Regulating Cryptoassets in the UK

There can be no doubt that there has been a shift in our everyday lives towards a cashless society. This has been hastened by the easy access to technological advances through the omnipresent mobile phone and the pandemic creating a greater aversion to physical cash. As digital payments increase in frequency and become commonplace, it is incumbent on governments to regulate the sector and on regulators to keep up with the technological developments.

The recent crash in the value of numerous cryptocurrencies brought home the potential for volatility in the market and the risks associated with investing in cryptoassets. Governments around the world are looking at ways to capitalise on the boom in cryptoassets, while managing the risks to their economies that could result from close links to the crypto ecosystem.

In this Advisory, we look at the efforts of the UK in regulating this sector.

Key Definitions

Cryptoasset is the catch-all term for digital assets that use cryptographic technologies in their operation. The most common are cryptocurrencies and non-fungible tokens (NFTs).

Cryptocurrencies are digital, decentralised currencies which are created and administered by private companies.

NFTs are digital assets which represent real-world objects, such as art, music or videos. Each NFT is unique.

Stablecoins are cryptoassets which are “tethered” to the value of real-world government issued (or fiat) currency such as the US dollar, with the intention that they should be more stable in value than other types of cryptocurrency.

Innovation in the UK

The UK government has announced its intention to introduce regulation for stablecoins in the UK, by amending the Electronic Money Regulations 2011 and the Payment Services Regulations 2017. The intention is to deliver a world-leading regulatory regime for stablecoins, and to fulfil the government’s aim of placing the UK’s financial services sector at the forefront of cryptoasset technology and innovation. This ambition is not surprising, given the huge growth in interest and investment in cryptoassets, both in the UK and worldwide, which even the recent crash is unlikely to dampen in the long term.

In order to balance some of the economic risks of allowing stablecoins into the UK market, it was announced earlier this month that the Bank of England is being lined up to take on responsibility for protecting the wider economy from the collapse of a systemically important stablecoin. This will allow for intervention with a “special administration regime”, in a similar manner to the way the Bank of England would react to the collapse of a traditional bricks and mortar bank.

The Bank of England is also actively considering whether it may be able to issue a central bank digital currency (CBDC), with the intention that this would be more reliable and retain its value over time. This would not merely be tethered to the pound, as a stablecoin might be, but instead intrinsically linked, such that £10 of the UK CBDC would be worth the same as a £10 note. There will be a consultation later this year to determine whether a UK CBDC should be developed.

The Royal Mint, which produces all of the coins of the UK for real-world circulation, has been tasked by HM Treasury to create a series of NFTs, to again demonstrate the UK’s credentials as a global hub for cryptoasset technology. More details about these NFTs are expected over the course of the summer.

Current Regulation of Cryptoassets Businesses

So far we have looked to the future of cryptoasset regulation in the UK and the ambitions to make the UK a world leader as cryptocurrency becomes more mainstream, but what of the regulation already in place? As matters stand the main regulation of cryptoassets in the UK does not relate directly to the assets themselves, but instead to their ability to be used for money laundering and is targeted at two particular types of business: (i) cryptoasset exchange providers; and (ii) custodian wallet providers; which are collectively known as cryptoasset businesses.

On the one hand it is easy to see why cryptoassets might be an easily accessible way to launder money, given the ability to provide anonymity and the general lack of regulatory oversight, as well as the extra-territorial nature of the assets and the ease with which cryptocurrency can be transferred. On the other hand, given the public nature of the blockchain, there is the potential for tracing funds, if you know what you are doing, as every transaction is documented and publicly accessible. In theory this should make it easy for law enforcement to follow the passage of criminal property into the exchanges, along the relevant blockchain to identifiable assets, or even to fiat currency where assets have been removed from the crypto ecosystem. However, this requires expertise and can be time consuming, depending on the complexity of the tracing required.

In order to combat the risks of money laundering associated with cryptoassets, cryptoasset businesses operating in the UK are required to be registered with the Financial Conduct Authority (FCA) as a result of their inclusion as a regulated business under the Money Laundering Regulations 2017 (MLR 2017). In order to be registered, businesses need to demonstrate to the FCA that they are able to comply with the MLR 2017, which includes conducting a risk assessment looking at money laundering, terrorist financing and proliferation risks, ensuring they conduct appropriate customer due diligence, including “knowing their customers” and establishing source and destination of funds, as well as ensuring appropriate record keeping. The businesses also need to have a process in place for dealing with suspicious transactions, including a reporting process to the National Crime Agency.

As already described, given the very nature of cryptoassets, it is difficult for these businesses to prove compliance with many of the requirements of the MLR 2017. As a result, nearly three quarters of the applications made by cryptoasset businesses to the FCA for registration have been rejected. As matters stand, only 35 businesses have been able to satisfy the FCA of their compliance with the MLR 2017, with one further business allowed to continue trading while the FCA continues to review its application.

This is in stark contrast to the more than 240 businesses which the FCA has identified as unregistered cryptoasset businesses operating in the UK. The FCA has produced this list, which it updates on a daily basis, as part of its focus on consumer protection. The intention is that consumers who are considering making an investment or otherwise engaging in a cryptoasset transaction, are able to check the business they are proposing to deal with, and make an informed choice about whether or not to go ahead.

Consumer Protection

The FCA has been at pains to emphasise that there is significant risk to consumers who make investments in cryptoassets, publishing numerous notices and warnings. This has been in relation to specific businesses, as well as generic warnings about asset classes, for example, cryptocurrency advertised by celebrities on social media. The FCA frequently highlights to consumers that these are very high risk investments, and that they should be prepared to lose all of the money they put into cryptoassets.

Building on this, it is expected that later this year, following a pledge by the UK government, certain cryptoassets will be included within the financial promotion regime which the FCA regulates in respect of traditional investments. This is likely to have a significant impact on the way relevant cryptoassets are advertised to UK consumers, as it will require the use of particular risk warnings, as well as requiring approval from a relevant FCA-authorised firm with competence and expertise in the cryptoasset market.

What’s Next?

As explained above, the UK government is still consulting on regulation and certainly will be continuing to monitor matters, as the crypto ecosystem evolves and new issues are revealed. What does seem clear is that the government has barely scratched the surface of the required regulation that will need to be put in place in respect of cryptoassets. There is still a lot of work to be done in order to reach a balance between the need for regulation to protect consumers and the wider economy, against the need to encourage innovation and investment in the cryptoasset ecosystem in the UK, by avoiding overly onerous regulation. The current incremental regulation is likely to continue, as the UK assesses the success (and failure) of regulation put in place both domestically and elsewhere, to determine how best to regulate this sector.

We will continue to watch and report on the sector, including providing a series of advisories through the summer, providing a more detailed look at some of the issues raised in this Advisory.

© Arnold & Porter Kaye Scholer LLP 2022 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.