set out in further detail in Table 4.A including activities for the purposes of:

• Issuance – for example issuance and redemption of a fiat-backed stablecoin, admitting a cryptoasset to a cryptoasset trading venue or making a public offer of a cryptoasset;
• Payment – for example the execution of payment transactions or remittances involving fiat-backed stablecoins;
• Exchange – for example operating a cryptoasset trading venue which supports (i) the exchange of cryptoassets for other cryptoassets (ii)the exchange of cryptoassets for fiat currency (iii) the exchange of cryptoassets for other assets (e.g. commodities) or post-trade activities in cryptoassets (to the extent not already covered);
• Investment and risk management – for example dealing, arranging, managing or advising on transactions in cryptoassets;
• Lending, borrowing and leverage – for example operating a cryptoasset lending platform;
• Safeguarding -for example safeguarding or safeguarding and administrating a fiat-backed stablecoin or a cryptoasset other than a fiat-backed stablecoin and/or means of access to the cryptoasset; and
• Validation – for example mining or validating transactions or operating a node on a blockchain or using cryptoassets to run a validator node infrastructure on a proof-of-stake network.

The list of proposed cryptoasset activities set out above seeks to incorporate the full scope of activities that currently require registration under the MLR into the regulatory perimeter of FSMA using a specific authorisation process for firms carrying out cryptoasset activities. 

Although HM Treasury and the FCA both have a strong preference for having a single authorisation process and register for regulatory clarity they concede that this may take time to achieve given the phased approach for regulating cryptoassets.

Expanding “specified investments” under the RAO and use of DAR

The government intends to include the financial services regulation of cryptoassets within the regulatory framework established by FSMA as updated by the FSM Bill.  Under FSMA, HMT has secondary legislation powers to bring activities into the regulatory perimeter by specifying them in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO).  It is proposed that the list of “specified investments” in Part III of the RAO will be expanded to include cryptoassets. 

For those activities that are not suitable for regulation under the RAO (e.g. they are carried out by firms which are not authorised under Part4A FSMA) HMT proposes to use the new regime set out in the FSM Bill, the Designated Activities Regime (DAR) to designate certain activities in order to prohibit the activity in its entirety or set direct requirements relating to that activity.  HMT asks respondents whether they see any potential challenges or issues with the use of the DAR for certain cryptoasset activities.

HMT does not intend to expand the definition of “financial instrument” set out in Part 1 of Schedule 2 to the RAO to include presently unregulated cryptoassets. This is due to the limitations of retrofitting an existing regime to a new asset class with unique features and risks.

Clarifying the current regulatory landscape for cryptoassets

The consultation provides a summary of the current financial services regulatory landscape relevant to cryptoasset activities in the UK.  The consultation makes the point that certain types of cryptoasset may already fall within the existing FSMA regulatory perimeter set by the RAO as they qualify as “specified investments”. For example, security tokens providing rights and obligations akin to shares, debt instruments or other securities would be specified investments as set out in the RAO. The FCA’s Perimeter Guidance for Cryptoassets (PS19/22) sets out more detail on the different types of cryptoassets and their interactions with the existing regulatory perimeter. 

HMT expects continuation of the current treatment of those cryptoassets already falling within the definition of specified investments or other elements of existing financial services regulation though it anticipates changes over time for example updating the custody obligations in the Client Assets Sourcebook for security tokens.

HMT confirms that when the broader cryptoasset regulatory regime becomes effective, it expects firms to adhere to the same financial crime standards and rules under FSMA that apply to equivalent or similar traditional financial services activities.  This is necessary as the financial crime rules in FSMA are broader than those contained in the MLR.  The FCA will also consider whether to update the Senior Management Arrangements, Systems and Controls sourcebook and other financial crime rules to apply to new cryptoasset activities. Further communications will be provided in due course to ensure standards for approval are clearly available to crypto firms operating in the UK.  

