In 2018, the world seemingly went mad for Bitcoin.
What was once seen as the preserve of get-rich-quick-schemers trading from their bedrooms developed a boardroom appeal, with established banks and companies seeing how they could get in on the act.
This attitudinal shift is perhaps best reflected by Jamie Dimon, chief executive of JP Morgan, who famously said about Bitcoin: “I don’t really give a _.” The missing word can be easily guessed.
However, JP Morgan later rolled out the first bank-backed cryptocurrency, overseen by the very same chief executive. From effluence to affluence, Bitcoin is now mainstream.
As interest grew, the Financial Conduct Authority was compelled to give greater clarity on where the regulatory perimeter lies.
The recent Guidance on Cryptocurrency, which clarifies where crypto slots into the current regulatory regime, is vital reading for any financial adviser with clients considering venturing into this sphere, though important questions remain unanswered.
Those involved engaged in a ‘specified activity’ in relation to a ‘specified investment’ will fall within the scope of the FCA.
The broad thrust of the guidance is that crypto-tokens can be separated into two distinct types: regulated (security tokens and e-money tokens) and unregulated (utility tokens and exchange tokens).
Token definitions
When determining what constitutes a security token, we must refer to the definition of a specified investment for the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO).
Such factors include (i) the contractual rights and obligations the token-holder has by virtue of holding or owning that cryptoasset; (ii) any contractual entitlement to profit-share; or (iii) whether the token is transferable and tradeable on cryptoasset exchanges.
Key points
- Some banks have dipped a toe into cryptocurrencies
- The FCA has recently issued guidance on them
- Many regulators are trying to decide how to regulate cryptoassets
Specified investments under the RAO include shares, debt instruments, warrants, units in collective investment schemes, and rights and interests in investments.
The other category of regulated cryptotokens, e-money tokens, are based on the definition of e-money under the Electronic Money Regulations 2011.
Unregulated tokens, by contrast, are exchange tokens and utility tokens that cannot also be classified as e-money.
Exchange tokens can be described as cryptocurrencies, such as Bitcoin, and a form of fiat, albeit not legal tender.
Utility tokens, on the other hand, provide the holder with particular benefits or rights, such as discounts to products or services that are being developed from the proceeds of the initial coin offering pursuant to which the utility token was issued.
Importantly for advisers, there is no consideration of tokens with mixed characteristics, such as utility tokens with a security token wrapper, but lacking the clear and obvious characteristics of a security.
However, the FCA will look at the substance of an asset, and not what might be stated in a white paper.
It seems here that the FCA has copied the approach of the Securities and Exchange Commission, among others, which holds that cryptoassets offered by way of an ICO should be assessed on their characteristics. Perhaps optimistically, that could be interpreted to mean that the FCA will not default to the highest standard of regulation.
A new perimeter
This is only a high-level overview of the different categories of market participants and regulated activities, which might fall within regulation such as the Prospectus Regulations or within the RAO as activities such as advising on investments; dealing in investments; arranging investments; operating an OTF or MTF; safeguarding investments; or sending dematerialised instructions.
Operators such as exchanges and trading platforms, wallet providers and custodians, and payment providers are likely to be within the perimeter. In contrast, issuers of tokens are not undertaking regulated activity, just as a company issuing shares is not, but are examples of where the Prospectus Regulations and financial prohibition regime may apply.
However, the guidance only considers what falls within the existing perimeter and provides little commentary on a potential new perimeter.
As such, the FCA does not consider those areas of regulated activities that differ in practice on distributed ledgers than with traditional securities, such as custody services and settlement.
The FCA’s approach does not represent a step change from the previous approach in examining how existing regulation applies to cryptoassets with particular characteristics.
The UK is far from alone in doing so, as relevant authorities including those in Australia, Germany, France, Canada, Israel, Singapore and Switzerland are presently taking the same approach.
As with the UK, these countries have identified where cryptoassets might be regulated and where they are not, with those that are not being flagged as potentially falling within the purview of other legislation such as consumer protection or payment services.
The latter is particularly the case in the EU, where the Payment Services Directive would regulate the operators at either end of the payment system but not necessarily the asset itself – for example, an exchange token.
Aiming for a global regime
A smaller number of countries have enacted new legislation on cryptoassets and connected activities. These have tended to be very specific.
In Belarus the legislation relates to a government-established technology park and in Gibraltar specific legislation provides official regulation for exchanges.
There are outliers, with Malta notably being quick out of the blocks to introduce wider legislation in order to seize a first-mover advantage.
At the other end of the spectrum, China banned all ICOs in 2017 and it remains illegal to host any type of cryptoasset sale within China or to Chinese citizens. India has taken a similar approach.
The difficulty is that this area continuously evolves, propelled by innovation.
Australia, long seen as one of the more forward-thinking jurisdictions, has traditionally taken the approach of allowing the market to develop and reacting accordingly, rather than playing crypto whack-a-mole.
It is therefore interesting that the Australian Securities and Investments Commission recently consulted on specific legislation to regulate ICOs.
The outcome aims to make clearer what regulatory territory certain ICOs will occupy and the need for appropriate licensing. We are aware the FCA is also interested in bringing security tokens into the securities regime.
However, ASIC acknowledges that the taxonomy of cryptoassets in Australia is not yet as clear as in the UK, Switzerland and Singapore.
The FCA acknowledges that the ideal is to have a consistent regime across the globe, not least to prevent those seeking to exploit regulatory arbitrage, but the embedded market structures and legal and regulatory frameworks mean it remains somewhat of a dream.
That said, the FCA will continue to work with supranational organisations to encourage harmonisation.
The guidance brings welcome clarity, but it does not advance matters in a material way, leaving advisers with clients interested in crypto-investing still largely in the dark.
Sam Pearse is a partner at law firm Pillsbury
