HM Treasury posed twelve questions in their main consultation on regulation of financial promotion of cryptoassets. In essence the plan is to regulate cryptoasset promotion like other investments, so they need to be made or approved by an authorised person, or an exemption needs to apply. Here are the questions, with our responses:
Q1: Do you have any comments on the proposed definition of qualifying cryptoassets?
HMT defines a “qualifying cryptoasset” as “any cryptographically secured digital representation of value or contractual rights that uses a form of distributed ledger technology and which is (a) fungible; (b) transferable or confers transferable rights, or is promoted as [such]; (c) not any other controlled investment; (d) not electronic money; and (e) not currency issued by a central bank.”
Many believe that cryptoassets will develop to rival traditional securities. However, for the foreseeable future (5-10 years) the cryptoassets sector is very small by comparison, and it is too early to consider regulating cryptoassets as traditional financial services. Cryptoassets are a new asset class with new technology which must be treated in an appropriate manner relative to other financial sectors. The total value of all cryptoassets is $393 billion. In the UK over the past year cryptoasset holders have increased from 3.5% to 5.35%, or 1.5 million to 2.6 million people. These numbers are miniscule compared to retail holdings of traditional securities.
Secondly, the two key definitions of fungibility and transferability are too broad and do not futureproof the dynamic nature of the technology and industry.
There are fundamental differences between an exchange or payment token, a security token and a utility token. While some have speculative reasons for buying utility tokens, that wasn’t what they were designed for. We would like a more appropriate definition of “qualifying cryptoasset”.
The government views supermarket customer loyalty tokens as falling out of scope of regulation as they would not be freely transferable outside the system. However, one could envision a scenario where a company offers digital tokens or vouchers to its customers, initially within the company’s ecosystem as a discount or means of payment. Later it may partner with another company, to enable the token to be moved across platforms, or transferred from one holder to another. This concept is not very far off and currently under trial.
Many digital assets that appear to be fungible can actually be non-fungible. One token may appear like a £5 note in that it cannot be differentiated as a means of payment, unit of account or store of value. However, unlike the history and operation of the £5 note, with cryptoassets every transaction and destination (wallet address) is coded into the blockchain, so every Bitcoin token is different as each history is unique. Bad actors could add design features to appear non-fungible and avoid regulation. Encompassing cryptoassets that have yet to be defined is hasty, may stunt innovation and make the UK uncompetitive.
Q2. Do you agree that the correct tokens have been excluded?
Further clarity should be provided. There is no mention of hybrid tokens. These may start life as a security token, then become a utility token. The SEC has provided a “safe harbour” policy to support development of the sector. As utility and exchange tokens are unregulated they should be treated in a similar fashion to spot FX. The additional compliance burden on smaller firms drives out competition. There is a real danger of unintended consequences. It is crucial for the UK to be competitive particularly as it has become the world’s fintech capital with deals of £4.525 billion in 2019.
Q3: Which of the controlled activities correspond most closely to those undertaken by cryptoasset firms?
The government considers most relevant controlled activities are:
- Dealing in securities and contractually based investments
- Arranging deals in investments
- Managing investments
- Advising on investments
- Agreeing to carry on specified kinds of activity
Exchange and utility tokens are currently unregulated. The government proposes to add certain unregulated cryptoassets to the list of controlled investments.
This would create a 2 tier system between regulated and unregulated cryptoassets. MiCA is all encompassing compared to the piecemeal UK approach. MiCA would bring clarity, consistency and a level playing field. The UK approach may have the opposite effects, create confusion and add unnecessary resource requirements.
We could end up with multiple regulatory inconsistencies. The FX spot market is not regulated in the UK. The ability to swap one currency for another could be impeded for cryptoassets. The FX Spot market is self regulated through the Global FX Committee operating the FX code of conduct. Initial UK financial services regulation involved extensive use of SROs and this structure made for better regulatory communication than in many respects exists today.
Q4: Do you agree that the list of controlled activities best captures the activities of cryptoasset firms?
We broadly agree the list best captures the majority of crypto participants. However, “agreeing to carry on specified kinds of activity” is too broad and needs additional guidance.
Offshore firms targeting the UK may attempt to fall outside the proposals through direct emails, social media and web advertising. Proposals need to be equivalent to other jurisdictions, but the EU MiCA proposals are more comprehensive.
There is no mention of DeFi which uses blockchain technology for smart contracts.
Q5: Would the activities described fall within scope of the FPO if the controlled activities applied to cryptoassets? Are there other important cryptoasset activities that pose similar risks?
The consultation lacks a forward looking approach.