Financial promotions regime

In July 2020, HMT published a consultation on bringing qualifying cryptoassets into the scope of the financial promotions regime. The consultation response (January 2022) confirmed the government’s plan to introduce legislation to address the significant risk of misleading cryptoasset promotions. HM Treasury is seeking to lay the secondary legislation to extend the financial promotions perimeter when Parliamentary time allows (subject to a temporary bespoke exemption also announced on 1 February 2023 for financial promotions for qualifying cryptoassets)  The bespoke exemption is covered further in this Engage article. The FCA also consulted on proposed rules for cryptoasset promotions, such as risk warnings and consumer frictions in January 2022 with the corresponding Policy Statement (PS22/10) published in August 2022. HMT intends to confer powers drawn from FSMA to enable the FCA to make rules applying to financial promotions communicated in reliance on the exemption.

Regulatory outcomes for cryptoasset issuance and disclosures

Within traditional financial services the closest parallel to the creation, issuance and distribution of cryptoassets probably exists in the securities markets.  For cryptoasset issuance and disclosures, the government proposes to follow a similar approach to that for securities and apply regulation when the asset is admitted to trading on a regulated cryptoasset trading venue and therefore becomes exchangeable for fiat currency, or subject to a public offer. In line with the approach applied to securities, HM Treasury does not intend to directly regulate the “creation” of unbacked cryptoassets under financial services regulation.

The government proposes to establish an issuance and disclosures regime for cryptoassets grounded in the intended reform of the UK prospectus regime – the Public Offer and Admissions to Trading Regime – and tailored to the specific attributes of cryptoassets.

For admission of cryptoassets to a UK cryptoasset trading venue, the government is proposing to adapt the MTF model from the intended reform of the UK prospectus regime.

The government considers public offers of cryptoassets – including ICOs where a fund raiser creates new tokens and sells them to investors – may meet the definition of a security offering. For public offers of cryptoassets which meet the definition of a security offering and are considered a security token offering (STO), the intended Public Offers and Admissions to Trading Regime could be an adequate regulatory framework to capture this activity.

For public offers of cryptoassets which do not meet the definition of an STO, the government is considering an alternative route to regulate the activity. The DAR – or similar legislative mechanism – is suggested as a means for prohibiting these offers unless they were conducted via a regulated platform.

Regulatory outcomes for operating a cryptoasset trading venue

HM Treasury is proposing to establish a regulatory framework which is based on existing RAO activities of regulated trading venues – including the operation of an multi-lateral trading facility (MTF). Persons carrying out these activities would be subject to prudential rules and various other requirements including consumer protection, operational resilience, and data reporting as set out in further detail in chapter 6 of the consultation.

Regulatory outcomes for cryptoasset intermediation activities

The consultation seeks views on proposals for requirements applying to analogous regulated activities – such as “arranging deals in investments” and “making arrangements with a view to transactions in investments” set out in article 25 of the RAO – to be used and adapted for cryptoasset market intermediation activities.  The consultation sets out proposed design features for a cryptoasset market intermediation regime including specific prudential, conduct, operational resilience and reporting requirements.   

Regulatory outcomes for cryptoasset custody

The government is proposing to apply and adapt existing frameworks for traditional finance custodians under Article 40 of the RAO for cryptoasset custody activities, making suitable modifications to accommodate unique cryptoasset features, or putting in place new provisions where appropriate. The proposed design features including specific requirements relating to prudential, conduct and operational resilience for a cryptoasset custody regime are set out in further detail at chapter 8 of the consultation.

General market abuse requirements

The government is proposing a cryptoassets market abuse regime based on elements of the UK’s market abuse regime for financial instruments. The offences against market abuse would apply to all persons committing market abuse on a cryptoasset that is requested to be admitted to trading on a UK trading venue. This will apply regardless of where the person is based or where the trading takes place. It would entail obligations for certain market participations, in particular cryptoasset trading venues who would be expected to detect, deter, and disrupt market abusive behaviours.

