UK cryptoasset regulation: coming sooner rather than later?

On 4 November 2022, the revised Financial Services and Markets Bill was published following the Public Bill Committee stage where a number of amendments were introduced. The bill represents a landmark in post-Brexit financial services legislation and much of its content – the approach to retained EU law, changes to the financial promotions regime and financial market infrastructure – was unsurprising as it had been well publicised for some time.

Significant amendment introduced

The day before the end of the committee stage, on 3 November 2022, the Financial Secretary to the Treasury, Andrew Griffith, introduced a new amendment to the bill, to amend the Financial Services and Markets Act 2000 (FMSA):

"(3) In section 22 (regulated activities), in subsection (4) at end insert: “(including where an asset, right or interest is, or comprises or represents, a cryptoasset).

(4) In [Definitions]: “cryptoasset” means any cryptographically secured digital representation of value or contractual rights that—

(a) can be transferred, stored or traded electronically, and

(b) that uses technology supporting the recording or storage of data (which may include distributed ledger technology).”

If passed into law, this amendment to FSMA would be highly significant for three reasons. Firstly, it may bring cryptoassets generally within the regulatory perimeter. Secondly, the broader definition of "cryptoassets" may capture a wider class of digital assets (including, for example, non-fungible tokens (NFTs)) than previously expected. Thirdly, and perhaps most importantly, this last minute addition may represent a change in approach to the regulation of cryptoassets.

Cryptoassets inside the regulatory perimeter

The change opens the door to bringing all cryptoassets inside the regulatory perimeter and subject to Financial Conduct Authority (FCA) oversight.

Currently, cryptoassets are not a specified investment in their own right. They are only subject to regulation if the cryptoassets in question are being used in a specified way (for example, as a security token, or as part of a collective investment scheme).

This amendment would make cryptoassets regulated "investments" in and of themselves – in the same way as shares or units in collective investment schemes are. This would have two important consequences:

• It would give the Treasury the power to designate "specified activities" (or "designated activities" under their new powers under the bill) relating to cryptoassets. By amending the Regulated Activities Order, or making new secondary legislation, the Treasury could establish regulated activities involving cryptoassets.
• Firms conducting these regulated activities would need to be authorised by the FCA to do so, and would be subject to the wider framework of rules within the regulatory perimeter.

Regulated activities for traditional investments include arranging deals in investments, managing investments, advising on investments, dealing in investments (as agent or principal) and safeguarding.  Such activities are capable to being extended to cryptoassets – not least arranging deals in cryptoassets and/or providing custody services.

Currently, cryptoassets firms that are registered with the FCA under the anti-money laundering regime (MLD5) only need to comply with a very narrow set of rules relating to anti-money laundering.  If firms are required to be fully authorised, then – in addition to any specific rules which are brought in by the FCA in response to that legislation – those firms could potentially be subject to the full suite of FCA rules set out in the FCA Handbook. These range from the broad, high-level Principles (including the forthcoming "Consumer Duty") to the detailed systems, controls and senior management rules, to being subject to the senior managers regime and the Financial Ombudsman Service rules on complaints.  

This would undoubtedly be a significant step-up for firms' compliance activities. It may be that a lengthy transition period for implementation could mitigate that impact, and allow firms time to adapt their way of doing business, but they are likely to need to make significant changes to meet their new obligations.

Broader definition of cryptoassets

The proposed definition of "cryptoassets" is wider that the current definition of a "cryptoasset" which has been used for the purpose of the UK's anti-money laundering rules (which define it as a “cryptographically secured digital representation of value or contractual rights that uses a form of distributed ledger technology and can be transferred, stored or traded electronically”). 

Specifically, the bill's definition moves beyond the need for "distributed ledger technology" and makes specific provision for the Treasury to be able to amend the definition in the future.  

This leaves significant flexibility for the expansion of the perimeter in due course and, arguably, captures cryptoassets such as NFTs, which it had previously appeared the Treasury intended to leave unregulated for the time-being.

Treasury's change in approach

Perhaps most significantly, this amendment may indicate a more ambitious approach, or more accelerated timetable, to the regulation of cryptoassets in the UK. The proposed amendment is only the first step, but it was taken in surprising circumstances.

Until the amendment was introduced, the bill was only expected to regulate stablecoins (or "Digital Settlement Assets" in the language of the bill) and financial promotions relating to cryptoassets, not cryptoassets themselves.

The proposed changes introduced in the original bill had been limited to:

• bringing stablecoins capable of being used to effect payments (Digital Settlement Assets) within the supervision of the Bank of England with respect to systemic risk;
• making those "payment stablecoins" subject to appropriate competition regulation by the Payment Services Regulator; and
• making cryptoassets subject to the rules on financial promotions.

The changes in respect of stablecoins had been expected since the first consultation over 18 months ago, and the extension of the financial promotions regime anticipated since January 2022.

Consequently, the broader scope of the proposed amendment came somewhat as a surprise. Only days earlier, while responding to a question about whether it was necessary to regulate all type of cryptoassets, Mr Griffiths had suggested it would be prudent to begin with stablecoins, and incrementally extend the perimeter over time:

"The reason we have started with stablecoins is that there are challenges in bringing them into regulation for the first time. The hon. Lady would not want us to rush, because by bringing them into the regulatory perimeter, we confer a status on them that may lead to some of the consumer harms she mentioned. The Government’s position is to start with the most stable, least volatile coins, which are likely to be used by intermediaries as settlement currencies, and then to go forward and consult from there."

The bill, as it then stood, followed a consistent approach of incremental development, following consultation, starting with stablecoins and financial promotions. The potential extension of the perimeter to all cryptoassets was not on the agenda, so it appears that the incremental approach may now being set aside.

What next?

This proposal is only the first step in a long road to full regulation of cryptoassets in the UK. The timeline for the bill to pass is unknown: it still needs to be read in the House of Commons for a third time, and go through the House of Lords, before receiving Royal Assent.  

Once given, it would then be for the Treasury to propose amendments to the Regulated Activities Order to identify the "specified activities" relevant to cryptoassets (or potentially to exercise its proposed powers in the bill to "designate activities"). 

The government has already committed to consult on the extension of the regulatory perimeter to all cryptoassets before the end of 2022 and the Bank of England is due to consult further on the regulatory framework for stablecoins in 2023. It is likely that those consultations will give a clearer view of the direction for cryptoassets regulation and the timeline.

Osborne Clarke comment

The extension of regulation to cryptoassets is likely to increase consumer confidence in those assets, provide some level of stability, and therefore encourage growth in the industry.  

On the other hand, the requirement for firms dealing with cryptoassets to be fully authorised with the FCA will mean a significant increase in those firms' compliance obligations, and an equivalent increase in their costs of compliance.  

Firms will have some time before the precise scope of the impact of this proposal become clear, and any rules come into force. However, the impact could be very significant on those who are already registered with the FCA for MLD5 purposes, and could cause some to delay entering into the UK market until the position become clearer (to avoid the need to go through both the MLD5 registration process and a subsequent FCA-authorisation process).

Firms should track these developments closely; not least the forthcoming Treasury consultation, promised before the end of the year.

If you have any questions about the potential impact of the Financial Services and Markets Bill, contact our experts below.

You can learn more about cryptoasset regulation in the EU and UK at our webinar held on 10 November.

Read more about financial promotions and the FCA's supervisory priorities for alternative firms.