by Andrew Henderson, James Burnie, Zia Ullah and David Cook at Eversheds-Sutherland.
The UK's Treasury Select Committee released a report into crypto-assets on 19 September. The Committee’s key conclusion is that regulation of crypto-assets is necessary.
Striking a negative tone, it identifies the problems of volatile prices, hacking vulnerabilities, minimal consumer protection, and anonymity aiding money laundering, the fact that Blockchain is “currently slow, costly and energy-intensive” with the potential for data storage uses and the ambiguity of the UK Government and regulators' position is not sustainable.
On a positive note, it recognises that, if the UK develops an appropriate and proportionate regulatory environment for crypto-assets and if future innovations in crypto-assets proved themselves as beneficial to society and industry, the UK could be well placed to become a global centre for this activity. Thus, in deciding its regulatory approach, Govern ment should decide if growth should be encouraged.
Although providing, at best, an early indication of the precise regulatory response to the issues identified in the Report and while perhaps overstating some of the risks, the Report does give some indication of a future regulatory environment. This shows links with the current regulatory concerns and is this useful for those in the sector seeking to navigate uncertainty.
Regulatory change is the key theme of the Report:
In addition to the generally positive tone about the development of an appropriate and proportionate regulatory environment for crypto-assets, the Committee recognise that “crypto-asset” is a preferable term to “crypto-currency” observing that “there are no so-called “cryptocurrencies” that serve all the functions of currency”
They also note that since crypto-assets are not widely used as a means of payment, and the linkages to systemically-important firms and markets are negligible, the risk to financial stability arising from crypto-assets is low
On a more cautious note, they focus on consumer detriment, the potential role of crypto-assets in money laundering and the inadequacy of self-regulation. This forms the basis for the need for regulation which, at a minimum, should address consumer protection and anti-money laundering
To protect investors against mistreatment, the FCA needs more power to control how crypto-exchanges and ICO issuers market their services, by bringing the activities they perform into the regulatory perimeter
The absence of regulation of crypto-asset exchanges - through which individuals convert crypto-assets into conventional currency - is particularly problematic
As to money laundering: the FCA should be the relevant regulator for supervising anti-money laundering and the transposition of the Fifth Anti-Money Laundering Directive, which imposes duties on crypto-asset exchanges, is a priority
Instead of designing a special regulatory regime, crypto-assets and associated activities should be regulated through extending the Regulated Activities Order and thus providing the FCA with the necessary legal powers to execute its duties of protecting consumers and maintaining market integrity
Although a dry point, the preference for the term “crypto-asset” is a helpful clarification in framing, although not necessarily resolving, the issue of regu latory classification and legal nature of crypto-assets.
This still leaves open the question of crypto-assets which function like securities and investments and which should already be subject to the existing regulatory regime, albeit that their precise classification, and hence treatment, remains unclear.
The recognition of specific crypto-asset related activities, such as operating a crypto-asset exchanges, i.e. one where crypto-assets are exchanged into fiat currency or other assets, is also significant and indicates clearly where law-makers see “activity gaps” in the current regime.
The report alludes to technical issues but does not develop them. Given its preliminary nature, this is unsurprising but the extended regime for regulating “new actors” is likely to have a heavy technology and operational risk focus with governance and oversight being focused on this.
The recognition that an extension of the current financial regulatory regime rather than the creation of a special crypto regime, highlights the fact that crypto-assets are capable of being accommodated within the current regime. A lack of certainty both on scope of the current regime and, more importantly, regulatory power highlights the need for extension.
Summary of the Report and its Key Findings in more detail
Crypto-assets, and most Initial Coin Offerings (ICO), are currently not within the scope of FCA regulation. Crypto-asset investors are currently afforded very little protection from the litany of risks, namely there are no formal mechanisms for consumer redress, nor compensation.
