Legalism, Ideology and Pragmatism: Unpacking the UK Government’s Crypto Regulatory Proposals

Contents

Last updated on February 12th, 2024 at 10:52 am

TL;DR:

The UK government has published a set of proposals for the regulation of the crypto sector for public consultation. The proposals cover the authorization of crypto firms and the types of requirements to be imposed on them. Importantly, it sets out the activities that, in addition to stablecoins, will be regulated in the UK. These are: Cryptoasset Issuance and Disclosure Regime, Operating a Cryptoasset Trading Venue, Cryptoasset Intermediation Activities, Cryptoasset Custody, Operating a Cryptoasset Lending Platform, and General Market Abuse Requirements.

WATCH: A Video summarising the UK’s Crypto Proposals

Introduction

If 2022 was the year of high-profile crypto failures, then 2023 is shaping up to be the year of crypto regulation. A combination of the maturation of the crypto sector as an important one attracting great interest from institutional and retail investors alike and growing unease with the lack of regulatory oversight means that it is no longer tenable for public policymakers to ignore the sector.

On 1 February 2023, the UK government, via its Ministry of Finance (HM Treasury), published the eagerly awaited consultation paper setting out its proposed approach to the regulation of cryptoassets in the UK. The document, titled: “Future financial services regulatory regime for cryptoassets,” is designed to help make the UK a safe destination for crypto activity and innovation. The consultation closes for comments on 30 April 2023.

In this article, we provide a comprehensive overview of the proposals, which cover:

The UK’s Policy Objectives and Design Principles
Definition of Cryptoassets
Cryptoasset Activities
Cryptoasset Issuance and Disclosure Regime
Operating a Cryptoasset Trading Venue
Cryptoasset Intermediation Activities
Cryptoasset Custody
Operating a Cryptoasset Lending Platform
General Market Abuse Requirements

The UK’s Policy Objectives and Design Principles

In line with the existing regimes for traditional financial services, the UK intends to regulate the financial services activities of the crypto sector rather than the assets themselves. This aims to reduce the risk of “regulatory arbitrage,” i.e., firms structuring products or instruments in particular ways to circumvent financial services regulations.

Until now, the absence of a regulatory framework for crypto in the UK has meant that crypto startups have been able to create platforms for providing financial services without first obtaining regulatory licences for these. Simply put, there has been no possibility of obtaining such licensing due to the absence of a legislative/regulatory framework and reticence from UK regulatory bodies.

It is worth stating at the outset that, once passed into law, the proposals will mean that legal persons (i.e., individuals and entities) wishing to carry out certain activities in the crypto sector will require prior authorization under Part 4A of the Financial Services and Markets Act 2000 (FSMA) – the same legislation that governs traditional finance in the UK.

Policy Objectives

The consultation paper sets out the four policy objectives underpinning the UK’s proposed approach to the regulation of cryptoassets, which are to:

Encourage growth, innovation, and competition in the UK
Enable consumers to make well-informed decisions, with a clear understanding of the risks involved
Protect UK financial stability.
Protect UK market integrity

Design Principles

Similarly, three core design principles guide the UK’s approach, which are:

Same risk, same regulatory outcome
Proportionate and focused
Agile and flexible

In its bid to protect UK consumers and ensure financial stability, it is clear that the UK government wants a certain equality of outcomes relative to similar activities carried out by traditional finance (TradFi) firms but recognizes that crypto may require a different regulatory approach. The UK also wants a flexible approach that enables regulators to adapt and evolve to changes in the crypto market as well as developments in international regulatory standards.

Those fearing a draconian regulatory approach may be encouraged by the fact that the UK plans to focus on addressing urgent or acute risks and opportunities. That is, it will aim to avoid imposing disproportionate regulations, especially when end-users are aware of the risks involved and the activities do not pose a threat to market integrity or financial stability.

