There is no universally agreed definition of cryptoassets. Definitions vary from one jurisdiction to another and are revisited from time to time as the technology keeps evolving. A cryptoasset, as defined in the UK Cryptoassets Taskforce Report of October 2018, is “a cryptographically secured digital representation of value or contractual rights that use some type of [distributed ledger technology] DLT and can be transferred, stored or traded electronically”. National legal regulators are struggling to catch-up with the development of cryptoassets and to adapt their domestic laws to the global paradigm shift represented by the possibilities of cryptoassets. What is at stake is the national regulation of a developing global system facilitated by the use of digital innovation.
The UK is a leading country in the global financial sector and aspires to be amongst the most innovative economies. It has been closely monitoring and undertaking work on cryptoassets and DLT since 2014. The UK is keen to support legitimate innovation while maintaining its financial sector as a safe and transparent place offering appropriate protection to businesses and consumers. To this end, it has been working towards developing an approach to cryptoassets and DLT in a way which meets its objectives in the financial sector, and the Cryptoassets Taskforce is part of that work. This post aims to set out and explain the main findings of the Final Report of the Taskforce in order to understand what is next for the UK on cryptoassets.
Background to Cryptoassets
For cryptoassets, all started in 2008 when the publication of a 9 page whitepaper on Bitcoin by its pseudonymous founder Satoshi Nakamoto established the revolutionary idea that “a purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution”. Bitcoin, underpinned by new and even more revolutionary DLT generally referred to as ‘blockchain’, was then introduced in 2009 as the first ‘virtual’/‘digital’/‘crypto’ currency to enable the making of non-cash payments with secure digital records being held independently of the usual central trusted authorities (i.e. without intermediation - see Geva’s article on disintermediation).
Bitcoin was originally designed to create an alternative system of payment in the context of the exchange of goods and services. It has however also challenged the payment systems we use today by offering a fundamentally different alternative to these nationally regulated and centralised systems dating back to the 16th century based on intermediation. It is remarkable that just 10 years later in December 2018 we witness a global market with over 2,000 cryptoassets inspired by or based on Bitcoin. Furthermore, the underlying technology of Bitcoin has demonstrated a significant potential to transform various sectors in financial services and beyond.
UK Cryptoassets Taskforce
In order to work on developing an approach to revolutionary and fast-evolving cryptoassets and DLT in a way which meets the UK objectives in the financial sector, three main authorities were brought together to establish the Cryptoassets Taskforce as part of the UK government’s FinTech Sector Strategy: HM Treasury (the Government’s economic and finance ministry), the Financial Conduct Authority (the financial service regulator) and the Bank of England (the UK’s central bank). The Cryptoassets Taskforce had been launched by the Chancellor of the Exchequer (the Government’s chief finance minister) in March 2018 and published its final Report in October 2018, following the publication of the House of Commons Treasury Committee Report on Cryptoassets in September 2018.
Main Findings of the UK Cryptoassets Taskforce Report
In its Report the Taskforce assessed the potential benefits and risks associated with the current generation of cryptoassets and DTL, then established a path forward for the UK’s policy and regulatory approach. In preparing the report, they also included insights from industry by engaging with over 60 stakeholders across various sectors.
The Report assessed that the current size of the UK cryptoassets market is relatively small, compared to the global cryptoassets market, but noted that it has been growing. Given the fast-evolving nature of the cryptoassets market with technological developments, the Taskforce has committed itself to convene every 6 months to consider developments and review the UK’s approach.
1. Definition, Classification and Current Regulatory Perimeter
In defining cryptoassets as “cryptographically secured digital representation of value or contractual rights that use some type of DLT and can be transferred, stored or traded electronically”, the Report takes a broad approach by including both cryptocurrencies (such as Bitcoin) and tokens issued through an Initial Coin Offering (ICO).
The Report then classifies such cryptoassets via three main categories: exchange tokens, security tokens, and utility tokens. Exchange tokens are cryptocurrencies like Bitcoin that are used as a means of exchange and investment but are not state-backed (i.e. they are not issued by a central bank or other central authority of a state). The Report however does not prefer to use the term ‘cryptocurrency’, probably to avoid any confusion with fiat currencies, as exchange tokens are not considered as money or currency in the UK. It notes that, “they are too volatile to be a good store of value, they are not widely accepted as a means of exchange, and they are not used as a unit of account”, and therefore do not satisfy the three main criteria for an asset to be considered as money. Security tokens are used for investment and as a capital raising tool. They amount to a ‘specified investment’ under the Financial Services and Markets Act (2000) (Regulated Activities) Order (RAO) and may provide certain rights such as ownership, repayment of a sum of money or entitlement to a share in future profits. They may also be transferable securities or financial instruments under the Markets in Financial Instruments Directive II (MiFID II) of the European Union (EU). Utility tokens are also used for investment and as a capital raising tool, and they can be redeemed for access to a specific product or service typically provided using a DLT platform.
