Following the collapse of the FTX exchange, the government’s proposals to regulate cryptoassets has become even more relevant. This article analyses the proposed regulatory changes and their potential impact on market actors involved in the crypto sphere.

Proposed amendments

HM Treasury and the Financial Conduct Authority (FCA) have indicated that the increase in retail investors’ ownership of crypto products has been accompanied by a decline in understanding of such products and an increase in misleading advertising. Similarly, while no cryptoasset scams were reported to the FCA in 2017, in 2021, the total number of such reports was 6,372. This is an indication that measures aimed at protecting retail investors and preventing crypto-scams are urgent and necessary.

The FCA has warned of the risks of unregulated cryptoassets for some time. In response, the government has drafted a bill to bring certain cryptoassets within the scope of the financial promotion restriction of the Financial Services and Markets Act 2000 (FSMA) and within the definition of ‘regulated investments’ within the FSMA. The Bill is still in the report stage in the House of Commons and is expected to pass into law in the first half of this year.

There appears to be a general consensus that the promotion of cryptoassets should be regulated. Assuming the Bill passes into law, cryptoasset providers will be given a six-month transition period to ensure compliance with the new rules. The situation is, however, less clear with respect to the inclusion of cryptoassets within the definition of regulated investments. The amendment was a last-minute proposal by Andrew Griffith, Economic Secretary to the Treasury, without prior consultation. Whether it will pass into law remains uncertain and how the changes proposed will be used to create a regulatory framework is equally unclear. In addition, a new consultation on this topic is expected in early 2023.

Including cryptoassets within the scope of regulated investments would be an important step to bring cryptoassets within full FCA regulation. Although being less comprehensive at this stage, this approach seems to follow the proposed EU Markets in Cryptoassets Regulation which designed a unified licencing regime for cryptoasset providers within the EU. If activities concerning cryptoassets fell within the scope of regulated activities, anyone carrying on such activities in the course of business would have to obtain prior FCA authorisation or risk committing a criminal offence, under section 19 of the FSMA. Full FCA regulation would also introduce a whole suite of requirements and obligations (set out in more detail below).

Impact of the amendments

In respect of the financial promotion restriction, although promotion of certain cryptoassets (such as security tokens or e-money tokens) is already covered, the proposed amendment would bring certain currently unregulated cryptoassets within the ambit of the Financial Promotions Order. This would make any promotion of such products subject to the financial promotion restriction, breach of which, is a criminal offence, under section 25 of the FSMA.

If cryptoasset providers are brought within full FCA regulation, in addition to requiring the FCA’s prior authorisation to carry on their business, they would be subject to its supervision and a wide range of regulatory provisions, which would undoubtably impose a significant regulatory burden on them. Most importantly, their senior managers would have to be approved under the FCA’s Senior Managers Regime and aspects of their business, such as the treatment of client funds, the management of market risk and prevention of financial crime would be subject to FCA scrutiny. The FCA would also have the power to require firms to cease trading, should they have significant concerns, and investigate and penalise any breaches of its rules.

For the purposes of the changes proposed by the Bill ‘cryptoassets’ are defined as those which can be transferred, stored or traded electronically, and that use technology supporting the recording or storage of data (which may include distributed ledger technology), as per Section 61(4) of the Bill. This is a broad definition and is different to that already used for purposes of money laundering supervision of the crypto sector by the FCA (see Regulation 14A of the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLR). There are also concerns within the market that these rules are too complex – even HM Treasury has conceded that whether the rules apply to some cryptoasset products will have to be considered on a case-by-case basis.

What should firms do?

The new amendments are an important development for cryptoasset providers and intermediaries. Ultimately, these entities would need to make sure that they comply with the new regime. Should firms inadvertently breach the new rules, they may find that, in addition to their criminal liability, their business revenues are regarded as criminal property under the Proceeds of Crime Act 2002. This then raises the risk of committing further money laundering offences when mixing, or otherwise dealing with, those funds.

