Regulation of cryptoassets may change over lifetime of use, says FCA

Out-Law News | 25 Jan 2019 | 10:30 am | 5 min. read

Businesses planning to issue their own cryptoassets have been warned that the regulatory treatment of the tokens could change during the lifetime of their use.

In draft new regulatory guidance it has prepared, the Financial Conduct Authority (FCA) highlighted the potential for re-categorisation of tokens, and explained the different regulatory responsibilities and permissions that apply to the different types of tokens on the market.

The FCA's draft guidance comes as an increasing number of business globally are exploring 'initial coin offerings' (ICOs) as a means of generating capital.

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 funds 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 technology.

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 growth in popularity in, and the nature of the activities being carried out in relation to, cryptoassets, has drawn intense scrutiny from regulators in recent times.  Some countries, notably China and South Korea, have banned ICOs altogether amidst concerns expressed by regulators that they have been used as tools for fraud, while authorities in other parts of the world, including the US, Hong Kong, Singapore and Switzerland, have issued guidance on how the regulations in their jurisdictions apply to cryptoassets and related activities.

The latest draft guidance produced by the FCA is the most detailed intervention to-date by the regulator in the UK in relation to activities in the crytoassets, and comes after a Cryptoassets Taskforce, which brought representatives from the FCA together with the UK Treasury and Bank of England, recommended tighter regulation of cryptoassets in the UK in the autumn last year.

According to the FCA, while it has seen "potential benefits" from the use of cryptoassets, particularly in relation to "increased speed and a reduction in cost of cross border money remittance with cryptoassets as a vehicle for exchange", their use poses "a range of substantial risks to consumers" as well as of financial crime and to market integrity. It said its guidance is aimed at reducing harms by "increasing clarity".

The FCA said there are "three broad categories of cryptoassets". These are exchange, security and utility tokens. However, it said those categories are "not mutually exclusive, nor exhaustive of the types of cryptoassets that can exist".

While exchange tokens are "intended and designed to be used as a means of exchange" and are commonly "a decentralised tool for buying and selling goods and services without traditional intermediaries" that typically fall outside the scope of regulation, security tokens are generally subject to regulation as they convey "specific characteristics" that can qualify them as shares, debentures or other 'specified investments', the FCA said.

Utility tokens are different again, as they "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". Despite this, the FCA said utility tokens can in some cases fall subject to regulation under the electronic money (e-money) regime.

In its draft guidance, the FCA has gone into detail about how the existing regulatory regime applies to each of exchange, security and utility tokens. It said too that in certain circumstances the function of tokens can change during their lifetime and that this can alter the regulatory treatment that applies to them.

The FCA illustrated this point by setting out an example of where a utility token issued could later be classified as a security token.

"A token that provides access to a current or prospective product or service is likely to be considered a utility token (and probably outside our regulatory perimeter)," the FCA said. "However, a token that confers a reward can potentially be considered a security token if the reward has the same or equivalent characteristics as specified investments, as detailed in the guidance. A utility token can, during its lifecycle, become a security token if the intrinsic characteristics of the token are altered to confer the same rights as a security."

In relation to exchange tokens, the FCA warned companies that while their activities may fall outside the scope of its regulatory regime at the moment, forthcoming new EU anti-money laundering laws could soon apply to them.

The FCA also said all firms, whether regulated or not, should "apply the financial promotion rules and communicate financial promotions for products and services … in a way which is clear, fair and not misleading".

The regulator also offered guidance on the territorial scope of UK regulation in relation to activities involving cryptoassets, which can often involve businesses based overseas or targeting customers in other jurisdictions.

The FCA said: "The requirement to be authorised only applies in relation to activities that are carried on by way of business in the UK. Given the decentralised nature of cryptoassets with a large cross-border element, it can be difficult to determine where the activity is carried on. [FCA perimeter guidance] ... sets out that even where part of the activity is outside the UK, a person may still be carrying on a regulated activity in the UK."

"For example, a firm that is situated in the UK and is safeguarding and administering security tokens (specified investments) for clients overseas will be carrying on activities in the UK even though the client may be situated outside the UK," it said.

The FCA said it hopes its new guidance will clarify its expectations for firms carrying on cryptoasset activities within the UK.

"The cryptoasset market, and the underlying DLT (distributed ledger) technology, is developing quickly and participants need to be clear on where they are conducting activities that fall within the scope of the FCA’s regulatory remit and for which they require authorisation," the FCA said. "It may be a criminal offence to carry on regulated activities without the relevant authorisations."

"We also want to support consumers to understand the cryptoasset market and the implications for the types of protections they are afforded depending on the product. The final guidance will help market participants to understand whether the cryptoassets they employ are within the regulatory perimeter. This will alert market participants to pertinent issues and should help them better understand whether they need to be authorised and what rules or regulations apply to their business," it said.

Late last year, HM Revenue and Customs (HMRC) published new guidance on tax treatment of cryptoassets for individuals. The government and FCA provided further details of the action they intend to take too in response to the Cryptassets Taskforce report, which includes opening a consultation on the potential introduction of new legislation early this year, and issuing the now-published draft FCA guidance.

The FCA's consultation is open until 5 April 2019, and the final guidance is expected to be issued by the summer.