The UK publishes a call for evidence on proposals to create a financial services regulatory regime for crypto-assets and confirms its approach to setting up financial promotions regime for crypto-assets

On February 1 2023, the UK Government (the Government) published two important developments for cryptoassets:

i. the Government’s statement on its approach to crypto-asset financial promotions regulation; and

ii. the future financial services regulatory regime for cryptoassets: Consultation and call for evidence (the Consultation),

both outlining the Government’s intention to bring crypto-regulation to the UK. These developments follow through on the UK’s agenda to become a “global hub for crypto technology”, as envisioned in April 2022 by then Chancellor Rishi Sunak.

The FCA on 6 February responded with a statement on the Government’s approach to cryptoasset financial promotions regulation policy. The statement introduces additional clarity to the financial promotion regime and its implications on cryptoasset firms marketing to UK consumers. This Insight also touches on this statement from the UK regulator.

i. Government approach to cryptoasset financial promotions regulation policy statement

The policy statement follows a previous a response to a consultation published in January 2022 on a proposal to bring certain qualifying cryptoassets within the scope of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (FPO) which would result in financial promotions in relation to crypto-assets needing to be issued by an authorised person under the Financial Services and Markets Act 2000 (FSMA), approved by an authorised person or fall within an exemption under the FPO.

Feedback summarised from the consultation is:

• the requirement to be authorised means most crypto firms will not be able to communicate their own promotions, unlike other financial services firms which are typically authorised by virtue of having Part 4A permissions to carry on regulated activities (most crypto firms are not required to hold such authorisation in respect of their crypto activities under existing regulation); and
• there is evidence of a lack of suitable authorised persons in the market willing and able to approve crypto promotions of third parties.

Evidence from the Consultation suggested it would be unlikely for cryptoasset firms to find authorised persons to willingly approve the promotions of unauthorised firms, leading to an effective ban on cryptoasset financial promotions. As a result, the Government will introduce a bespoke exemption from the financial promotion restrictions in section 21 of FSMA so that a cryptoasset exchange provider or custodian wallet provider registered under Regulation 54(1A) of the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs) will be able to communicate their own promotions in relation to qualifying cryptoassets.

The FCA will be given special powers from HM Treasury (HMT) to respond flexibly to breaches of the financial promotion’s rules by registered cryptoasset businesses relying on the exemption.

Registered cryptoasset businesses will not need to apply for any further registration or authorisation from the FCA.

The FCA also plans to increase its own resourcing for cryptoasset business registration assessments, to ensure registration takes place in a timely manner.

Next steps

• The Government will introduce new statue to give effect to the new cryptoasset financial promotions regime including the bespoke exemption.
• The Government will reduce the implementation period for the measure after the statue is given effect from 6 months to 4 months
• Detailed rules for the regime to be set independently by the FCA once the relevant legislation has been made.

The FCA Statement published on 6 February clarifies that subject to Parliamentary approval, when the regime comes into force there will be 4 routes to communicating cryptoasset promotions to UK consumers:

• The promotion is communicated by an FCA authorised person.
• The promotion is made by an unauthorised person but approved by an FCA authorised person. Legislation is currently making its way through Parliament which, if made, would introduce a regulatory gateway that authorised firms will need to pass through in order to approve financial promotions for unauthorised persons (Financial Promotion Regulatory Gateway).
• The promotion is communicated by a cryptoasset business registered under the MLRs with the FCA.
• The promotion otherwise complies with the conditions of an exemption in the FPO.

Promotions that are not made using one of these routes will be in breach of section 21 of FSMA, which is a criminal offence punishable by up to 2 years imprisonment.

With regard to the territorial scope of the financial promotions regime the statement also provides that cryptoasset businesses marketing to UK consumers, including those based overseas must get ready for the regime. This is likely to have a significant impact on overseas firms that will need to consider their regulatory position and product offering to customers in the UK.

More on the FCA’s Financial Promotion Gateway can be read in our insight here

ii. The future financial services regulatory regime for cryptoassets: HMT consultation and call for evidence

In parallel to recent regulatory work undertaken by the Government, BoE and FCA on cryptoassets the consultation builds on global standards produced by the Financial Stability Board and the Financial Action Task Force.

The implications of the high-profile collapse of firms like FTX have also been taken into consideration within the Consultation which has brought to light important questions on conduct of business requirements, operational resilience, safeguarding and conflicts of interest.

