UK Government Responds to Submissions on Cryptoassets Regulation - Part 2

The UK Government has published three documents that expound on its plans for the regulation of certain cryptoassets, including fiat-backed stablecoins used for payments:

• Update on Plans for the Regulation of Fiat-Backed Stablecoins (the Update)
• Future Financial Services Regulation of Cryptoassets: Response to the Consultation and Call for Evidence (the Response)
• Managing the Failure of Systemic Digital Settlement Asset (including Stablecoin) Firms: Government Response to Consultation (the Systemic DSA Firm Paper)

This note is in two parts, which draw out the points that are made more certain by the Response and Update. In the first part, we consider the approach to fiat-backed stablecoins described in the Update and the scope of regulation set out in the Response, taking account of the changes to potential insolvency arrangements described in the Systemic DSA Firm Paper. In this second part, we look at additional issues raised in the Response.

1. Issuers and Disclosures

The Government intends to take forward plans for all cryptoassets made available for trading on a UK trading venue to have disclosure documents that describe the asset's features and associated risks. The model is for the forthcoming Public Offers and Admissions to Trading Regime (POATR) to apply as it does for Multilateral Trading Facilities (MTFs). This would require trading venues to settle their disclosure requirements in line with principles defined by the FCA; taking into account whether the trading venue is supporting retail or wholesale activity. For public offers, the Government is considering using the DAR to prescribe requirements, while the POATR would control incentives and awards (eg, free tokens via airdrops). Cryptoassets representing financial instruments are already required to comply with the Prospectus Regime, and that will continue to be the case once these other changes are made.

Pre-Existing Tokens

The Government intends that trading venues will produce disclosure documentation for cryptoassets that they admit to trading, if there isn't an issuer undertaking that task. The responsibility for determining the content of admission documentation rests with the trading venue, but the Government looks forward to a private sector approach to settle standards with FCA input.

Liability

Liability for the accuracy of disclosure documentation is intended to attach to the person responsible for creating it. The Government does not expect, however, that trading venues preparing disclosure documents should become strictly liable for all losses that might be connected to the relevant token. It proposes a safe harbour for trading venue operators creating documentation with reasonable care to identify and describe the risks. It gives the example that an operator should be excused from liability arising from the failure of a protocol or network where the operator has undertaken due diligence, disclosed its findings, and avoided making misleading statements about the operation of the protocol or network. Following the proposed POATR approach, the Government suggests that forward-looking statements ought to be subject to recklessness/dishonesty standards, while statements of fact about past events or conditions should be subject to a negligence standard.

Barriers to Admission

The Government has agreed that the requirements for disclosure/admission documentation should not apply in certain circumstances:

• Tokens that are not available to the UK public
• Offers made for no consideration or below a certain threshold
• Offers to a limited number of persons or only to professional investors
• Tokens acquired as rewards from a consensus protocol mechanism

2. Operation of Trading Venues

In its consultation, the Government proposed to use the MTF trading venue as a model for the trading of cryptoassets. The feedback received included suggestions that organised trading venue (OTF) models might be more appropriate, given the discretionary nature of execution in some cryptoasset trading environments. In its Response, the Government has indicated that it is not intending to prescribe or endorse any trading protocols or business models in legislation. The responsibility will be on trading venue operators to address the potential for conflicts of interest connected to, eg, matched principal trading.

3. Intermediary Activities

The RAO describes a number of activities that can be undertaken by authorised intermediaries. The Government intends to adapt that list for cryptoasset services, with the focus on the following:

• "Buying, selling, subscribing for or underwriting….as principal"
• "Buying, selling, subscribing for or underwriting….as agent"
• “Making arrangements for another person (whether as principal or agent) to buy, sell, subscribe for or underwrite…”
• “Making arrangements with a view to a person who participates in the arrangements buying, selling, subscribing for or underwriting…(whether as principal or agent)…”

In order to prevent cryptoasset exchanges from seeking authorisation in the UK as intermediaries rather than trading venues, the Government intends to require that a disclosure/admission document is filed for each cryptoasset before an intermediary deals or arranges deals in it.

Sophisticated parties who would be classified as "eligible counterparties" under MiFID II rules do not need the same protections as are provided for retail-level consumers. The Government has, therefore, agreed with feedback that there should be a different level of expectation on intermediaries provided services to eligible counterparties. In general, questions about treatment of different clients or counterparties are matters for the FCA, and the Government has deferred to the regulator on matters relevant to rulebooks and conduct standards.

