On 7 January 2021, Her Majesty’s Treasury (“HM Treasury“) published a consultation (the “Consultation“) that called for evidence on the Government’s approach to the regulation of cryptoassets and stablecoins. This article refers to both products, and the terms will be used interchangeably throughout it.
Cryptoassets is the umbrella term used to describe digital tokens/coins issued on a distributed ledger technology (“DLT”) system. A DLT is a type of technology that allows records of transactions made using cryptoassets to be shared and updated in a decentralised way.
The term “cryptoassets” covers a broad range of products, which includes the following:
- bitcoins – these are a decentralized digital currency;
- stablecoins, also known as stable tokens – these are an evolution of cryptoassets and will be explained in more detail below;
- utility tokens – these are backed up by a current or future service which the holder can have access to, and such token can be exchanged; and
- security tokens, also known as equity tokens – they represent shares in an issuing company.
A stablecoin generally derives its value from an outside asset, which could be anything from gold, to currencies like United States Dollars, or even other cryptocurrencies. However, this is not always the case and it is possible for stablecoins to be uncollateralised. Stablecoins are used to minimise the volatility of the value of the underlying collateral, or its own volatility, in case it is not backed up by any collateral. They also stablise, as the name suggests, the prices of such collateral, or the stablecoin itself. There are two types of stablecoins:
- asset-backed stablecoins, which peg their value on commodities or currencies, as shown above, or
- algorithmic stablecoins, which use algorithms to regulate their prices to match supply and demand and are not backed by any assets.
The cryptoassets market continues to develop rapidly, and more so as a result of the Covid-19 epidemic, which sparked public concerns around the virus being transmitted by cash. The risks to users of these products become therefore inevitable. While HM Treasury is keen to maintain the UK’s status as a world-leader in financial technology, it is committed to building a regulatory environment that benefits both the innovation of firms and the safety of consumers.
Currently, the majority of the existing types of cryptoassets fall outside the regulatory perimeter. Yet, despite the Consultation representing only the initial stage of the consultative process, it could significantly impact the way in which the market for these digital assets could develop.
The main areas covered by the Consultation are set out below.
The Consultation has identified three main objectives:
- Maintaining financial stability and market integrity – to ensure that the regulatory framework is strong enough to absorb negative impacts on the financial system and that it has the necessary tools in place to manage any risks to financial stability;
- Ensuring a high level of consumer protection – to make sure that consumers of cryptoassets benefit from the same level of protection as they would when using other regulated instruments for the same purpose (e.g. payments);
- Promoting competition, innovation and supporting UK competitiveness – to continue encouraging and supporting fintech firms in the UK, and ensuring that consumers and businesses have access to a variety of high-quality services and products.
In order to achieve the above objectives, HM Treasury has proposed the following principles to guide market makers of cryptoassets:
- Maintain the current division of UK regulator responsibilities and apply the principle of ‘same risk, same regulatory outcome’ – this supports the goal of maintaining a level playing field and reducing the possibility of arbitrage. The proposal is to draw on existing regulations and requirements and to make adjustments where necessary to address risks that are specific to cryptoassets. The aim is to maintain the current allocation of responsibility between the different regulatory bodies as far as possible, which includes the Bank of England, Financial Conduct Authority (the “FCA”) and Payment System Regulator (the “PSR”);
- Ensure proportionate approach and focus on the most urgent or acute risks and opportunities – an incremental approach to adjusting the regulatory requirements is encouraged to avoid disproportionality and burden to entities;
- Ensure an agile approach to reflect international discussion and align to governmental approaches – this allows regulatory changes in the UK to reflect any international discussions as easily as possible, taking into account the cross-border nature of cryptoassets. This will assist the harmonisation of treatment of cryptoassets on a global basis.
The approach proposed by the government requires independent regulators to design and implement their own requirements. This ensures a level of agility that is necessary and comparable to the development of cryptoassets for two reasons: (i) to be able to respond to the rapid changes in this area and (ii) to flexibly review existing guidelines and update regulation to reflect any international developments where needed.
As such, HM Treasury did not specify any legislative requirements. Instead, its focus is on defining the scope of the regulatory perimeter to allow regulators to implement requirements accordingly.
Expanding the regulatory perimeter
The current proposals provide that bitcoins and other currently unregulated tokens and associated activities, which have the primary purpose of being speculative investments, will remain outside the perimeter for conduct and prudential purposes. However, they will be subject to tougher checks under the Anti-Money Laundering and Combating the Financing of Terrorism (AML/CTF) Regulation and the financial promotion regime under the Financial Services and Market Act (“FSMA”) when being used in consumer communications. Utility tokens will also remain outside the authorisation perimeter.
The use of stablecoins has grown rapidly, overtaking bitcoins and having the most value in transactions for the first time in June 2020. Although its potential in promoting innovation and industry growth has been recognised, the government has nonetheless identified a number of possible risks of using stablecoins, if no appropriate regulations are put in place. These include:
- Risk to financial stability and market integrity – as with any other private assets that function as money-high instruments, stablecoins could experience large fluctuations in their value. As such, it is paramount that consumers are properly protected and given stability and redeemability for the risks that come with using stablecoins.
- Risks to consumers – risks of the value of stablecoins being volatile increases where protections to consumers are limited. Consumers should be informed and educated on the risks associated with the service and product they are using.
- Risks to competition – the scalable nature of stablecoins means that it could adapt its service to mirror that of a regulated one without being subjected to the same compliance obligations, resulting in an unlevel playing field.
For these reasons, the government proposes a regulatory regime for stablecoins used as a means of payment. Such approach will be designed to offer sufficient flexibility to adapt to any future changes, subject to appropriate consultation and scrutiny.
TOKEN IN SCOPE OF REGULATION AND REQUIREMENTS
Presently, the priority of the UK government is to appropriately regulate tokens that could reliably be used for retail or wholesale transactions. Since algorithmic stablecoins closely resemble unbacked exchange tokens, the government considers them not suitable for retail or wholesale transactions, and as such, they fall outside the scope of the government’s consideration for this purpose. Security tokens and utility tokens are also excluded for the same reason.
CALL FOR EVIDENCE
While existing regimes are in place to ensure more efficient securities issuance, they are not originally decided to support the use of cryptoassets or DLT-based innovations. As such, HM Treasury has issued a call for evidence, in particular relating to:
- adopting existing regimes to support security tokens;
- DLT-based financial market infrastructures, including the benefits and drawbacks; and
- whether the UK government should bring other unregulated tokens and decentralized finance into the regulatory perimeter, and if so, how.
The Consultation will close on 21 March 2021. Stakeholders, such as cryptoassets firms, affected businesses, trade associations and consumers, are invited to respond to the questions set out in this Consultation, which the government will consider carefully for legislative purposes. The timings for which will be confirmed.
For more information, and any guidance or advice on cryptoassets and stablecoins, Cleveland & Co External in-house counselTM, your specialist outsourced legal team, are here to help.