On 30 October 2023, HM Treasury (“HMT”) published 3 key updates on its proposed approach to regulating cryptoassets under the UK’s financial services regulatory framework, namely:
Together, these publications represent a significant step in HMT’s development of a comprehensive regulatory regime for cryptoassets, which HMT rightly regards as being of fundamental importance in delivering on its stated ambition for the UK to become a global hub for cryptoasset technology – a central tenet of its broader ambition for the UK to be home to the most open, well-regulated, and technologically advanced capital markets in the world.
We set out our high level summaries of each publication below and will follow up with more detailed analysis of key issues in subsequent articles.
(i) An update on the future regulatory regime for cryptoassets – HMT’s response to the February 2023 consultation and call for evidence
This publication set out HMT’s responses to the feedback it received as part of its February 2023 Consultation, which set out a wide and comprehensive range of proposals to bring cryptoasset services within the scope of UK financial services regulation. Our original article on the February 2023 Consultation can be found here.
By and large, the response confirms that HMT intends to adopt most proposals from the February 2023 Consultation without modification, although it is clear that HMT has listened to the consultation responses from industry and there are some important adaptations and clarifications in this regard.
While the document itself is extensive and worth reading in full, we have summarised some key takeaways below.
- Assets and activities
- Although a majority of respondents felt the proposed definition of “cryptoasset” was too wide, HMT stated it still intends to proceed with its original definition, noting that it was intentionally broad to allow HMT and the FCA to adapt and apply regulation to the new types of cryptoassets as and when they are created, and that only cryptoassets used in or for one of the regulated activities identified by the new regime would be in scope.
- HMT confirmed that only activities related to (i) issuance; (ii) exchanges; (iii) investment and risk management; (iv) lending, borrowing, and leverage; and (v) custody would be considered regulated activities under the new regime.
- Cryptoasset types
- With regard to specific token types, HMT confirmed its proposed approach for security, utility, and asset-referenced tokens, NFTs, and algorithmic stablecoins and crypto-backed tokens, and whether and how each would be regulated.
- Territorial scope
- HMT also confirmed it will proceed with the proposed territorial scope of the new regime, and that the regime will apply to services provided “in or to” consumers in the United Kingdom. Together with HMT’s confirmation that the overseas persons exemption (“OPE”) will not apply to cryptoasset activities, this represents a fundamental departure from and broadening of the territorial scope of the financial services regulatory regime for traditional asset classes and raises questions around the intended interaction with the financial promotions regime and the concept of reverse solicitation, which the industry will be eager for further clarification on.
- While HMT acknowledged the importance of equivalence or deference arrangements, it also felt that conditions required for such deference/equivalence arrangements were not yet in place, but confirmed that it intends to cooperate with international bodies and standards to eventually create such arrangements.
- Given this, HMT noted that an approach is required that will facilitate access to global liquidity pools under specific circumstances, for example where the global liquidity pool is being operated in a jurisdiction which is meeting international recommendations and standards. This would apply on a time-limited basis for the interim period before appropriate equivalence/deference type arrangements are in place. The development of this approach in subsequent legislation and in FCA rules and guidance will be of particular interest to the industry.
2. Regulatory approach
- Cryptoasset services as financial services, not as gambling
- HMT directly addressed the Treasury Select Committee’s recommendation to regulate cryptoasset services as gambling and calls to ban cryptoassets entirely, stating that both approaches would run counter to globally agreed recommendations and fail to address other risks associated with the industry.
- Phases 1 and 2
- Consequently, HMT confirmed its adherence to the phased approach as set out in the February 2023 Consultation, and that it would initially regulate only fiat-backed stablecoins in Phase 1, before regulating cryptoassets captured by the proposed regime generally in Phase 2.
- To address requests for clearer timelines and expedite the overall implementation process, the government's objective is to present Phase 2 secondary legislation in 2024, pending Parliamentary availability. HMT did not comment on the timeline for Phase 1.
- Cryptoasset service firms already registered with the FCA under the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (“MLRs”) will need to seek authorisation from the FCA under the new FSMA-based regime.
