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August 16, 2022

A Spotlight on Digital Asset Regulation in the UK

In the United Kingdom, digital asset regulation is characterized by a culture of uncertainty thanks to the UK's legal heritage and general regulatory reluctance in the post-Brexit landscape.

Understanding digital asset regulation is especially important for Polymesh users–after all, Polymesh is a blockchain for regulated assets! To help our users become better acquainted with the global regulatory situation, we’re offering a series of posts spotlighting specific locales. 

This post focuses on digital asset regulation in the UK, home to a thriving fintech industry which saw a record $12 billion in investment last year. 

The UK’s current approach to crypto can best be characterized as conservative and practical: policy focus appears to be on areas that can be regulated within existing jurisdictional boundaries, with consumer protection a key priority.

But there’s a worry that the UK is falling behind the US and EU by placing too much emphasis on mitigating risk and creating hurdles for crypto firms that will displace them from the UK market.

Post-Brexit, there’s one question to ask: will the UK’s approach to crypto regulation prevent it from remaining a global leader in financial innovation?

The main players: the FCA, the Bank of England, and the UK Treasury

Compared to the US, the UK regulatory framework is much more centralized and unified thanks to fewer regulatory bodies. 

Only three main players dominate the landscape for crypto asset regulation: the Bank of England (BoE), the Financial Conduct Authority (FCA), and Her Majesty’s Treasury (or the ‘Treasury’).

The BoE and FCA both operate independently from the government. The Bank of England is responsible for financial stability with prudential authority over financial services and risk management, while the FCA is the main financial regulator and oversees UK financial markets with regulatory authority over financial products and services, investigating individuals/entities, restricting products, and freezing assets.

The FCA works under purview of the Treasury, the UK government department in charge of public finance and economic policy.

In 2018, the FCA, BoE, and Treasury jointly established the UK’s Cryptoassets Taskforce, a dedicated government task force for evaluating how the UK should proceed with crypto asset regulation. Its goal is to find an approach to blockchain native businesses that guards against risk, maintains high regulatory standards in financial markets, and protects consumers while enabling industry innovators to thrive and cement the UK’s reputation as a leader in finance. 

While the FCA and BoE have both issued strong and repeated warnings about the use of crypto in the UK, the Treasury has emerged more enthusiastic. Nevertheless, the three operate rather single-mindedly. 

The FCA formally became the UK’s authority for anti-money laundering and counter-terrorism financing for crypto asset companies in 2020. 

What's within UK jurisdiction?

The UK applies its existing regulatory framework for crypto assets which provide rights or obligations similar to traditional financial instruments. For this purpose, the Taskforce agrees on three main categories:

  1. E-money (which fits the definition of electronic money in the 2011 Electronic Money Regulations, e.g. digital representations of the Great British Pound)
  2. Security tokens (which fit within categories of financial securities applied by UK law, e.g. tokenized equity or debt instruments)
  3. Unregulated tokens (which are neither e-money or security coins– currently, the UK recognizes utility tokens and coins used as a medium for exchange within this category)

In 2020, the UK confirmed crypto assets are property and that cryptocurrencies such as BTC or ETH are not considered legal tender (or ‘money’) because they lack the classical definitional characteristics. However, there’s no blanket ban on them. 

Currently only e-money and security token markets fit within the UK’s regulatory perimeters and can be regulated by the FCA; utility token markets, exchange token markets, and NFT markets are beyond its regulatory scope. Still, some rules still apply depending on the products and services.

Crypto exchanges and wallets, for example, have to register with the FCA and comply with anti-money laundering/counter terrorist financing (AML/CTF) obligations. Bitcoin ATMs are legal, but only if licensed or regulated by the FCA (which, according to the FCA, is none of them). Meanwhile, trading cryptocurrencies is allowed for retail investors except for crypto derivatives, which are capable of being financial instruments under UK law and hence regulated by the FCA. Finally, crypto marketing is subject to the existing financial promotions regime. 

Uncertainty within existing legislation

Luckily for the UK, there isn’t much debate on how to classify digital assets–but this doesn’t mean there aren’t gray areas.

Like the US, the UK’s regulatory regime has primarily taken the approach of applying existing laws to products and services for which they were never intended. The result is confusion about how to legally treat digital assets; even when traditional legislation is fairly clear, it’s not cut out to reconcile with non-traditional products. 