With respect to the financial promotion restriction, cryptoasset providers would need to work carefully with authorised financial promotions approvers to continue to advertise cryptoassets to retail investors. However, most approvers will have only limited experience of cryptoproducts: how clearly the FCA will set out its expectations or vigorously enforce the regime remains to be seen.

Should the regulated investments amendment be included in any final bill, firms will have to then be alive to a further regulations which might then bring them within the scope of regulated activities. Perhaps most significantly, any firm which wishes to be authorised will also have to obtain the FCA’s approval of its senior management team and ensure that its policies and procedures meet the FCA’s regulatory requirements. Looking to some of the reported failings at FTX, some requirements in particular, such as those concerning the treatment of customer money and management of conflicts of interest, should be welcomed by crypto investors.

Will the FCA be able to deal with crypto enforcement and oversight?

Following its lobbying for the inclusion of cryptoassets within the financial promotion rules, it should be expected that the FCA will take a robust approach to their enforcement. However, the extent to which the FCA has the capacity to exercise its powers effectively remains uncertain.

The regulator has been here before. The Fifth EU Anti-Money Laundering Directive brought the registration and supervision of cryptoexchange and custodian wallet providers under the auspices of the FCA for the purposes of money laundering supervision under the MLR).

Registration was subject to significant delays with a twice extended temporary scheme implemented by the FCA, allowing those who had already applied for registration but whose application had not yet been determined to carry on their business. This extension was necessary because, although to carry on business without registration was a criminal offence, the FCA had been unable to process the applications received in time. The FCA asserted that delays in registration were, at least in part, because of the poor standard of regulatory applications. Others in the industry have been reported as describing the FCA’s handling of the crypto registration as frustrating and chaotic.

Based on the FCA’s own figures, the potential scale of alleged crypto scams is large and growing and, according to the regulator, regulatory knowledge within the industry is inadequate. This suggests there is plenty of supervisory and enforcement work to be done.

The FCA is acutely alive to criticism that it has in the past failed to identify and act on evidence of wider misconduct arising out of firms supervised for the purposes of financial promotions only. This was most recently made in an independent review, led by Lady Gloster, which identified that the FCA had repeatedly failed to identify and act on evidence of wider misconduct and potentially, fraud, while relying on the fact that the conduct in question fell outside of its regulatory responsibilities.

Early figures for investigations opened by the FCA into breaches of money laundering rules by crypto firms were not auspicious. In a freedom of information response from June 2022, the FCA confirmed it had not opened any investigations despite becoming responsible for their supervision, with respect to money laundering rules, since January 2021.

However, recent action by the FCA suggests that it is takings its existing supervisory duties concerning the crypto sector seriously. Two cases fought successfully by the FCA in the Upper Tribunal in the summer of 2022 have shown the FCA taking a robust approach to the registration of cryptoasset exchange providers, and application of the MLR (see Gidiplus Ltd v the FCA [2022] UTUT 00043 (TCC) and Vladimir Consulting Ltd v the FCA [2022] UKUT 00168 (TCC)).

More recently in September, in Money Brain Ltd v the FCA [2022] UKUT 00257 (TCC), the FCA has refused an application by a firm to be registered under the MLR on grounds that it was a not a “fit and proper person”, under Regulation 58A of the MLR. Significantly, the FCA’s determination, which was upheld by the Upper Tribunal, was based on misleading statements on the firm’s website asserting that that a token was ‘asset-backed’ when in truth it was not. Interestingly, the judgment in the case shows that the FCA’s financial promotions team led much of its engagement with the firm. The FCA also expressly relied on the findings of Lady Gloster’s report, which stated that a firm’s business should be considered “holistically”, in justifying the broad approach it has taken to the application of its regulatory responsibilities.

If the FCA has the will and resources to take a similarly robust approach when its powers are widened, then cases like these augur well for future regulation of the sector.

Promising signs?

The government has repeatedly stated its intention for the country to be a “global hub” for crypto. Its intentions and willingness to act are encouraging. Although there are promising signs, many may question whether the coming regulatory changes are enough and the FCA is sufficiently resourced to ensure that bad actors within the industry are contained and a compliant, regulated crypto sector nurtured.