- Firms with existing permissions (i.e. current FSMA authorisations or Phase 1 authorisations for the corresponding activities) may apply to vary their permissions to engage in Phase 2 activities.
3. Specific rules
- Issuance and disclosure
- HMT will continue with its proposed approach for disclosure documents and which will be in place for all cryptoassets which are made available for trading on a UK cryptoasset trading venue (whether or not there is an identifiable issuer). However, firms will be able to use publicly available information in preparing the documents.
- Disclosure content requirements should be defined by venues, however HMT intends to use a “necessary information” test as a starting point and supports the idea of industry associations to coordinate this effort with FCA oversight. Liability, including for any and all cryptoassets listed on exchanges, will rest with the firm which prepares the documents, and HMT expects this will result in the delisting of some tokens.
- Intermediation activities
- HMT intends to define a whole new set of activities specifically relating to the intermediation of cryptoassets, and certain requirements (e.g. disclosures, appropriateness checks) will differ for intermediaries dealing with eligible counterparties, following the “same risk, same regulatory outcome” approach.
- A new regulated activity will be created in relation to cryptoassets, although it is unclear whether firms with this permission currently will need to go through a VOP to carry on this activity moving forward.
- Insolvency and restructuring
- HMT plans to implement the insolvency provisions outlined in Part 24 of FSMA. These provisions grant the FCA equivalent rights to safeguard consumers of crypto firms and allow the FCA to participate in standard insolvency processes like administration and liquidation, as it does for FSMA authorised firms and payment/e-money firms.
- Market Abuse
- The government intends to take forward most aspects of the proposed approach set out previously, including the suggested scope of the regime, the regulatory trigger points, and the use of MAR as the basis for the regime including the prohibitions, although it acknowledged the need for a staggered approach for exchanges.
- Cryptoasset Lending
- A new activity of operating a cryptoasset lending platform will be brought within scope.
- HMT envisages a different regime for retail and wholesale, in line with its view that wholesale lending in the crypto space is akin to securities lending, rather than cash lending. This will be a particularly welcome clarification for the industry.
- HMT recognises that regulating DeFi activities in the UK at present would be premature and ineffective. Instead, HMT will actively engage at the international level with both foreign regulators and the industry through the Financial Stability Board (FSB) and standard setting bodies (SSBs) to inform future domestic regulatory frameworks.
- Mining and Validation Activities
- In alignment with feedback from the February 2023 Consultation, HMT has no plans to regulate cryptocurrency mining as a controlled activity currently.
- HMT is aware of industry concerns in connection with staking and recognises the importance of clarifying the future regulatory treatment of staking in the UK. To address this, they are expediting exploratory work, engaging extensively with stakeholders, and outlining specific steps, which include:
- Crafting a precise definition of cryptoasset staking on a PoS blockchain.
- Establishing a classification system for the various PoS staking business models.
- Identifying ways to mitigate associated risks and take advantage of benefits of staking.
- HMT intends to carve out certain manifestations of staking from the CIS definition, or alternatively introduce a regulatory regime for “operating a staking platform” outside of the CIS framework.
- These proposals will be particularly welcomed by industry, with staking representing an ongoing pain point in terms of regulatory uncertainty.
- HMT has confirmed that it will proceed with the approach of tackling sustainability issues primarily through disclosures in the first instance. However, HMT will continue to monitor developments in the industry to consider if a bespoke regime would be suitable.
(ii) Update on plans for the regulation of fiat-backed stablecoins
This update provides details of HMT’s plans to regulate the use, issuance and custody of fiat-backed stablecoins in UK payment chains (as part of Phase 1 of HMT’s general approach to cryptoasset regulation), and builds on the Consultation Response published in April 2022 (which we covered here). HMT intends to bring forward secondary legislation by early 2024 (subject to the availability of parliamentary time).