In terms of the regulatory landscape of financial services law, the current UK regulatory regime does not include all cryptoassets. The Report notes that only certain cryptoasset instruments and activities may fall within the perimeter of current UK legal regulation via the RAO and the Payment Services Regulation 2017. Though, in general terms, security tokens will fall within the current regulatory perimeter, exchange tokens and utility tokens typically do not. Most ICOs are also not within the UK regulatory perimeter. However, as the Report underlines, it is not necessarily so straightforward at present to decide whether and what regulation applies to a particular instrument or activity; this is an exercise that can only be done on a case-by-case basis.
It is interesting that central bank digital currencies (CBDCs) are not considered by the Report. Although we know that the Bank of England is not currently planning to create a CBDC, it has been conducting research to understand better the implications and consequences of such a thing. There are also countries, including Norway, Switzerland and Canada, which are seriously considering the possibility of issuing their own CBDCs. The Managing Director of the International Monetary Fund (IMF), Christine Lagarde, has recently also made a case for CBDCs in her speech at the Singapore Fintech Festival, by referring to a newly released paper of the IMF on CBDCs.
2. Benefits of Cryptoassets
The Report recognises certain benefits of cryptoassets. As a means of exchange, they can reduce time and cost in making payments due to disintermediation, which is significant particularly for international funds transfers that are traditionally carried out by correspondent banks located in different jurisdictions and operate in different time zones. Other potential benefits are improving the transparency and traceability of transactions, improving system resilience, and lowering certain entry barriers, encouraging competition and providing an alternative to traditional payment services. However, as the Report rightly assesses, these are the benefits brought by mainly the DLT underpinning cryptoassets, not by cryptoassets themselves.
As a means of investment, cryptoassets can widen access to new and different types of investment opportunities for consumers. As a means of capital raising, they can offer a range of potential benefits with the use of ICOs in supporting innovation and competition for new business models, products and services, improving efficiency of the process, addressing financial gaps for high risk-high reward early stage projects, and building a new investor and customer base. Against these benefits, the Report acknowledges the potential detriment to consumers in the absence of appropriate protection.
3. Risks of Cryptoassets
The Report assesses that cryptoassets pose a range of current risks regarding financial crime, consumers, market integrity, and a potential risk regarding financial stability depending on the growth of the market in the future. This is a non-exhaustive list highlighting the main risks falling within the Taskforce remit, and, for instance, does not include tax-related risk which has been being assessed by HM Revenue and Customs (HMRC) separately.
Risks of financial crime arise from the very nature of the cryptoassets being globalized, easily accessible online and encrypted to establish pseudo anonymity. These characteristics mean that they are vulnerable to being used for illicit activities such as money laundering, terrorist financing and cyber-crime, making payments between criminals, and purchasing illicit tools or services from criminal marketplaces including online ones. The Report notes that the use of cryptoassets to move large amounts and high volumes for illicit purposes (e.g. money laundering or terrorist financing) is seemingly currently low but is a growing issue.
The Report assesses that risks to consumers can be substantial in the absence of any appropriate regulatory protection since consumers may suffer losses due to purchasing unsuitable cryptoassets products without sufficient information and knowledge, from fraudulent activity and cybercrime, and from issues with the present immaturity of market infrastructures and services. The Report refers to the preliminary findings of a FCA commissioned qualitative consumer research suggesting that some consumers invest in cryptoassets to be wealthy quickly or under the influence of social media while some believe that they are investing in tangible assets because they misunderstand the terminology and images used to describe cryptoassets (such as ‘mining’ and ‘coins’) to suggest a physicality which is striking but absent. Similar consumer behaviours on cryptoassets and risks they can be exposed to have also highlighted in an interesting BBC Panorama documentary entitled “Who Wants to Be a Bitcoin Millionaire?”.
Risks to market integrity may arise from the vulnerability of cryptoasset markets to abuse and manipulation due to market immaturity, the pseudo anonymous nature of the participants and activities leading to the lack of the availability of necessary information, and potential illiquidity.
The Report does not identify any current material risk to the UK or global financial stability as yet, but, as the cryptoassets market and the underlying technology keep evolving rapidly, the Report recognises that potential risks may arise in the future, particularly if risk is transmitted from the cryptoasset markets to the formal financial system.
Overall, in a risk-benefit analysis with the current generation of cryptoassets, the Report considers that risks prevail over the benefits, which indicates the need for appropriate provisions to be put in place. On the other hand, the Report recognises that the underlying technology has the potential to deliver significant benefits in and beyond financial services. Therefore, the UK will continue to encourage and enable initiatives and experiments to explore the use of DLT and further innovation.