HMT are pursuing four policy objectives:

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

We’ve broken down key aspects of the consultation:

1. The Legislative Approach for creating A Global Cryptoasset Framework
2. The future of financial regulation for crypto assets
3. Territorial scope
4. Non fungible tokens (NFTs) and Utility tokens
5. Regulatory outcome for Cryptoasset Issuance and Disclosures
6. Cryptoasset lending platforms
7. Cryptoasset custody
8. Market abuse
9. Sustainable finance

1. The Legislative Approach Toward Creating a Cryptoasset Framework

Unlike the EU’s Markets in Cryptoassets Regulation (MiCA) which is a bespoke cryptoasset regulation (expected April 2023), the UK Government intends to regulate cryptoassets within the UKs existing framework for financial services through FSMA.

The UK’s approach to creating a cryptoasset framework is made up of several stages and two Phases, the final and ongoing stages form part of this consultation:

1. The Anti-Money Laundering and Counter Terrorist Finance (AML/CTF) registration regime has been in place for businesses undertaking cryptoasset exchange or custody wallet services in the UK since January 2020 (Status:Complete).
2. Financial Promotions: The Government will introduce legislation to require the regulation of promotions of cryptoassets by the FCA to ensure promotions are clear, fair and not misleading. The FCA currently have a consultation out for a new approval gateway for firms who approve financial promotions (Status: In-progress).
3. Financial Services and Markets Bill 2022 (FS&M Bill) will introduce a regime that will allow for the regulation of fiat-backed stablecoins used as any other payment method (“Phase 1” Status: In progress).
4. The FS&M Bill will also introduce a regime to regulate broader cryptoasset activities, such as the trading of and investment in cryptoassets, specifically targeting areas of; (i) a higher degree of risk from a consumer and overall market perspective and (ii) greater opportunities to support the UK’s growth agenda. Not all crypto asset activities are proposed to form part of Phase 2 (“Phase 2”- this Consultation).
5. Future phases cryptoassets: The government will continue to strategically assess developments in the market to determine future phases of work from industry views and industry standards (“Phase 2”- this Consultation).

The purpose of the consultation and call for evidence is to focus on Phase 2. HMT intends to apply a phased approach the regulation of cryptoassets. The consultation represents the next step to the process.

The regulatory approach

The design principles for a new framework for cryptoassets is for it to be “proportionate and focused”, “agile and flexible”. Regulation will be consistent with the Future Framework Regulatory Regime which will be established by the FS&M Bill and the Government hopes that regulators will be better positioned with new regulatory powers to adapt to changes in the market and international standards more readily.

The principle of “Same risk, same regulatory outcome” is a predominant theme behind many of the proposals in the consultation. The Government intends to regulate financial services activities, rather than the assets themselves, although there may be cases where entities pose or are likely to pose systemic risk and may warrant further regulation.

Phase 2: Specified investments

“The Consultation proposes to expand the list of “specified investments” in Part III of the FSMA (Regulated Activities) Order 2001 (RAO) to include cryptoassets, which form the basis of the rest of the proposals. Amendments to FSMA, made through the FS&M Bill currently working through Parliament affirms the use of the RAO power for the financial services regulation of cryptoassets. This clarifies that people who are carrying out certain activities involving cryptoassets “by way of business” would be performing regulated activities and therefore require authorisation under Part 4A of FSMA. For example, this would cover “arranging”, “dealing”, “managing” and safeguarding activities in relation to crypto-assets.

HMT does, however, confirm that it does not intend to expand the definition of “financial instrument” in Part 1 of Schedule 2 to the RAO to include presently unregulated cryptoassets. Therefore, while mainly the proposals will mean that existing regulated activities will now apply in relation to cryptoassets in addition to previously specified investments, there are also proposals for some new RAO activities, specific to cryptoassets. For example, lending activities in relation to crypto-assets could fall within a new regulated activity of “operating a crypto-lending platform”.

It would mean the FCA would be able to regulate new activities once the FCA are given power to create tailored rules. The FCA will consult in due course.

As well as specified investments some crypto-assets may also fall within services under the Payment Services 2017 and Electronic Money Regulations 2011.

2. The future of financial regulation for cryptoassets

In Phase 1, the FS&M bill includes the following definition of cryptoasset.

“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 phrase is drawn broadly to capture a wider range of underlying technology, the definition is also very similar to MiCA and share some features with the definition of “virtual asset” in the FATFs recommendations.