Definition of Cryptoassets

Historically, the UK has tended to avoid the word “currency” when referring to cryptocurrencies, hence the name “cryptoasset.” It believes only fiat currencies issued by governments qualify for such a designation. For consistency, in this article, we avoid the term “cryptocurrency,” but we do use the terms “crypto” and “cryptoasset” interchangeably.

The UK has already defined cryptoassets in the draft Financial Services and Markets Bill 2022 (FS&M Bill), which is currently going through parliament (and addresses fiat-backed stablecoins, among other things).

A cryptoasset is defined as:

“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).”

This definition is intentionally broad so as to capture all current types of cryptoassets and be flexible enough to cover any digital assets that may be created but which are not based on a distributed ledger or blockchain technology. Still, there is recognition that the definition may need to be updated in the future to keep up with developments in the sector. Therefore, the FS&M Bill includes the power for the government to update the definition via secondary legislation if needed.

Notwithstanding the broad definition, since the UK is adopting an activities-based approach (rather than seeking to regulate the assets themselves), the consultation paper clarifies that actual regulatory requirements will typically apply to a particular subset of cryptoassets depending on the matter being regulated, i.e., a narrower definition will be used to capture these.

Cryptoasset Activities

Understandably, the UK government plans to capture regulated activities provided by UK firms to customers “in” the United Kingdom (or abroad) as well as those provided by foreign firms “to” customers in the United Kingdom.

Geographic scope of cryptoasset activities captured by the UK’s proposals

Given the borderless nature of the internet and the fact that UK customers may choose to access services provided by foreign firms, there will likely be an exemption for so-called “reverse solicitation” to cover instances in which a UK customer decides to access a cryptoasset service “entirely at their own initiative from an overseas firm and the firm does not otherwise solicit from such customers.” This would not require UK licensing under the FSMA for that overseas firm.

Although subject to change following the consultation process, the following are the proposed scope of cryptoasset activities to be regulated in the UK.

The UK’s proposed scope of cryptoasset activities to be regulated

Category of Activity	Indicative sub-activities
Issuance activities	Issuance and redemption of a fiat-backed stablecoin Admitting a cryptoasset to a cryptoasset trading venue Making a public offer of a cryptoasset
Payment activities	Execution of payment transactions or remittances involving fiat-backed stablecoins
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 Arranging (bringing about) deals in cryptoassets Making arrangements with a view to transactions in cryptoassets
Lending, borrowing and leverage activities	Operating a cryptoasset lending platform
Safeguarding and /or administration (custody) activities	Safeguarding and/or administering (or arranging) a fiat-backed stablecoin, means of access to the fiat-backed stablecoin (custody), or other cryptoassets

The table above is indicative at this stage and could be amended in due course. Other activities may also be added. Note that the consultation paper also includes Calls for Evidence on a number of areas e.g. Decentralized Finance (DeFi) (but this is outside the scope of this article). The evidence gathered will then be used by the UK government to influence how it proceeds in those areas.

Other areas that may in future fall within the UK’s scope of cryptoasset activities to be regulated

Category of Activity	Indicative sub-activities
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 Using cryptoassets to run a validator node infrastructure on a proof-of-stake (PoS) network (layer 1 staking)

Cryptoasset Issuance and Disclosure Regime

The UK government proposes to establish an issuance and disclosure regime for cryptoassets that is modelled on the ‘UK Prospectus Regime’ (which is itself set to be reformed shortly) but tailored to the specific attributes of cryptoassets. The design of the regime borrows from existing TradFi regimes for ‘Multilateral Trading Facility (MTF)’ and public offer platform disclosures. The following actions will serve as the triggers for the operation of the future UK crypto regime:

Admitting (or seeking admission of) a cryptoasset to a cryptoasset trading venue; or

Making a public offer of a cryptoasset (including ICOs), which would need to be done via a regulated platform.