DeFi experienced explosive growth in 2020, total value today exceeding USD 12 billion. DeFi can lower costs, and increase security, privacy, and accessibility. The ability to borrow funds, save funds, or trade financial products, without asking for permission, is gaining traction, in stark contrast to bank account opening times.
Many DeFi platforms have adopted incentive mechanisms, which has caused DeFi asset values to surge. DeFi’s accessibility may widen availability of credit and investment opportunities to the financially excluded.
Today, for borrowers to access DeFi loans is impractical, unless they already own crypto, and the level of knowledge to use protocols, can bring risks. There are risks of slow blockchain throughput and high transaction fees, liquidity, security and smart contract risk related to theft risk, or code bugs enabling price manipulation.
Regulatory risk also exists. Some DEXs are truly decentralised, so creators are pseudonymous and jurisdictions impossible to discern, making enforcement challenging.
DeFi protocols are permissionless, allowing anyone to access them. Regulators are concerned that DeFi could be exploited. However, DeFi could be partially permissioned, using decentralised methods to authenticate identity and block inappropriate users and trades.
Q6: Do you have any other comments on the proposed treatment of controlled activities?
Certain parts of the consultation have a “cut and paste” approach from MiFID and FSMA, which is akin to forcing a square peg into a round hole. We welcome regulatory clarity but caution against using existing traditional frameworks where a bespoke solution would be better.
Q7: Do you have any views on the government’s proposed treatment of exemptions (i.e. consistent with other investments so those offering cryptoassets for goods and services are not covered)?
We agree with the goods and services exemption. Cryptoassets are already used to pay school and professional fees. There are bitcoin ATMs. However, there is an inconsistency. Bitcoin, for example, is generally seen as a means of exchange, unit of account and a store of value, similar to fiat currency, whereas, proposed treatment is as a controlled investment.
We would like to see further limited exemptions, making clear that where the purpose of an unregulated token is to facilitate payment, advertising should not be subject to the financial promotions regime.
Designating cryptoassets as specified investments would require a firm to become authorised to deal in them. Further analysis is required to determine whether this is appropriate, proportionate and necessary.
Q8: Do you agree with the government’s assessment of cryptoasset risks, as in the Cryptoassets Taskforce report?
We work hard to address risks through collaboration, education, media outreach and development of standards, with market participants, policymakers and regulators.
Without consumer confidence, a market cannot exist, but inappropriate regulation can have unintended consequences such as participants moving offshore, the UK becoming uncompetitive globally, and regulation not having the intended effect.
We were surprised by the recent ban on sale of cryptoasset derivatives and exchange traded notes to retail customers. We are not convinced they are really any different to similar alternative asset products which have not been banned for sale to the UK’s many sophisticated retail investors. We do run appropriateness and suitability tests.
We question the quantitative versus qualitative nature of this conclusion. The underlying research is flawed through having no control element. Research against other retail financial instruments is needed. Some conclusions are based on anecdotal evidence. We need to see a proper Regulatory Impact Analysis (RIA) undertaken.
We disagree with FCA that there is no legitimate investment purpose for cryptoasset derivatives. Derivatives have been traded in the UK since the 19th century and have been of great benefit. They transfer risk from those who don’t want it to those who do, like insurance. An investor may hedge against a spot position in a fiat currency and wish to hedge against exposure to cryptoassets. Any ban thus needs careful consideration. It also sends a negative signal about the UK’s stance on cryptoassets, as well as derivatives.
FCA’s move is drastic and blunt. Alternatives, such as implementing leverage limits, should be explored. Cryptoassets have been unfairly singled out as compared to other alternative retail investment, without a proper RIA.
Q9: Do you agree with the government’s assessment of alternative policy options?
- Take a slower, stepped, and measured approach in introducing regulation to reduce unintended consequences (uncompetitive / market moves offshore / no appropriate impact). Require clear language and a transparent framework, like the gaming industry “gamble responsibly”. Clear and prominent risk warnings could be an easy, proportionate and effective approach.
- MiCA proposes promotions be submitted to the regulator before publication without waiting for approval as proposed by HMT. We need EU equivalence for markets to access each other smoothly.
- We could form an institution that is fee based, understands crypto assets and does not have a conflict with approving marketing campaigns.
Q10: Do you have any views on the government’s proposal not to provide for a transitional period?
We feel a short transition period of 3-6 months and a longer implementation period to iron out wrinkles would benefit all concerned.
Q11: Do you have any views on the proposed approach to territoriality.
Q12: Do you have any additional comments to make on the proposed approach?
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