Schedule 6 to the FS&M Bill also extends the application of the existing scope of Part 5 of the Banking Act 2009 to include payment systems using digital settlement assets. A “digital settlement asset” comprises only those digital assets that can be used for the settlement of payments (it therefore covers other digital assets that can be used for the settlement of payments, as well as cryptoassets used in payments). The Government has confirmed that non-fungible tokens (NFTs) will not be in scope of the cryptoassets financial promotions regime, since NFTs can represent a wide array of different assets which might constitute non-financial services products.

For Phase 2, the Government’s intention is for activities rather than the asset itself to be regulated in the future if the crypto-asset is being used for financial service activities. Cryptoassets which could be considered for future financial services regulation where being used for financial services activities are outlined in paragraph 2.4A: exchange tokens, utility tokens, security tokens, NFTs, stablecoins (Phase 1 proposals apply to fiat-backed stablecoins), asset-referenced tokens, commodity-linked tokens, crypto-backed tokens, algorithmic tokens, governance tokens and fan tokens. If the token is non-financial in nature it may be covered by other laws and regulations.

HMT does not currently intend to expand the definition of “financial instrument” in Part 1 of Schedule 2 to the RAO to include presently unregulated cryptoassets. […] However, in line with the principle of “same risk, same regulatory outcome”, HMT will seek to use other legislative and regulatory mechanisms to put in place equivalent or similar safeguards where cryptoassets present similar risks to financial instruments (e.g. market manipulation practices which arise from the fact that cryptoassets are traded in a way which resembles financial instruments).

The consultation provides proposals for the cryptoasset activities the Government want to bring into the regulatory perimeter (Table 4.A):

Phase 1:

• Issuance activity: Issuance and redemption of fiat-backed stablecoin
• Payment activities e.g. execution of payment transactions or remittances involving fiat-backed stablecoins
• Safeguarding or safeguarding and administering (or arranging the same) a fiat backed stablecoin and/or means of access to the fiatbacked stablecoin18 (custody)

Phase 2:

• Issuance activity: Admitting a cryptoasset to a cryptoasset trading venue
• Issuance activity: Making a public offer of a cryptoasset
• Exchange activities: Operating a cryptoasset trading venue which supports:
  • the exchange of cryptoassets for other cryptoassets
  • the exchange of cryptoassets for fiat currency
  • the exchange of cryptoassets for other assets (e.g. commodities)
• Investment and risk management activities: Dealing in cryptoassets as principal or agent
• Investment and risk management activities: Arranging (bringing about) deals in cryptoassets
• Investment and risk management activities: Making arrangements with a view to transactions in cryptoassets
• Lending, borrowing and leverage activities: Operating a cryptoasset lending platform

Future phases

• Exchange activities: Post-trade activities in cryptoassets (to the extent not already covered)
• Investment and risk management activities: Advising (to the extent not already covered) on cryptoassets
• Managing (to the extent not already covered) cryptoassets
• Validation and governance activities: Mining or validating transactions, or operating a node on a blockchain
• Validation and governance activities: Using cryptoassets to run a validator node infrastructure on a proof-of-stake (PoS) network (layer 1 staking)

FSMA approval and Senior Managers Regime to include cryptoassets

Once the cryptoasset regime consulted on becomes effective, HMT will expect firms undertaking regulated cryptoasset activities to adhere to the same financial standards and rules under FSMA. This is likely to include crypto-asset firms needing to comply with the Senior Managers & Certification Regime and SYSC requirements relating to financial crime.

FCA authorisation – standards of approval

The introduction of an authorisation regime under FSMA for persons who are carrying out certain activities involving cryptoassets means that crypto firms already registered under the UK AML regime and carrying out those activities would be required to also seek authorisation under the new FSMA-based regime. This is because businesses will need to be assessed against a wider range of measures than they have been as part of the UK AML registration process. However, in order to smooth this transition, HMT has stated that the FCA will adopt a timely and proportionate authorisation process for complete and accurate applications, and will endeavour to avoid duplicative information requests of businesses, taking into account the supervisory history of businesses during the authorisation process. New crypto firms not yet registered under the AML regime would not need to separately apply for registration under the MLRs. All crypto firms in scope of the MLRs will still be expected to comply with them, as with current FSMA-authorised businesses that are subject to the MLRs.

3. Territorial scope

HMT proposes to capture cryptoasset activities provided in or to the UK, not only activities that are carried out in the UK which is the current requirement of FSMA. This would capture activities carried out by oversees firms to UK persons, with the intention of creating a level playing field for UK firms with oversee firms with UK customers. HMT recognises that there may be nuances in the application for specific services.