4. Custody

The intention of the Government is that the provisions of FSMA 2000 concerning custody should apply, with appropriate modifications, to the custody of cryptoassets. They clarify that the provision of self-hosted wallets is not expected to come within the activities of "safeguarding" or "safeguarding and administering," but the practice will be kept under review and given further consideration as an outsourced service arrangement. The use of third-party storage companies, however, could be treated as "arranging" custody services. 

The Government notes the Law Commission's Final Report on Digital Assets and takes on board the need to consider its findings before finalising its views on the custody of cryptoassets.

Security Tokens

Although security tokens are functionally identical to securities under existing legislation for most purposes, the Government has clarified that the custody of security tokens requires alignment with the approach to be taken with fiat-backed stablecoins in Phase 1 of its regulatory programme for cryptoassets.

Liability

The Government has confirmed that it will not be seeking to attach strict, unlimited liability to custodians in respect of client holdings. 

5. Authorisations

The overall intention is for FSMA 2000 to be the basis of regulation for cryptoasset activities. A number of firms will need to apply for Part 4A permissions. Firms which already hold Part 4A permissions will need to apply for variations of permission – unlike the MiCAR regime in the EU, there will not be a simple notification process for such firms. Where firms have permissions under FSMA for Phase 1 activities involving fiat-backed stablecoins, they would need to submit applications for variations of permission to add any Phase 2 activities.

6. Market Abuse

The cryptoasset markets have suffered from poor practices ranging from "pump-and-dump" schemes to "rug-pulls," resulting in substantial losses for investors. Some actors have obtained unfair advantages through their involvement in issuances ahead of the general market. The Government intends to deal with these issues by applying a market abuse regime that is based on the Market Abuse Regulation (MAR) for financial instruments. Although concerns were raised through the consultation about the extraterritorial scope of the proposed rules, the Government is not minded to narrow their scope. Instead, it intends to discuss their application with the FCA.

Taking on-board concerns about information sharing by exchanges and regulated firms, the Government intends to bring in rules in stages. It will look to the private sector to develop standards for information sharing, with HM Treasury and the FCA providing input. One precedent for this is the Joint Money Laundering Steering Group, which produces guidance on anti-money laundering and counter terrorist financing rules in the UK. By putting cryptoasset exchanges together with other key industry actors, the expectation is that technical barriers to information sharing to identify, prevent and disrupt market abuse can be overcome in time.

In order to prevent the misuse of inside information, the Government intends to require regulated cryptoasset firms to have policies and procedures to manage price sensitive information. They will also be required to maintain lists of insiders and publish inside information when needed to ensure fairness in the markets for cryptoassets.

Accepting that the cryptoasset markets are dynamic and evolving, and that guidance would be helpful to illustrate regulatory expectations, the Government intends to address with the FCA how non-exhaustive examples can be made available to market participants.

7. Operating a Cryptoasset Lending Platform

The high-profile failures of several cryptoasset lending businesses in 2022 drew attention to the risks for retail investors of engaging in those markets. In particular, the "sale and buy-back" nature of lending transactions exposed investors lending their cryptoassets to counterparty risks that they might not have understood. In its consultation, the Government proposed to create the new regulated activity, "operating a cryptoasset lending platform," impose own-funds requirements on platform operators, and require the publication of risk warnings and clear contractual terms on ownership.

The proposal received substantial support, and regulations are expected with an initial focus on retail-level activity. Further rule-making for wholesale, bilateral lending will follow in a later phase, drawing on the transparency requirements in the UK Securities Financing Transactions Regulation.

8. DeFi

The Government sought evidence about the conditions in which decentralised finance (DeFi) arrangements are suitable for or require regulation. Its first conclusion is that it will not seek to ban DeFi. The second is that it would be "ineffective and premature" to attempt to regulate DeFi unilaterally, outside of the international work by bodies such as the FSB and IOSCO.

9. Staking

The Government intends to keep the staking of cryptoassets under review. It draws a distinction between true staking – ie, the locking up of cryptoassets as part of validation procedures, potentially for reward – and other activities which are characterised as "staking" but could reflect other commercial activities (eg, lending). Where these present risks to consumers, they might be addressed through other planned avenues (eg, regulation of intermediation activities). Where they resemble collective investment schemes, the Government intends to make a distinction to allow for the most effective regulation of the activity.

10. Sustainability

One of the criticisms levelled against cryptoassets is that the systems creating or hosting them consume significant energy resources, which has consequences for the natural environment. The Government sought input on the ways to address this and has settled on information disclosures as the best way forward, for the time being. Given the need for international coordination, it intends to advance this through IOSCO and avoid taking unilateral action.

To view part 1, please click here.