Tokenized securities, for example, can fall under two regulatory regimes in the UK. Depending on a token’s features it might classify as an equity or debt security, or a collective investment scheme–all of which are formally recognized as ‘security tokens’ and regulated. But if it fails to be defined by a category of securities contained in pre-existing legislation, it could be unregulated.

Likewise, the FCA remains unclear on whether it will treat cryptocurrency as foreign exchange or commodities. While the crypto community likely favors the former, the FCA hasn’t wanted to give it that level of credibility just yet and has urged caution in ushering in regulation too fast, lest it fails or halts the normal economic flow of markets. 

Of benefit to the UK is its quality legal system, which has impressively recognized both the importance and legal status of crypto assets. To date, English law recognizes cryptocurrency as property even though it fails to meet either form of property entrenched in historic law; lawyers and judges agree that a 19th century case law shouldn’t be interpreted strictly as it was certainly never intended to deal with things such as bitcoin.

The Law Commission is currently considering whether a third property can be introduced to provide clarity on the legal characterization of digital assets, with a paper on the matter expected to be published in 2022. It also recently began a project on conflicting laws and emerging technology

While the UK has yet to legally classify crypto assets, it’s clear there’s movement ahead. In fact, the UK’s HM Revenue and Customs already has a manual on its crypto assets taxation policy. 

Lost in the post-Brexit landscape

Partly, this uncertainty is owing to the post-Brexit financial landscape; in the wake of the UK’s landmark referendum on EU membership in 2016, regulating the emerging digital asset industry lost priority as officials grappled with more nascent regulatory challenges of divorcing from the EU.

By 2020, however, the UK had already transposed some EU cryptocurrency regulation requirements into domestic law– notably 5AMLD and 6AMLD. Accordingly, from January 2021 all UK crypto asset firms (including exchanges, advisers, investment managers, and professionals) with a presence or market in the UK or that provide services to UK resident clients were required to register for licensing with the FCA and comply with its money laundering controls and customer protection obligations. 

Also in January 2021, the FCA banned UK retail investors from accessing cryptocurrency derivatives to protect them from market volatility and other inherent risks–a move which hurt the wider industry and created hesitancy for London clearing houses to offer crypto derivatives even to professional investors. 

Then in April 2021, the FCA strengthened legislation to crack down on misleading crypto advertising and restrict crypto marketing to existing financial advertising regulation, rattling the industry further. 

Meanwhile, UK regulators appeared reluctant to introduce any comprehensive crypto legislation, drawing criticisms that its focus on risk only was throttling innovation and fostering an uncompetitive industry (ironically at a time when the UK pledged to capitalize on its post-Brexit freedom).

Crypto firms pack their bags

From the beginning, the FCA licensing requirement created friction for the crypto asset community due to the lengthy process in which it was rolled out. 

Incapable of pre-emptively registering crypto business in time for the introduction of the requirement, the FCA installed a “temporary registration regime” in December 2020 that would allow companies to operate in the UK and continue trading while the regulator processed their applications for authorization.

By early 2021, more than 100 crypto firms had joined the FCA register. But by mid-March 2022–two weeks before the temporary regime was set to close–the FCA had approved only a quarter of applications. Almost two dozen remained awaiting a decision on whether they could continue their digital asset business in the UK, while more than 80% had either withdrawn their applications or received rejections. 

Crypto firms left in limbo on the FCA’s register included $33 billion digital bank Revolut and crypto brokerage Copper. On March 31, the FCA put the two companies along with ten others on a temporary extension list. The wait created frustration for the companies whose fates were left uncertain– particularly Copper, for whom FCA-purgatory impacted its ability to close VC funding.

To date, only three have been approved and only Revolut remains on the list; the rest have either been rejected or withdrawn.

Unnamed crypto companies complained to reporters that delays were largely the fault of FCA administration, while a few claimed that they felt pressured to withdraw their applications under threat from the FCA. 

Not knowing whether they would be forced to wind down their crypto business and fearing the impact a published rejection or appeal would have on clients or overseas licensing, many firms flocked to other jurisdictions where they could serve UK clients without being based within Britain’s borders. 

With FCA approval seen as the gold standard thanks to how rigorous it is, it’s safe to say this outcome came at the disappointment of many in the space who had been hoping the license would help demonstrate their credibility to customers.