Exceptions which may be considered would be for example to accommodate “reverse solicitation”, for example where a UK customer accessed a particular cryptoasset service at their own initiative from an overseas firm and that firm does not otherwise solicit from such customers, it may not trigger a FSMA authorisation.

HMT intends to pursue equivalence type arrangements whereby firms authorised in third countries can provide services in the UK without needing a UK presence, provided they are subject to equivalent standards and there are suitable cooperation mechanisms to help make this work. Whether firms carrying out these activities would be required to have a physical presence in the UK in order to obtain authorisation is under consideration and for the FCA to determine at the point at which firms apply for authorisation.

4. Implications for Non fungible tokens (NFTs) and Utility tokens

The consultation proposes a new treatment for NFTs and utility tokens. Cryptoasset services included in section 2.4A will be regulated rather than the asset itself. All cryptoassets including NFTs and utility tokens, would have the potential to be in included in the future regulatory perimeter if they were used in one of the activities listed above. If an NFT or utility token is not used in such a way, it would not fall into scope of financial services regulation unless – as a result of the particular structure and characteristics of the NFT or utility token – it constitutes a specified investment and the activities carried on in relation to the token constitute regulated activities that fall within the existing perimeter. This may need further clarity as most NFTs are able to be traded and so would fall within the “arranging” activities if a platform facilitated the trading in these types of crypto-assets.

Financial promotions

According to the consultation HMT is seeking to lay the secondary legislation to extend the financial promotions perimeter in 2023.

5. Regulatory outcome for Cryptoasset Issuance and Disclosures

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, HMT does not intend to directly regulate the “creation” of unbacked cryptoassets under financial services regulation. The Government proposes an issuance and disclosure regime for cryptoassets.

6. Cryptoasset lending platforms

Crypto asset lending and borrowing activities conducted by lending platforms typically fall outside the current regulatory parameter. There are significant risks with operating a lending platform as in the case of FTX. Most safeguards for traditional lending and borrowing are unavailable to users of similar cryptoasset products and services. HMT believes there is a strong case for developing a lending and borrowing regime in phase 2 and have set out proposals to require platforms to disclose important information to customers, such as the terms of legal ownership, collateral, and margin calls.

7. Cryptoasset custody

The UK’s custody framework is set out through Article 40 of the RAO and the FCA’s Client Assets Sourcebook (CASS). Currently there is no clear custody framework for cryptoassets in the UK and so the Government is seeking industry feedback on this and hope to modify Article 40 or put in new provisions to accommodate cryptoassets. The Government plan is for custody requirements to be addressed through phase 1 for fiat-backed stablecoins and under Phase 2 for other types of cryptoassets that come into the regulatory perimeter. The Government expects the same custody requirements will be adopted for all types of cryptoassets as they come into regulation.

Cryptoassets that already meet the definition of a specified investment (security tokens), the existing regulatory framework that currently applies will be replaced by the new custody regime. The FCA expect to run a separate consultation on this.

8. Market abuse

The consultation discusses the various challenges with regulating for market abuse in cryptoassets among some of the reasons includes the global nature of crypto assets. However, HMT considers there is value in enabling authorities to sanction market abuse behaviour which is hoped overtime will be enhanced through new technologies, international cooperation and introducing criminal offences.

The Government proposes a cryptoassets market abuse regime based on elements of the UK’s market abuse regime (MAR) for financial instruments. Offenses would apply to all persons committing market abuse on a cryptoasset that is requested to be admitted to trading on a UK trading venue, regardless of where the person is based.

9. Sustainable finance

The Government is concerned of the environmental impacts of mining and reinforces its intention for making the UK a competitive location for sustainable finance. The Government is also seeking views on what information about environmental impact for energy intensity would be useful for customers making decisions about investing in cryptoassets, including whether there are any important metrics that can be used to calculate environmental impact and where these are interoperable with other recognised sustainability disclosed standards.

Next steps

We expect the following developments in due course.

• The Government will introduce a new statue to give effect to the new cryptoasset financial promotions regime including the bespoke exemption in 2023.
• The Government will receive feedback on the Consultation and we would expect a further consultation to be published by the Government on these proposals.
• The FCA are expected to run a consultation on a new custody regime.

Co-authors: Gavin Punia, Finance & Financial Regulation Partner, London, [email protected], Tom Hepplewhite, Finance & Financial Regulation Associate, London, [email protected] and Melissa Daley, Knowledge Manager, London, [email protected]

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