4. Path forward regarding the UK’s policy and regulatory approach
Based on the evidence and analysis, the Report concludes that although certain types of cryptoassets have the potential to deliver benefits in the future, particularly for the purpose of capital raising, this requires effective action to manage cryptoasset risks in relation to financial crime, consumers and market integrity. The Report is clear that the immediate priority is to mitigate the risks associated with cryptoassets, and thus identifies several action points:
Preventing financial crime: The UK is determined that there will be no tolerance on the use of cryptoassets for illicit activity, strong action will be taken by the authorities to address these risks and the UK will also continue to actively engage in discussions at the international level to develop a global response to address the risks. To this end, the UK Government will develop and provide one of the most comprehensive regulatory responses globally to the use of cryptoassets for illicit activity, and legislate during 2019 to give effect to this response after consultation. The intention is to transpose the 5th Anti-Money Laundering Directive (5AMLD) of the EU and go significantly beyond requirements set out therein. This seems in line with the Financial Action Task Force (FATF) recommendations as well. After the publication of the Report, the 6th Anti-Money Laundering Directive of the EU was published on 12 November 2018 (6AMLD) with a transposition period by 3 December 2020. Given that the 6AMLD may not be transposed by the UK due to Brexit (and Brexit is interestingly not addressed by the Report) the UK position on developing an equivalent and robust regulatory response is important and seems to be the right way forward given the cross-border/transnational nature of cryptoassets.
Regulating financial instruments referring to cryptoassets: The FCA will consult on a prohibition of the sale to consumers of all derivatives referencing exchange tokens for the purposes of protecting consumers and maintaining market integrity. It is also made clear that the FCA will not authorise or approve the listing of a transferable security or a fund referencing exchange tokens.
Clarifying the regulation of security tokens: Given the complex and novel nature of cryptoassets, the FCA will provide further clarity on the application of the current regulatory perimeter to security tokens and will consult on perimeter guidance by the end of 2018.
Consulting on extending the regulatory perimeter for ICOs: With a view to address concerns that firms may issue cryptoassets with features similar to specified investments but structured differently to avoid necessary prudential regulation, the UK Government will issue a consultation in early 2019 to further explore whether such examples exist in the UK cryptoassets market and whether an extension of the current regulatory perimeter is required in order to protect investors, eliminate fraudulent activity and ensure market integrity.
Addressing the risks of exchange tokens: It is recognised that exchange tokens presents new challenges to traditional forms of financial regulation and pose substantial risks to consumers and markets. The UK Government will issue a consultation in 2019 to further explore whether and how these risks can be addressed meaningfully and effectively through regulation of these tokens and related firms such as exchanges and wallet providers. The Report also highlights the importance of a consistent and coordinated international approach and actions with other countries on these questions due to the nature of this type of cryptoasset.
Ensuring a coordinated international approach: Emphasising the need for a more integrated approach, the UK will continue to be actively involved in international efforts on cryptoassets, including the ones currently pioneered by Financial Action Task Force (FATF), various European Supervisory Authorities (in particular the European Securities and Markets Authority (ESMA)), the Global Financial Innovation Network (GFIN), the Financial Stability Board, the Basel Committee on Banking Supervision (BCBS), and Financial Dialogues and Fintech Bridges.
Improving consumer awareness: The authorities will continue to warn consumers of the risks of investing in cryptoassets and the lack of regulatory protections with many of these products through various ways, such as media appearances and issuing relevant warnings.
Maintaining financial stability: The Bank of England will continue to monitor the market developments and be alert to potential issues that might lead to a material threat to UK financial stability in the future.
Taxation: Being an issue outside of the Taskforce remit, tax related matters are being assessed and considered by HMRC which will draw on the Taskforce work in updating its current guidance on the tax treatment of cryptoassets by early 2019.
As noted by the Report, various consultations will be issued by different authorities starting at the end of 2018 on various aspects of cryptoassets to develop the UK’s policy and regulatory approaches. The Report does appear to indicate that the UK is heading towards the regulation of cryptoassets. This conclusion is also supported by the findings and assessments of the House of Commons Treasury Committee which described the current situation as a “wild west” and found the current ambiguity surrounding the positions of the UK Government and its regulators to be “clearly not sustainable”. What is unclear is how this will be achieved: will it be in the form of a new and specific regulation on cryptoassets (which might take some time to develop and implement) or will it be through introducing changes to the Regulated Activities Order to this end (which may be achieved more quickly but runs the risk of further complicating the financial regulatory environment)? Unlike the Committee Report, which favours the latter by considering the issue to be treated as a matter of urgency, the Taskforce Report does not express a clear preference for a given course of action. It remains important that the consultations are widely fed into by different actors across cryptoassets sectors in reaching a meaningful and effective regulation responding well to issues and challenges in the financial sector that current cryptoassets do present while encouraging and supporting beneficial financial innovation within the UK and in global markets.
Blog post by Burcu Yüksel