Government Advances Financial Services Regulation for Cryptoassets

Introduction

HM Treasury has recently published the U.K. government’s response to its consultation document circulated in July 2020. The response also included additional feedback received from the public, trade bodies and firms.

The consultation was initiated by the U.K. government to consider its proposals to create new rules regarding the “financial promotion” of certain additional groups of cryptoassets in order to protect consumers, acknowledging the rising ownership of crypto products.

Financial promotions

It is acknowledged that consumers’ deliberations when purchasing financial products are heavily influenced by the information they receive when such products are marketed to them. These purchases can be particularly risky when they involve financial service products due to the often complex and long-term nature of such products. As such, consumers are heavily influenced by the content and nature of information they receive in financial promotions. The restrictions on the making of financial promotions under the Financial Services and Markets Act 2000 (“FSMA”) seek to address such risks.

Financial promotions can take many forms, including adverts in print, broadcast or online media, marketing brochures, emails, websites or social media posts. Restrictions regarding the making of financial promotions to people in the U.K. have a wide reach and provide that a person must not, in the course of business, communicate an invitation or inducement to engage in investment activity or claims management activity unless it is authorised by the Financial Conduct Authority (“FCA”) or the Prudential Regulation Authority, the content is approved by a firm which is so authorised or an appropriate exemption applies (such exemptions being set out in the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (SI 2005/1529) (“FPO”).

Communicating a financial promotion in breach of U.K. legislation can be a criminal offence and the new proposals seek to align promotion of certain cryptoassets to the existing legislation or otherwise amend such legislation accordingly.

Although financial promotions made to those outside the U.K. is generally exempt from U.K. legislation, local securities laws in the recipient’s host country will also need to be considered on a case-by-case basis.

Background

In February 2018, Parliament’s Treasury Select Committee published a report into digital currencies, the impact of distributed ledger technologies and how regulation may protect consumers. In response Brown Rudnick partner Neil Foster co-authored a white paper, along with a group of leading business figures, in response to that report – “Response to The Treasury Select Committee Report on Regulation of Crypto-Assets” (October 2018). The Treasury Select Committee’s report was then followed by a further report in 2018 by the “Cryptoassets Taskforce,” which comprised HM Treasury, the FCA and the Bank of England.

In the Cryptoassets Taskforce’s report, concern was expressed about the proliferation of misleading advertising in the marketing of crypto products and lack of suitable information to consumers to enable them to make fully informed decisions. In particular, the Taskforce noted that such advertising often overstated certain benefits while not appropriately warning consumers of the corresponding risks. Foster provided further commentary on the report – “Crypto-Assets in the UK - 2018 Roundup and 2019 Outlook” (January 2019).

As we noted in our guide to cryptoasset regulation in the U.K., most cryptoassets are currently unregulated in the U.K. The FCA currently classifies cryptoassets into four types of tokens:

• “security tokens,” which meet the definition of a "specified investment" in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 – these are regulated;
• “e-money tokens,” which meet the definition of "electronic money" in the Electronic Money Regulations 2011 – these are regulated;
• “exchange tokens,” which have no central issuer and are used as a means of exchange such as Ether or Bitcoin – these are unregulated; and
• “utility tokens,” which can only be exchanged for a specific product or benefit within a particular environment – which includes loyalty schemes represented with tokens – these are unregulated.

What is now being proposed?

HM Treasury is now seeking to introduce secondary legislation to further amend the FPO to require anyone promoting investments and activities relating to certain new categories of “qualifying cryptoassets” to be regulated. Such secondary legislation will be implemented when parliamentary time allows.

The new definition of “qualifying cryptoassets” will cover any cryptographically secured digital representation of value or contractual rights that is both ‘fungible’ and ‘transferable’ (and excluding electronic money as defined in the Electronic Money Regulations and currencies issued by a central bank or public authority). Looking at this definition in a little more detail:

1. “Transferability” – it must be possible to transfer the cryptoasset to another person. However, the government will expressly exclude certain tokens such as travel passes, lunch passes and supermarket loyalty schemes, for example, that are cryptographically secure and do not pose a risk to consumers. In addition, such exclusions will differentiate between tokens used only for payment purposes to one or more sellers (which fall outside the definition) and tokens that can be traded for speculative purposes (which will fall within the definition).
2. “Fungibility” – this means the cryptoasset must be exchangeable for another cryptoassets of the same type. An obvious example of this would be a cryptocurrency where one Bitcoin could be easily exchanged for another Bitcoin. However, non-fungible tokens (“NFT”) such as digital works of art) cannot be readily exchanged for similar NFTs (such as an identical work of digital art) and therefore wouldn’t fall within this new regime. It should be noted that “wrapped tokens” (where a fungible token is wrapped in a NFT) will be assessed on a case-by-case since some of these may present key characteristics of fungibility if it could be exchanged for similar tokens.

A cryptoasset will not need to use distributed ledger technology to fall within the definition of a “qualifying cryptoasset.” It is believed that this should “future-proof” the definition to allow for innovations in the technology that underlies the cryptoassets since, while most cryptoassets do use DLT at this time, this may change in the future.

The government is keen to stress that the proposed definition is subject to the final drafting of the legislation. However, it is hoped that the proposed definition will give the industry an indication of how the government expects the new regime to be implemented to allow it to prepare accordingly.

It is worth also noting that two of the exemptions from the FPO regime, being promotions to the “certified high net worth individual” or “self-certified sophisticated investor,” will not apply to such cryptoassets. The exemptions for investment professionals, communications to journalists and communications to overseas recipients will continue to apply.

The consultation and report also considered if ‘cryptoasset lending’ and ‘decentralised finance’ should be captured by the changes to the FPO:

1. Cryptoasset lending has grown significantly since the initial publication of the HM Treasury consultation document and is where a firm hold cryptoasset deposits and pay ‘interests’ on such deposits based on the income the firm receives from cryptoasset borrowers. The government concluded that such activities are already covered by existing legislation.
2. Decentralised finance platforms take the form of decentralised apps, which are not controlled by any form of central authority. Such apps use smart contracts to automate transactions, facilitating peer-to-peer lending and peer-to-contract lending, borrowing or trading with financial instruments on a permissionless network. An example of this is a platform which enables users to earn interest on their tokens by connecting token holders to other borrowers. The government concluded that certain decentralised finance platforms may be in the scope of the regime, but these would need to be assessed on a case-by-case basis.

Following the FCA publishing its own updated rules and the publication of the amended FPO, there will be a transitional period of approximately six months before the new regime comes into force.

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