Out-Law / Your Daily Need-To-Know

FCA refuses to close the door to 'permissionless' blockchain networks and steps up scrutiny of ICOs

Out-Law News | 19 Dec 2017 | 2:04 pm | 3 min. read

Financial services firms that wish to set up "permissionless" blockchain networks will not automatically be engaged in outsourcing and be in breach of Financial Conduct Authority (FCA) rules, the regulator has said.

Blockchain, or distributed ledger technology (DLT), is being increasingly experimented with by businesses in a range of sectors, including financial services, as digital infrastructure capable of enabling the exchange of assets in a transparent and secure way.

According to the FCA, the DLT networks can be set up in a permissioned or permissionless way. Permissionless networks "allow general public visibility of transactions online and are open for broad participation", while permissioned networks "typically feature a ‘gatekeeper’ who controls access", it said.

In a statement (32-page / 435KB PDF) issued in response to feedback received to a discussion paper it had published in April on the top of distributed ledger technology (DLT), the FCA said some businesses had expressed the view that the way permissionless DLT networks work "could be incompatible" with the regulator's rules on outsourcing.

"[The respondents] reasoned that, in their purest form, permissionless networks have limited governance, tend not to identify participants, and depend on a public network to validate and store transactions without any particular organisation supporting the network," the FCA said. "These respondents said that only permissioned networks would be able to fulfil our outsourcing requirements."

However, the FCA said that there is no automatic ban on using permissionless networks under existing regulations.

"We believe that use of permissionless and public networks is not inherently incompatible with our regulatory regime," the FCA said. "We do not discern any fundamental incompatibilities between the two. Our view is that firms will need to assess each case to see whether using a DLT network amounts to ‘outsourcing’ in the context of our regulatory requirements."

"We do not consider that using a permissionless network always necessarily amounts to outsourcing in that context. Thus, we do not consider that regulation necessarily prohibits firms from using public, permissionless DLT networks, provided appropriate risk management is deployed. So a firm’s focus in each instance of DLT application should be on identifying and appropriately mitigating the associated operational risks," it said.

Expert in blockchain and outsourcing contracts Tim Roughton of Pinsent Masons, the law firm behind Out-Law.com, said that the FCA was correct to state 'that use of permissionless and public networks is not inherently incompatible with our regulatory regime'. 

"The regime is, or should be, technology agnostic," Roughton said. "What is important to assess is whether the function or activity being carried out on the DLT network amounts to outsourcing in the first place – only then will the regulatory regime apply. However, once it has been established that it is an outsourcing, I agree with the industry view that it is difficult to envisage how a permissionless DLT network can be compatible with the regulatory regime."

In its paper, the FCA also confirmed that it intends to conduct deeper analysis of developments in relation to 'initial coin offerings' (ICOs).

ICOs are an increasingly popular way for businesses to raise money. Typically, businesses will develop a digital token, such as their own proprietary virtual currency, and look to sell those tokens to investors in a bid to raise capital in return for existing cryptocurrency, such as Bitcoin, Ether or Ripple rather than fiat currency such as dollars, euros or pounds. The trade of these tokens is recorded using blockchain.

Investors can in most cases sell on those tokens for profit on certain peer-to-peer exchange platforms should the value of the tokens increase. They are sometimes further incentivised into buying the tokens by being given the opportunity to share in profits generated from the business ventures that benefit from their investment. 

The FCA has previously warned consumers about the potential risks in investing in ICOs and said that it now plans to "gather further evidence on the ICO market and conduct a deeper examination of the fast-paced developments".

"Our findings will help to determine whether or not there is need for further regulatory action in this area," the FCA said.

The FCA said that it is open to businesses behind ICOs testing their ideas through its regulatory sandbox scheme providing that it is able to "satisfy the ‘consumer benefit’ criterion" for participation in the initiative.

"In the context of ICOs our consumer benefit criterion means, among other things, that: the ICO must fall within our regulatory perimeter and be fully compliant with UK and other relevant regimes, or if outside our regulatory perimeter, designed, promoted and governed in line with best practice, so that potential acquirers are properly informed about the proposition that is being marketed to them," the FCA said.

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