FCA TIGHTENS UP ON CRYPTOASSETS REGULATION IN CONSULTION PAPER

In January 2019, the Financial Conduct Authority (“FCA”) published a Consultation Paper which sets out draft Guidance on how cryptoassets can be subject to FCA regulation (“the Guidance”). The draft Guidance is relevant to any firm issuing, creating, buying, selling, holding or storing cryptoassets, as well as firms marketing cryptoasset products and services, and their advisers.

Ian Mason and Sushil Kuner from Gowling WLG summarise the FCA’s expectations and explore the key considerations for firms.

Overview

The draft Guidance seeks to clarify where different categories of cryptoasset tokens fall in relation to the FCA’s regulatory perimeter, i.e. the boundary that separates regulated and unregulated financial services activities. Activities which fall within the regulatory perimeter are regulated and require authorisation from the FCA, and in limited circumstances the Prudential Regulation Authority (PRA), before they can be carried out. Carrying out regulated activities without the relevant authorisations may constitute a criminal offence.

The FCA has categorised cryptoassets into three types of tokens, and has provided guidance on whether these tokens are regulated or unregulated. In categorising cryptoassets as below, the FCA has made it clear that the categories of token are not mutually exclusive, nor are they exhaustive of the types of cryptoassets that can exist. Whether a cryptoasset falls within the regulatory perimeter should always be considered on a case-by-case basis with regard to a number of different factors.  

Security Tokens

Security tokens include specific characteristics which bring them within the definition of a ‘Specified Investment’, such as a share or a debt instrument, which mean they fall within the regulatory perimeter. The FCA considers a security to refer broadly to an instrument which indicates an ownership position in an entity, a creditor relationship with an entity, or other rights to ownership or profit. Security tokens are securities because they grant certain rights associated with traditional securities.

If you carry on a regulated activity involving a Security Token, you will need to make sure that you are appropriately authorised or exempt. Issuers of such tokens may themselves not need to be authorised, however certain requirements related to the issuance of the tokens may still apply, for example prospectus and transparency requirements.

What to consider when determining if a token is a Security Token

Given the complexity of many tokens, the FCA has recognised that it is not always easy to determine whether a token is a Specified Investment. The FCA has, therefore, set out a non-exhaustive list of factors that it considers are indicative of a security to assist firms in determining whether or not they are undertaking regulated activities:

• the contractual rights and obligations the token-holder has by virtue of holding or owning that cryptoasset;
• any contractual entitlement to profit-share (e.g. dividends), revenues, or other payment or benefit of any kind;
• any contractual entitlement to ownership in, or control of, the token issuer or other relevant person (e.g. voting rights);
• the language used in relevant documentation (e.g. Whitepapers) . However, the FCA has made clear that if a Whitepaper declares a token to be a utility token, but the characteristics of the token indicate it is a Specified Investment, the FCA would treat it as a Security Token;
• whether the token is transferable and tradeable on cryptoasset exchanges or any other type of exchange or market;
• whether there is a flow of payment from the issuer or other relevant party to token holders; and
• whether any flow of payment is a contractual entitlement – the FCA has made clear that it would consider this to be a strong indication that a token is a security.

Exchange Tokens

Exchange tokens are not issued or backed by any central authority and are intended to be designed to be used as a means of exchange. These tokens can enable the buying and selling of goods and services without the need for traditional intermediaries such as central or commercial banks (for example on a peer-to-peer basis).

Exchange tokens are used in a way similar to traditional fiat currency. However, while exchange tokens can be used as a means of exchange, they are not currently recognised as legal tender in the UK, and are therefore not considered to be ‘currency’ or ‘money’ within the UK regulatory framework. Due to the fact that they tend to be decentralised, with no central issuer obliged to honour contractual rights, the FCA’s view is that they do not typically grant the holder any of the rights associated with ‘Specified Investments’.

As such, the FCA has confirmed that exchange tokens generally fall outside of the regulatory perimeter. Therefore, transferring, buying and selling these types of token, including the commercial operation of cryptoasset exchanges for exchange tokens, are activities not currently regulated by the FCA. This is the case even when Exchange Tokens are acquired and held for the purpose of speculation (and in the hope of making a gain) rather than exchange. However, they may be caught by the UK’s Anti Money Laundering Regime in future. The UK Government  will be consulting separately on the transposition of the EU’s Fifth Money Laundering Directive, which captures certain activities in relation to cryptoassets, including cryptoasset exchanges and wallet providers, later this year.

Utility Tokens

Utility Tokens grant holders access to a current or prospective product or service but do not grant holders rights that are the same as those granted by Specified Investments. They may have similarities with rewards-based crowdfunding where participants contribute funds to a project in exchange for a reward, for example access to products or services at a discount.

The FCA has stated that much like exchange tokens, utility tokens can usually be traded on the secondary markets and can be used for speculative investment purposes. However, this does not mean these tokens constitute Specified Investments.

Although utility tokens do not typically exhibit features of Specified Investments, they could still require FCA authorisation if they constitute ‘e-money’ or are used to facilitate regulated payment services.

E-money and Payment Services

E-money issuance is an FCA regulated activity and, depending on how they are structured, cryptoassets can constitute e-money. E-money is electronically stored monetary value as represented by a claim on the electronic money issuer which is :

• issued on receipt of funds for the purpose of making payment transactions;
• accepted by a person other than the electronic money issuer; and
• not excluded by the E Money Regulations.

Due to the fact that they are not usually centrally issued on the receipt of funds, nor do they represent a claim against an issuer, exchange tokens like Bitcoin and Ether are unlikely to represent e-money. However, the FCA has pointed out that any category of cryptoasset has the potential to be e-money depending on its structure and whether it meets the definition of e-money as outlined above. E-money must enable users to make payment transactions with third parties, so must be accepted by more parties that just the issuer.

Similarly, exchange tokens can be used to facilitate regulated payment services such as international money remittances.

What does this mean for FinTech businesses?

If you engage in activity by way of business in the UK, that relates to a security token or to a token that constitutes e-money or is involved in payment services, you should consider whether those activities require authorisation.

If a token is a transferable security and will either be offered to the public in the UK or admitted to trading on a regulated market, an issuer will need to publish a prospectus in accordance with the UK’s Prospectus Regime unless an exemption applies.

If your activities fall within the FCA’s regulatory perimeter, you should consider, in particular:

• • the application of financial promotion rules, including ensuring communications are marketed in a way which is clear, fair and not misleading;
  • the application of the Prospectus Directive;
  • the application of relevant financial crime controls; and
  • operational resilience and cyber security issues – cryptoassets are now regarded as high-value targets for theft and service providers (e.g. custodians/wallet providers) are increasingly being targeted by cyber-criminals to obtain the private keys which enable consumers to access and transfer their cryptoassets.

Next steps for firms

Given the concerns raised by regulators previously about cryptoassets, for example the perceived increased risk of money laundering, the highly speculative and volatile nature of the investment, and even the potential for market manipulation, it is unsurprising that the FCA proposes to tighten the regulatory net. This approach is in line with other authorities, such as ESMA. The fact that the FCA has proposed some draft Guidance is welcome clarification, but it is likely that there will be some grey areas in practice. Firms should consider whether the FCA have drawn the regulatory perimeter correctly, and whether the three category classification works.

If you are a firm proposing to launch a cryptoasset-based offering, it would be sensible to launch it soon, before the FCA finalises its guidance, which it intends to do in summer 2019.

Firms have until Friday 5 April 2019 to respond to the FCA’s consultation. Firms can do so by emailing fcacrypto@fca.org.uk