UK’s new holistic crypto regime can learn from global regulators
By Rebecca Thorpe, Bovill
Published: 20 March 2023
The UK’s proposed new regulatory regime for crypto assets shows the government’s determination for the UK to be a key player on the crypto stage, and is bold timing given the shadow still cast over public sentiment by FTX. While the proposals are welcome progress, the UK regulator would be wise to learn from the approaches of other jurisdictions. Digital assets are here to stay and present a wide range of risks which should be managed – and regulated – holistically.
The scope of the UK consultation brings home how far there still is to go but, uninhibited by EU harmonisation, the UK still may steal a march on the rest of Europe when it comes to a robust and welcoming destination for global crypto asset businesses.
The last few years have been sobering for the world of digital assets. It is thought that the closures of key market players in 2022 wiped out US$1.5 trillion in crypto market capitalisation.1 As the popularity of the sector increases, the risks to retail consumers as well as institutions need to be properly monitored and managed. The collapse of FTX, despite some of the commentary, did not sound the death knell for crypto. Instead, 2023 will be an important year to reflect and react, and for all global regulators to speed up their move to bring all aspects of necessary virtual assets regulation into statute to prevent any further scandal.
A broad church
It is first important to note that the digital asset ecosystem is a broad church, which covers far more than the headline grabbing cryptocurrencies. A cryptocurrency is a digital-only currency, that usually has no central issuing or regulating authority and uses a decentralised system to record transactions and manage the issuance of new units.2 A ‘stable coin’ is a type of cryptocurrency which is ‘pegged’ to a traditional currency or commodity, in order to make its price more stable. Just these two examples have quite different risk profiles. Also noteworthy is that some digital assets are already regulated under existing traditional securities regulation. Others will require new and nuanced regulatory oversight to take into account the different risk profiles of the different financial instruments.
More than money laundering
The attention of regulation in the digital asset sector historically focused for too long on anti-money laundering (AML), when financial crime is only one of a number of important risks to be managed. For example, exchanges and issuers must be made to hold sufficient regulatory capital before they can operate, to mitigate prudential risk. This was made clear by the collapse of both FTX and Terra Luna which was backed by the stablecoin TerraUSD last year. The Monetary Authority of Singapore (MAS) recently proposed prudential regulation for stablecoin issuers, which is an example of proposed good practice.3
Prior to the publication of the UK HM Treasury proposed regulatory framework, MiCA, or the Markets in Crypto-Assets, was without question the most holistic proposed digital assets regulation across the globe. MiCA is now being agreed at European Parliament level and so on paper seems more progressed than the UK proposed framework. MiCA will be required to be implemented across every EU member state. The downside is that history suggests that it will take a long time to achieve the utopia of harmonisation across EU countries; we still do not have consistent approaches to marketing alternative investment funds in Europe, despite AIFMD being first introduced back in 2011.
Holistic and robust controls
The proposed UK framework, in simple terms, will insert cryptoasset regulated activities into the existing mature activity-based framework already in place in the UK. For this reason, it is beautiful in its simplicity of design, and also means the coverage is as broad as the coverage of risks for traditional asset classes. The complete range of regulatory activities will be in scope, from operating trading venues, advising on cryptoassets, managing cryptoassets, to secure custody and to lending and more. Specific crypto activities are also mooted, such as mining coins and validating transactions on a blockchain. As with MiCA, the UK framework will also seek to create a cryptoassets market abuse regime, which will be based on elements of the existing Market Abuse Regulation (MAR). Offences will apply to all persons committing abuse who are trading on a UK venue, wherever the person is based.
The downside is, the devil will be in the detail (the detailed rules still to be drafted by the FCA that is), to adjust the implementation of the framework for the unique cryptoasset class. Some areas of proposed regulation will be very similar to existing ones – the basic concepts of managing conflicts of interest, segregation of duties and sound governance arrangements will apply to authorised crypto firms in the same as to all regulated firms.
Other areas such as custody will need more tailoring, to accommodate crypto-specific concepts like cold storage or hot wallets. Other important conduct risks are also considered in the new UK proposals, including proper segregation of client money, the importance of which was made evident in the US Securities and Exchange Commission (SEC) charge against Sam Bankman-Fried and FTX, which diverted customer funds to Alameda Research - Bankman-Fried’s privately owned hedge fund.4
Operational resilience is also key. The UK provisions include ensuring firms have proper wind down planning, cyber security is robust, and controls are in place to protect against third party outsourcing risk. In December last year, the Prudential Regulation Authority in the UK fined TSB Bank a total of £48,650,000 for operational risk management and governance failures, including management of outsourcing risks, relating to the bank’s IT upgrade programme.5 Large digital assets companies tend to implement a lot of third-party and cross-border outsourcing, and so this risk is particularly pertinent.
Consumer protection and a financial promotion work-around
Digital asset trading is a highly risky activity and regulations cannot protect consumers one hundred percent from losses arising from this inherently speculative sector. However, better disclosures requirements and rules around financial promotions can help investors make more informed choices. Research by the Hong Kong Monetary Authority last year,6 called for stronger disclosure requirements for stablecoin issuers and restrictions on the assets backing their value, to prevent volatility in cryptocurrency infecting the wider financial system. This was evidenced by the mass redemptions in Tether and collapse of Terra USD earlier in 2022.
The UK has for a long time promised better disclosures, but inclusion of cryptoassets in the UK financial promotion regime still seems a frustratingly distant goal. The publication of the UK proposed regulatory framework on 1 February 2023 was accompanied by an update on cryptoasset financial promotions. The statement points out that, in the absence of the long-promised change to the UK Financial Promotion Order, no current route for crypto firms to be authorised and a reluctance of any existing regulated firm to provide the necessary approval of cryptoasset financial promotions amounts to an effective ban on all crypto advertising.
This does not sit well with the UK Government aim to become a ‘crypto hub’ and attract additional post-Brexit investment. So, a temporary fix has been suggested, to amend the existing Financial Services & Markets Act and create an exemption allowing cryptoasset firms currently registered with FCA (for AML supervision purposes only) to issue their own financial promotions.
Time for regulators to act
Recent events in the crypto world have caused governments and regulators to pause and reflect, but the bottom line is that the digital asset sector is here to stay. Once the UK Treasury consultation concludes, the ball will be firmly in the FCA court to speed up progress of the delivery of the cryptoasset regulatory framework. The current proposals will bring crypto trading into the UK regulatory perimeter; and the UK may pass the finish post ahead of MiCA country implementation.
Whoever gets there first, regulators need to significantly speed up their response, and make sure they take a holistic approach to consider all types of regulatory risk. Assuming that ongoing scandals will eventually ‘make the problem disappear’ is no longer an option. Effective regulation of digital assets is a global challenge and some jurisdictions are stronger on certain areas and risks than others. As the UK designs its own regime to encourage investment while protecting consumers, its regulators would do well to learn from others and cherry pick the best examples.
1 Singapore’s crypto ambitions shaken by FTX collapse - BBC News
2 Cryptocurrency Definition & Meaning - Merriam-Webster
3 MAS proposes measures to reduce risks to consumers from cryptocurrency trading and enhance standards of stablecoin-related activities
4 SEC.gov | SEC Charges Samuel Bankman-Fried with Defrauding Investors in Crypto Asset Trading Platform FTX
5 TSB fined £48.65m for operational resilience failings | Bank of England
6 An assessment of the volatility spillover from crypto to traditional financial assets: the role of asset-backed stablecoins (hkma.gov.hk)