Crypto regulation – where are we now?

Neil Swift, James Tyler, and Michał Chajdukowski at Peters & Peters Solicitors LLP describe the UK government’s current plans to regulate the crypto sector

On 1 February 2023, HM Treasury published a report on crypto-assets Future financial services regulatory regime for crypto-assets: Consultation and call for evidence proposing a new, and comprehensive regulatory regime.

As the applications of technology associated with crypto, such as blockchain, and products aimed at investors such as coins and tokens have become increasingly mainstream, the government’s plans to regulate the sector should be welcomed by crypto-sceptics and enthusiasts alike.

The consultation also brings a degree of certainty and clarity regarding the government’s intentions for the industry, even if the final outcome will pose a challenge to the sector.

Why now?

The UK government’s intention to regulate has formed very late in the day. From the course of the legislation enabling the regulation of crypto, the Financial Services and Markets Bill, one can see that the government initially intended to regulate only how crypto products were promoted.

The original legislation was tabled on 22 July 2022 and the government’s amendment laying the ground for a fuller scheme of regulation was proposed only in October of the same year, shortly after Rishi Sunak, a loud supporter of the UK’s crypto-sector, became Prime Minister. (Full details of the progress of the Financial Services and Markets Bill can be followed on the UK Parliament’s website.)

In addition to the change in Prime Minister, the most obvious explanation for this change of course is the collapses of various crypto-connected entities in the USA which started in 2021 and culminated in the FTX scandal in late 2022.

The collapse concerned a number of pillars of the crypto-verse. This was seen most obviously with the collapse of the large crypto exchange FTX, which was preceded by the demise of stablecoins such as Terra-Luna and Tether, and followed by the bankruptcy of a number of brokerages and funds exposed to FTX and the subsequent market contagion. 

Particularly concerning to regulators and policy makers, were the allegations which followed these events. For example, Tether was fined $18.5 million, ordered to cease trading with New York state residents and made subject to reporting provisions by the New York Attorney General in February 2021 for misleading investors in claims that its coin was fully backed by US Dollars. The company was subsequently fined $41 million by the United States Commodities Futures Trading Commission on similar grounds.

The litany of allegations against FTX are of course, well-known: misuse of investor deposits; large loans to the company’s founders; near-absent record keeping; and, with respect to its founder Sam Bankman-Fried, fraud.  

These illustrate the vulnerability of the sector, arising from a lack of scrutiny and a susceptibility to contagion, a consequence of the connected nature of the entities, poor risk management, and high rates of vertical integration within businesses. It also demonstrated to policy makers the scale of consumer harm the industry might cause if not properly managed. 

What protections will the new regime offer?

From the consultation, it appears that key protections have been highlighted as missing by recent events: these include segregation and oversight of client deposits, effective systems and controls to manage risks and prevent defaults, and scrutiny of senior managers of firms.

Similarly, the consultation proposes some plans to identify and combat market abuse, such as pump and dump scams and insider trading.

However, as important as the specific form the regulation will take is the scrutiny that regulated crypto firms will, in theory, be subject to. When firms seek Financial Conduct Authority (FCA) authorisation, the FCA will be able to consider the competence and integrity of their senior management and matters such as the nature of their commercial relationships with counterparties and connected entities.

In particular, the FCA will want to identify issues such as concentration of exposure to market volatility and credit risk. The regulator will also expect firms to provide detailed plans for the prevention of financial crime and for ensuring that consumers are treated appropriately.

Firms will almost certainly be subject to the FCA’s new consumer duty, which comes into effect on 31 July 2023. This will include an obligation on a regulated firm to avoid causing foreseeable harm to consumers.

This is a broad duty and one which, the FCA considers, includes foreseeing a firm’s customers falling victim to scams, and the distribution of products to consumers for whom they were not designed. (See, for example, the FCA’s finalised guidance FG22/5.)

What does this mean for market participants?

For many, the weight and cost of the new regulatory burden will come as a shock and may push smaller firms out of the market entirely. 

There are also some concerns that, due to the broad scope of the new legislation, the types of firms that will be caught by the regulation are not wholly clear. (HM Treasury’s consultation response on crypto-asset promotions, which concerned the same statutory definitions, in July 2022 (Section 1 of Annex A on page 19), accepted that the application of the rules may, for some firms, may have to be determined on a case by case basis.)

On the other hand, the changes will recognise that the sector has an important role in, and is being absorbed into, the traditional financial services sector.

The FCA’s track record of oversight of crypto is patchy. The registration of crypto providers, a requirement of the money-laundering regulations imposed in 2020, was a debacle.

However, its subsequent conduct, particularly in respect of preventing the registration of firms it considered unfit, has been notably robust and proactive. (See, in particular, Vladimir Consulting Limited v The Financial Conduct Authority.)

However, when considering any plan to regulate the sector, it is important to acknowledge that the boom in consumer investment in crypto-assets is tailing off. What comes next, whether it is central bank digital currency, or something wholly unpredicted, is anyone’s guess: who could have anticipated the boom in non-fungible tokens?

What is, therefore, important is that any new regulatory scheme can adapt and innovate.

The consultation has already shown HM Treasury’s willingness to take a flexible approach to the sector. It accepts that the regulatory regime for crypto will be separate from the traditional form and tailored to the industry.

However, although based on a statutory framework, the rules applied will be created by the FCA. The regulator’s willingness to keep up with innovation in the market is unproven. Similarly, whether the FCA has the knowledge and expertise to exclude bad actors and foster innovation remains to be seen.

Likewise, should there be a change in government following the next UK parliamentary election, the strong political will behind this bout of regulation may not remain. 

The authors of this article are Neil Swift, Partner, James Tyler, Senior Associate, and Michał Chajdukowski, Associate, at Peters & Peters Solicitors LLP

Main image courtesy of iStockPhoto.com