Self-regulating bodies in the crypto-asset industry, which set out codes of conduct and best practice for the industry, are wholly voluntary. Inevitably, there are firms that will ignore them. This is clearly insufficient. As the Government and regulators decide whether the current “Wild West” situation is allowed to continue, or whether they are going to introduce regulation, consumers remain unprotected. The Committee strongly believes that regulation should be introduced. At a minimum, regulation should address consumer protection and Anti-Money Laundering.
In deciding the regulatory approach, the Government and regulators should evaluate the risks of crypto-assets, and assess whether their growth should be encouraged. If growth is favoured, regulation could lead to positive outcomes for the crypto-asset market, including the move toward a more mature business model and increased liquidity. If the UK develops a proportionate regulatory environment for crypto-assets, the UK could be well placed to become a global centre for this activity.
Currencies act as a medium of exchange, a store of value, or a unit of account. There are currently no cryptocurrencies that perform these functions. As cryptocurrencies are being used widely for speculation, well-functioning cryptocurrencies exist only as a theoretical concept. Accordingly, this Report uses the term 'crypto-assets' as it's more helpful and meaningful in describing Bitcoin and many other 'altcoins'.
A prominent feature of crypto-assets is the volatility of their prices. For example, the price of a Bitcoin increased from $6,472 in November 2017 to $17,629 in December 2017, and fell to $7,208 in February 2018. Investors are exposed to large potential gains, but correspondingly a greater risk of loss. Accordingly, investors should be prepared to lose all their money.
Several crypto-asset exchanges, which are used to convert crypto-assets into conventional currency, have been hacked and customers' crypto-assets have been stolen. As there is no collective deposit insurance scheme to compensate investors in the event of a hack, the risk of hacking associated with crypto-assets may not be something that investors in conventional assets have experience of. Therefore, they may not be well placed to judge this risk. This constitutes further evidence that crypto-assets are particularly ill-suited to retail investors.
An additional risk that consumers may not be aware of is that some customers who have lost their passwords to a crypto-asset platform have been told by the firm that runs their account that their password cannot be restored. Thus, there is no recourse for customers who have lost their password, and they are locked out of their account permanently. This oftenunexpected outcome for investors is a stark contrast against how customers of banks, and other regulated financial services firms, are treated.
The advertisements of both ICO issuers and crypto-asset exchanges are not regulated by the FCA. One-sided adverts imply that the crypto-asset market will only go up, and that anyone can make a lot of money easily. The FCA’s consumer warnings are a feeble corrective to such misleading adverts. The regulator needs more power to control how cryptoasset exchanges and ICOs market their services.
Crypto-asset exchanges are not currently included in AML regulations. Owing to this, and their inherent anonymity, crypto-assets can facilitate the sale and purchase of illicit goods and services and can be used to launder the proceeds of crime. The Committee recognises that the EU's Fifth AML Directive, which will require crypto-asset exchanges to comply with AML regulations, is a step forward. However, the Government’s consultation on transposing the EU’s Fifth AML Directive into UK regulation is not expected to finish until the end of 2019. The Committee has urged the Government to prioritise and expedite the transposition.
Blockchain is an electronic ledger that records and verifies transactions made using crypto-assets. Moving away from its origins with Bitcoin, blockchain has more recently been described as a database that works as a decentralised way of storing large amounts of data. A fundamental drawback of decentralised blockchains is the slow, costly and energy-intensive verification process for transactions. This may ultimately limit the extent to which crypto-assets and blockchain can replace conventional money and payment systems. But the Committee does recognise that blockchain technology may have the potential to be a more efficient method of managing certain types of data in the long-term.
How Eversheds can help
Eversheds Sutherland was the only law firm to submit evidence to the Commons Select Committee, which gave rise to the report. Since advising on the first successful initial coin offering in the United Kingdom, we have been at the forefront of advising firms on crypto assets, blockchain and the FCA sandbox process. We take a flexible approach to providing advice, taking a cross-sectoral and practical approach tailored to the diverse needs of our clients.
For more information contact
Andrew Henderson Partner +44 20 7919 0898
James Burnie Associate +44 20 7919 0879
Zia Ullah Partner +44 161 831 8454
David Cook Senior Associate +44 161 831 8144