Currently, 36 companies have received full registration.

Spring 2022: On the cusp of important change?

2022 didn’t begin optimistically for UK crypto assets as its taskforce on the potential of a UK central bank digital currency (CBDC) concluded there was no compelling case for a UK CBDC. However, this past spring saw a lot of regulatory involvement with crypto assets that seems promising for a comprehensive crypto legislation

Hope for a forward-thinking regulatory response to crypto in the UK was ignited in April 2022 when the UK Treasury issued various statements on its intentions. Jon Glen, Economic Secretary to the Treasury, gave a keynote speech on the government’s plans to make the UK a world-leading crypto regime while Chancellor Rishi Sunak announced the government’s intent for the UK to become a ‘global hub for crypto assets technology’– perhaps garnering a reputation for crypto-friendliness in line with other financial centers such as Singapore and Dubai. 

Crucially, the UK government plans to capture the potential in crypto and boost innovation not by lowering its standards but by implementing robust and effective regulation. 

The announced initiative would provide the FCA with new powers to establish clear rules for crypto assets and introduce regulation for stablecoin issuers, helping strengthen the nation’s image as crypto-friendly after years of regulatory caution. Additionally, the government would begin to study the possibility of issuing government debt using distributed ledger technology (DLT). As part of the initiative, Sunak even commissioned the Royal Mint to produce its first non-fungible token (NFT) by summer 2022. 

In the same speech, Sunak had announced the Taskforce would implement a Financial Market Infrastructures Sandbox to be in place by 2023 that would allow companies to explore the use of distributed ledger technology (DLT) in financial markets infrastructure. The Sandbox is a promising recognition by UK regulators of the need to ensure legislation can accommodate and support tokenization.

Then in early May 2022, the FCA held CryptoSprint, a forum focused on informing regulatory policy changes for emerging crypto technology. The forum provided a meeting point for the digital asset community to discuss with regulators three key issues in the life-cycle of crypto assets: 

  1. The disclosure of issuance information
  2. Regulatory obligations for centralized vs. decentralized models
  3. Where existing custody regulations fail to protect consumers and markets

The results will hopefully feed into the UK’s regulatory approach. 

Stablecoins to come within regulatory perimeter

In May 2022, shortly after the crypto community watched the collapse of stablecoin TerraUSD, the UK Treasury launched its consultation proposing an insolvency regime for the breakdown of digital assets and particularly stablecoins. 

This came a month after the Treasury had announced plans to bring systemic digital assets (digital assets with implications on the UK’s financial stability) within regulatory perimeters through an amendment to existing e-money and payment services regulations. This would likely see “stable tokens” created as a third regulatory category alongside e-money tokens and security tokens.

The Treasury’s proposed regime would position the BoE and not the FCA as the lead institution for regulating systemically important payments systems and service providers–expanding the definition to include digital assets– and for managing the collapse of stablecoins of systemic importance to the financial system. 

Meanwhile, the FCA would continue to have powers to regulate and supervise firms that engage in relevant electronic money and payment activities and be consulted by the BoE. Important to note is that traditional payment systems would not be impacted by legislative change, except where a digital asset is involved. 

The Treasury says these measures will help deliver a “world-leading regulatory regime for stablecoins” by fostering an environment where payment systems which use them can operate and grow with the assurance of an insolvency regime to handle any collapse. 

The proposed legislation is expected to be introduced by August 2022

What's next on the regulatory rollercoaster?

This past spring’s advancements are promising, but the UK regulatory situation is still a bit of a rollercoaster ride.

For starters, there haven’t been any actual major developments since the announced initiatives– most likely due to lack of detail around the proposals and how the government plans to protect the UK economy. 

The Treasury’s proposed plans also suffered a major setback this month (July 2022) as the initiative’s two most important players– Chancellor Rishi Sunak and Economic Secretary to the Treasury John Glen (the government’s ‘de facto crypto czar’)– quit their positions in cabinet, leaving crypto proponents concerned that the UK is back to square one.

Still, it appears that regulatory pressure is on. Just a few weeks ago on July 5 2022, the Bank of England’s Financial Policy Committee called for enhanced regulation of digital assets to mitigate potential risks and limit contagion from the current market turmoil. We’ll have to see how the situation unfolds and whether the UK can call back the businesses that have exited British shores.

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