The proposed FCA regime
In this update, HMT confirmed the following details about the proposed inclusion of fiat-backed stablecoins within the FCA’s regulatory perimeter:
- The definition of “fiat-backed stablecoin” will not include (and hence the regime will not regulate) non-fiat backed stablecoins, unbacked stablecoins, algorithmic stablecoins, commodity-linked tokens, tokenised deposits or e-money;
- The activities of issuance and custody of UK-issued fiat-backed stablecoins, as well as of operating a cryptoasset venue, will be included in the RAO, allowing the FCA to extend its supervisory powers over these activities;
- The Payment Services Regulations 2017 will be amended to cover mixed and pure stablecoin payments and will apply if:
(i) the transaction involves UK customers; or
(ii) a UK firm facilitates the transaction(s);
- An “arranger” structure is being considered as a possible avenue for overseas stablecoins to be used in UK payment transactions;
- Payment arrangers may be required to report the number of transactions to the Bank of England (“BoE”) and the FCA;
- The FCA/BoE may require backing assets to be held in a statutory trust; and
- In the case of firm failure for issuers and custodians, the Insolvency Act 1986 will apply and the Financial Market Infrastructure Special Administration Regime will apply in the event of a failure of a systemic Digital Settlement Asset (“DSA”) issuer.
The BoE & Payment Systems Regulator (“PSR”) regimes
- The BoE will set requirements for operators of and service providers to systemic DSA payment systems and service providers. Further details will be set out in the BoE’s discussion paper.
- Similar to the BoE, the PSR will have powers to regulate DSA payment systems.
- Systemic fiat-based stablecoin firms will be supervised by the BoE and will also be regulated by the FCA for conduct. There may be instances where the PSR is also responsible for regulating these firms for competition, innovation and access purposes.
- Further details of this co-operation will be set out in a memorandum of understanding.
(iii) Government outlines plans for handling the failure of systemic DSA firms
In conjunction with the details on Phase 1 fiat-backed stablecoin regulation set out above, HMT also published its response to its consultation on managing the failure of DSA (including stablecoin) firms (the “May 2022 Consultation”), which ran until August 2022 and contained four key proposals:
- To apply, with amendments, the existing Financial Market Infrastructure Special Administration Regime (“FMI SAR”) to systemic DSA firms.
- To establish an additional objective for the FMI SAR, as it applies to systemic DSA firms only, focused on the return or transfer of customer funds and custody assets, similar to that found in the Payments & Electronic Money Special Administration Regime (“PESAR”).
- To provide the BoE with the power to direct administrators of a failing firm and to introduce further regulations to ensure that the additional objective can be effectively implemented.
- To require the BoE to consult with the FCA prior to seeking an administration order or directing administrators.
While the majority of respondents supported the proposals, key stakeholder feedback was as follows:
- Some respondents suggested that a bespoke regime may be more appropriate in the longer term, or that the FMI SAR should be an interim measure until a more tailored regime is developed.
- Around a quarter of respondents asked for further clarity on the additional objective, including on how the return or transfer of customer funds and custody assets will function.
- Some respondents questioned how funds would be returned with regard to timing and form (e.g. in fiat currency or over the blockchain), what the BoE will have regard to when directing an administrator and the need for clearer definitions around terms such as customer funds.
- Some respondents asked for further detail to be provided on the process of the BoE consulting with the FCA.
Government Response and Next Steps
As part of its response to concerns raised, HMT noted that it may conduct further work to consider whether a bespoke legal framework for the failure of systemic DSA firms would be appropriate. However, HMT considers it important to ensure an existing legal framework can be applied in the shorter-term. HMT also confirmed that it intends that regulations will be drafted broadly to allow for the return of funds or assets to be in the most appropriate form, which may include fiat currency, DSA, or another cryptoasset (or a combination).
Moving forward, HMT intends to develop two core products:
- HMT initially intends to lay regulations which implement the policy intent described in the initial consultation regarding the overarching framework.
- HMT will provide further clarity on the operation of the FMI SAR to make requisite insolvency rules. This will cover the detail and mechanisms underpinning how the regime is intended to operate.
The BoE will also consider whether further guidance on the operation of the FMI SAR is necessary in the context of its finalised going concern regime and update stakeholders at the appropriate time.
The detailed considerations and proposals set out in the three publications are indicative of the government’s acknowledgement that cryptoassets, and their related services, are set to be a permanent and indeed prominent part of financial services in the UK. If you or your firm would like further guidance on any of these updates and how they may affect your business, please speak to one of our experts.