This means that listing a coin on a crypto exchange or conducting an Initial Coin Offering (ICO) will, in the future, be subject to the provision of a minimum standard of information, as well as other investor protection measures around marketing materials and advertisements.

An application for admission onto a trading venue (i.e., a crypto exchange) will need to be assessed in accordance with the venue’s detailed admission requirements, which will, in turn, be subject to overarching principles which the regulatory body, the Financial Conduct Authority (FCA), will set out. The issuer will need to make public disclosures akin to a prospectus – something the crypto sector is relatively familiar with (i.e., whitepapers). However, unlike whitepapers which may vary wildly in form and substance, a crypto issuance/listing disclosure document would have to provide a minimum set of information requirements, around:

the features, prospects, and risks of the cryptoassets
the rights and obligations attached to the cryptoassets (if any)
an outline of the underlying technology (including protocol and consensus mechanism)
if applicable, the person seeking admission to trading on a cryptoasset trading venue

Aside from the disclosure requirements to be imposed at the time of listing, there may be a need for ongoing disclosure requirements to be imposed on firms (such ‘continuing obligations’ are standard in TradFi for listed public companies). For instance, crypto firms may need to disclose key events such as Code Audits, changes to the way a cryptoasset functions (e.g., the recent Ethereum Merge), and so on.

Understandably, these disclosure documents will come with legal and regulatory liability attached for negligence or omissions. Controversially, however, where the cryptoasset in question doesn’t have an issuer (because it is generated by a public, permissionless blockchain platform such as Bitcoin), the exchange wishing to list it would need to prepare the disclosure documents itself and, importantly, assume liability. Assuming liability for untrue or misleading statements or for omissions may result in a disproportionate burden for exchanges since they have no control over such platforms.

Operating a Cryptoasset Trading Venue

The UK government proposes to establish a regulatory framework that is based on existing activities around regulated trading venues (e.g., the operation of an MTF). For TradFi, this is currently set out in the Regulated Activities Order (RAO), a key piece of secondary legislation in the UK financial services sector.

Once the activity of Operating a Cryptoasset Trading Venue becomes a regulated activity under the RAO, it means that any crypto exchange wishing to operate in the UK (or offer its services to UK customers) will require authorization by the FCA. Authorized firms will be required to meet various requirements, including the following:

Prudential requirements – minimum capital and liquidity requirements to meet both ‘going concern’ and ‘gone concern’ needs.

Consumer protection – managing conflicts of interest, handling customer complaints, and ensuring fair and transparent access rules and fee schedules.

Governance requirements – exchanges will need to have robust governance arrangements in place (unsurprising that this will have even greater significance going forward, given the ongoing FTX debacle).

Operational resilience requirements – systems & controls, people and processes, outsourcing arrangements, business continuity, disaster recovery arrangements, and cyber security.

Data reporting – capability to readily provide accurate and complete information for both on- and off-chain transactions.
Resolution and Insolvency – FCA participation in insolvency proceedings and potentially a bespoke resolution regime could be developed in the future (similar to that applicable to TradFi firms).

Cryptoasset Intermediation Activities

Naturally, for intermediation activities (e.g., market making), the proposals draw inspiration from existing RAO-based regulated activities in TradFi. For example, the TradFi activity of “arranging deals in investments” easily translates into “arranging (bringing about) deals in cryptoassets,” and so on.

However, there may be a need for additional requirements to address specificities of the crypto market, e.g., conflicts of interest may arise from more vertically integrated cryptoasset business models. This is because crypto exchanges tend to conduct activities other than purely operating a trading venue (such as custody, post-trade activities, proprietary trading, lending, issuance of own native cryptoasset, etc.).

Similar to the types of requirements that will be imposed on exchanges above, those firms wishing to engage in intermediation activities will need to meet requirements around authorization/licensing, prudential soundness (capital and liquidity, etc.), consumer protection & governance requirements (conflicts of interest, transparency, suitability), operational resilience, data reporting, as well as resolution and insolvency considerations.