Regulatory outcomes for operating a cryptoasset lending platform

For the regulation of cryptoasset lending and borrowing activities the government is proposing to apply and adapt existing RAO activities, whilst making suitable modifications to accommodate unique cryptoasset features. Chapter 10 of the consultation sets out the proposed design features for a cryptoasset lending and borrowing regime.

Call for Evidence: Decentralised Finance (DeFi)

Decentralised Finance (DeFi) is an umbrella term used to cover a range of financial services – including lending, exchange, asset management and insurance – which are offered without the use of traditional financial intermediaries.  HMT is of the view that the regulatory outcomes and objectives described in the preceding chapters of the consultation should apply to cryptoasset activities regardless of the underlying technology, infrastructure, or governance mechanisms. However, due to the rapidly evolving and novel nature of the DeFi sector, DeFi presents complex and unique challenges for policy makers and regulators.  There is a long list of actors involved in DeFi product chains, from limited companies and coders creating or editing protocols and code, to Decentralised Autonomous Organisations (DAOs) and governance token holders, who in many cases may not be undertaking financial services activities by way of business.  Some parts of the value chain may not be practical to regulate, for example the underlying protocol if that has become truly opensourced and decentralised over time. 

HMT acknowledges that the work of international organisations are especially important in this area and it does not intend to front run any of this and develop a prescriptive framework that would need to be re-shaped when international approaches and standards are crystalised.

HMT proposes one option for regulating DeFi is to define a set of DeFi-specific activities – e.g. “establishing or operating a protocol” – as regulated activities under the RAO (or DAR). The persons carrying out those activities would then require authorisation, and the FCA could design a bespoke regime around these regulated activities.

HMT does not intend to regulate the activity of developing software but if software developers go on to maintain, run and operate systems used for financial activities then they could be subject to such regulation.

Overall, HMT is looking for a proportionate, innovation friendly approach, which recognises distinct opportunities offered by new business models and encourages a thriving and well-regulated UK DeFi industry. However, the government also wishes to deliver similar regulatory outcomes across centralised financial services activities and their DeFi equivalents, thereby preventing risks of regulatory arbitrage. The call for evidence questions for industry on DeFi will help inform how to balance these objectives.

Call for Evidence: Other cryptoasset activities

Respondents are asked whether they consider that there is a case for making cryptoasset investment advice and cryptoasset portfolio management regulated activities, whether mining or validation activities should be regulated in the UK and whether staking should be included as an activity to be regulated in phase 2.

Call for Evidence:  Sustainability

The government reiterates its firm commitment to making the UK a competitive location for sustainable finance.  In this section, respondents are asked to provide views on the type of information investors would find most useful in terms of environmental impact or energy intensity.  Other considerations relate to the types of indicators that would be useful and/or available to estimate the environmental impact of cryptoassets or the consensus mechanism and the type of methodologies that could be used to measure these indicators.  

Next steps

The consultation and call for evidence will close on 30 April 2023.  The government is inviting stakeholders to provide responses and to share any other views on the proposed approach to regulating cryptoassets. Responses are welcome from all stakeholders, including cryptoasset firms, technology firms, financial institutions, other businesses impacted by cryptoasset regulation, trade associations, representative bodies, academics, legal firms, and consumer groups. 

In line with the phased approach taken by the government, the proposals appear to be at a relatively early stage in defining possible new risks that cryptoassets pose as opposed to new manifestations of well-known stability, credit or liquidity risks.  It will be interesting to see how the industry responds and whether that will result in the potential risks and benefits being better defined as a first step in developing wider regulation of this rapidly moving sector.

We will be keeping a close eye on further developments in this rapidly evolving area. Please contact our specialist Global Digital Assets and Blockchain Practice who would be happy to provide further advice and guidance. 

Authored by John Salmon, Michael Thomas, Lavan Thasarathakumar, and Melanie Johnson.