It is worth noting that the concept of “best execution” – which is quite familiar to those involved in TradFi – will also extend to crypto, i.e., crypto firms will be required to take all reasonable steps to obtain the “best possible result for the client when executing a client order.”

Cryptoasset Custody

Unlike crypto exchanges and stablecoins issuers, previous public statements around the potential for crypto sector regulation have tended to focus less on custody. Therefore, it is especially welcome that the UK’s proposals for crypto regulation address custody directly. This is because, as the consultation points out:

“Custody represents one of the key aspects of the cryptoasset lifecycle in terms of providing investors access to, and safe storage of, their assets.”

To further buttress the need for robust regulatory requirements around custody, the consultation states:

“without clear and tailored regulatory standards to which firms are required to adhere, cryptoassets may not be safeguarded adequately, leading to risk of losses should the firm enter insolvency (either as a consequence of the assets being treated as assets of the firm or due to loss, fraud or operational errors). In addition to the harm to investors, an outcome that results in uncertainty in insolvency could also impact confidence in the market.”

The consultation indicates that crypto custodians will likely be required to ensure adequate arrangements to safeguard investors’ rights to their cryptoassets. Custodians will also need to establish clear processes for redress in the event that cryptoassets held in custody are lost.

However, perhaps disappointingly for retail customers in particular, the UK will likely fall short of requiring full liability in the event of loss of client assets. While the appropriate liability standards for custodians are still under consideration, the UK government is exploring taking an approach that may not impose full, uncapped liability on the custodian in the event of a malfunction or hack that was not within the custodian’s control.

Notwithstanding the probable absence of full liability, having clear rules in place which set out the circumstances under which custodian liability would exist and to what extent will be extremely beneficial. And in any event, this may open up competitive pressures on firms offering custody services to go beyond the regulatory minimum standards by establishing additional redress methods, e.g., via third-party insurance.

Firms providing custody services will need to meet requirements around authorization/licensing, prudential soundness (capital and liquidity, etc.), consumer protection & governance requirements (client disclosures, clear contractual terms, and whether Financial Services Compensation Scheme (FSCS) protection is available for claims – something the FCA will determine, operational resilience, data reporting, as well as resolution and insolvency considerations.

In addition, such firms will also need to meet custody-specific requirements around the safeguarding of client assets similar to those required of TradFi custody banks (set out in the FCA’s Client Assets Sourcebook (CASS)). These requirements aim to protect clients in both ‘going concern’ (i.e., investors’ rights to their assets) and ‘gone concern’ (to ensure that assets are returned to investors promptly and as whole as possible).

Operating a Cryptoasset Lending Platform

The recent failures of centralized crypto firms, Celsius, BlockFi, and FTX, have probably created the impetus for addressing crypto lending at this time. Firms engaged in lending activities are exposed to credit and liquidity risks, and yet cryptoasset lending and borrowing activities conducted by lending platforms typically fall outside the current regulatory perimeter.

Therefore, the UK government plans to introduce a crypto lending regime that will include requirements around effective risk management of collateral and contingency planning for the failure of participants’ largest market counterparties. To facilitate this, a newly defined regulated activity will be created for “operating a cryptoasset lending platform.”

However, in a curious break from the government’s stated design principle of “same risk, same regulatory outcome,” the proposed approach to crypto lending is not designed to achieve the same outcomes as those available in existing TradFi lending activities, e.g., FSCS protection, affordability assessments and forbearance periods.

For the future regulated activity of Operating a Cryptoasset Lending Platform, the UK government wishes to achieve the following outcomes:

“lending platforms should have adequate risk warnings for consumers lending to said platform (e.g., that the consumer could lose all their money, clarity on lack of FSCS protection)

lending platforms should have adequate financial resources – capital and liquidity – and wind down arrangements to carry out their business

lending platforms should have clear contractual terms on ownership and, if applicable, ringfencing of retail funds in case of insolvency”

The intention is to achieve these through a combination of requirements around authorization/licensing, prudential soundness (capital and liquidity, etc.), consumer protection (client disclosures, risk warnings, clear contractual terms including ownership of legal and beneficial title, collateral requirements and margin calls) governance arrangements and risk management processes, operational resilience, data reporting, as well as resolution and insolvency considerations.

General Market Abuse Requirements

Like TradFi, the crypto sector has attracted its fair share of inappropriate actors and behaviours. Suspicions and accusations abound of abuse of insider information and other market manipulation actions, e.g., so-called ‘rug-pulling.’

Further, given the lack of regulatory oversight, and the complexity of some crypto platforms, it can be argued that the opportunities for market abuse by project insiders and influential characters currently exceed tolerable or ‘acceptable’ levels.

The UK government admits that the globalized, fragmented, and borderless nature of crypto markets makes the policing of market abuse more challenging than for TradFi markets. Unlike, say, equity and fixed income markets, where there are specific, concentrated markets where the majority of trading occurs, there are hundreds of crypto exchanges around the world on which thousands of crypto tokens are traded.

The consultation proposes a Cryptoassets Market Abuse Regime, which imposes obligations on certain market participation, e.g., exchanges (cryptoasset trading venues) that would be expected to “detect, deter, and disrupt market abusive behaviours.” That is, an exchange would be expected to identify offenders, share information with other exchanges that list the same cryptoassets, and publicly blacklist offenders.

The UK hopes that, by placing such significant market abuse obligations on exchanges rather than on the FCA, exchanges would be incentivized to develop innovative technological approaches for detecting market abuse behaviours in the crypto sector.

Below is a summary of the proposed design features for a Cryptoasset Market Abuse Regime.

Scope of offences – similar to TradFi markets, civil law offences of market abuse would include insider dealing, market manipulation, and unlawful disclosure of inside information.

Enforcement mechanism – exchanges to be required to have processes for disrupting occurrences of market abuse activity in their own marketplace.

Obligations on trading venues – these may include Know Your Customer (KYC) requirements, public blacklists, order book surveillance, submission of suspicious transaction and order reports (STORs), use of blockchain analytics, ongoing public disclosures, etc.

Obligations for other market participants – all regulated crypto firms could be required to disclose inside information and maintain insider lists (this is stricter than TradFi, where only issuers are required to do so).

Requesting the admission of a cryptoasset to a UK cryptoasset trading venue will be the regulatory trigger point for the application of the Cryptoasset Market Abuse Regime. The regime would apply regardless of whether the market abuse activity takes place within the UK or overseas.

In Conclusion,

The proposals for crypto regulation represent a fundamental shift in the UK’s public policy approach to the nascent crypto sector. In addition to stablecoin issuers (for which the legislative process is already underway), the focus on exchanges, custodians, intermediation, and lending activities makes sense.
As a jurisdiction seeking to establish itself as a major crypto centre, the UK’s proposals should be welcomed as a critical step in establishing a comprehensive regulatory framework for the financial services aspects of crypto.
The proposed approach of regulating activities (rather than seeking to regulate the assets themselves) is hugely positive and maintains uniformity with the regulation of traditional finance activities. It also avoids a damaging attempt to regulate cryptoassets generated by decentralized, public, and permissionless platforms.
That said, the proposal to require exchanges wishing to list issuer-less assets (e.g., Bitcoin) to not only prepare disclosure documents but also assume liability for the accuracy of the information is arguably excessive.
Finally, the proposals are a hugely positive action that seeks to balance the desire to place crypto within the existing UK financial services regulatory framework (legalism), the principle of achieving equivalent regulatory outcomes vis-à-vis traditional finance regimes (ideology), and the need to take account of novel features of crypto’s technology and sectoral idiosyncrasies (pragmatism).