Recent crypto announcements: the impact for asset managers and investors
Whilst the announcements may not appear to have a significant impact on asset managers and investors, they are interesting in understanding the crypto-environment and the providers of crypto services. After all, crypto is certainly on the march: a report published by PwC last year highlighted a global increase in AUM of crypto funds from $2bn in 2020 to $3.8bn in 2021.
Summary of the announcements
There are also points for managers to note on their regulatory duties, especially in the FCA statement. The FCA’s and PRA’s expectations for crypto-firms and those with exposure to cryptoassets should also give regulated managers a taste of what the FCA is likely to expect from them when managing cryptoassets and the risks for their investing clients. The HMT publication also highlights the government’s interest in the role of Distributed Ledger Technology (DLT) in the trading of securities and similar wholesale market activity, highlighting benefits such as greater efficiency and transparency/traceability of transactions while noting drawbacks such as disruption in current practices and greater fragmentation. The application of DLT to the activities of market-users including managers and investors, with no interest in crypto as an asset class, is important and HMT acknowledges this.
The HMT publications are part of a campaign to make the UK a global hub for cryptoassets and also include announcements on a financial market infrastructure sandbox, ongoing work on Decentralised Finance - DeFi, the work of Centre for Finance, Innovation and Technology, the issuance of by the Royal Mint of a non-fungible token (NFT), and proposals for cryptoasset engagement groups. Besides the regulatory announcements, an important announcement on tax and crypto for fund managers requires mention: John Glen said in a speech that the UK would amend the Investment Manager Exemption to remove disincentives to UK fund managers from including cryptoassets in their portfolios. Our briefing on this can be found on our website.
A further step towards more universal regulation
As noted above, the publications continue the advance of regulation into the cryptoasset sector, with the extension of the financial promotion regime, which will see "qualifying cryptoassets" falling within the category of "Restricted Mass Market Investments" being a recent example (see our recent blog post for more detail). They also reinforce the concern with combining or including unregulated cryptoassets with or within regulated products offered to retail investors: the FCA rules ban the sale of derivatives and structured products linked to retail investors and the managers of authorised retail funds may not hold cryptoassets in those funds.
Although the extensions to the Money Laundering Regulations 2017 that took effect in 2020 require various cryptoasset providers to register with the FCA, there is still no move towards requiring firms carrying on activities, such as managing or advising on Bitcoin and similar cryptoassets, to become FCA authorised. Moreover, securities laws such as the Prospectus Regulation and Market Abuse Regulation, do not apply to cryptoassets, other than "security tokens". The general anti-fraud laws, however, do apply as do general regulatory standards, such as those set down by the Advertising Standards Authority (ASA) which recently issued a notice requiring those advertising cryptoassets to make it clear that cryptoassets are unregulated and not protected.
The question of whether the general law enforced through the courts is sufficient to protect cryptoasset investors and users of cryptoasset infrastructure will remain with decisions, such as that in Tulip Trading Ltd v. Bitcoin Association for BSV and others, causing some to argue that further regulatory protection is necessary. In Tulip Trading the court refused to accept that developers and/or controllers of blockchain software owed a duty of care to blockchain users that required them, for example, to re-establish access to stolen cryptoassets and reverse known frauds although left door open the door to the future imposition of other more restricted duties.
FCA regulated firms and cryptoassets
The FCA’s statement on exposure to cryptoassets followed a more comprehensive letter from the PRA.
Both the statement and letter bill themselves as reminders to all relevant regulated firms of their existing obligations when they are interacting with or are exposed to cryptoassets and related services and notes, amongst others, the following:
- being clear with customers – when assessing the risks cryptoassets pose, adopt a similar approach to that for regulated activities and ensure that consumers understand what is regulated and unregulated;
- appropriate systems and controls – have in place appropriate systems and controls to counter the risk of a firm being misused for financial crime and when firms doing business with cryptoasset service providers check the FCA list and have in place sufficient due diligence and money laundering controls;
- assess risks – assess the risks posed by a customer whose wealth or funds derive from the sale of cryptoassets, or other cryptoasset related activities, using the same criteria that would be applied to other sources of wealth or funds noting the evidence trail behind crypto transactions may be weaker; and
- custody considerations – apply Principle 10, which requires a firm to arrange adequate protection for clients’ assets, and check whether the Client Assets Sourcebook (CASS) applies to the cryptoassets held or managed.
The statements on regulatory capital, with a financial stability focus, are unlikely to resonate with investment managers. Managers will have to take notice of the points above, however, which are relevant to any regulated firm charged with managing another’s assets, including their cryptoassets.
The regulation of stablecoins
The HMT response to its 2021 consultation on the UK regulatory approach to cryptoassets and stablecoins focuses on stablecoins, albeit they examine the current state of UK cryptoasset regulation generally and the use of distributed ledger technology.
The response affirms the regulatory taxonomy for cryptoassets in the UK: "exchange tokens", such as Bitcoin, and "utility tokens", remain "unregulated" (although the financial promotion changes and application of AML requirements to providers qualify this term); security tokens, with the characteristics of otherwise regulated investments, are regulated. Stablecoins linked to a single fiat currency are to become regulated insofar as crypto-service providers, such as exchanges and third party custodians, will need to become FCA authorised on current HMT proposals. This does not extend to those managing stable tokens although, given that they represent value linked to cash and assets such as gold, it is unclear whether a manager would need to manage tokens when it can manage the underlying assets. HMT has decided that algorithmic stablecoins, or those that may be linked to assets other than fiat currency will not regulated because they share similar characteristics to unbacked cryptoassets and do not offer sufficient price stability.
In focusing on stablecoins, HMT is seeking to:
- amend the Electronic Money Regulations 2011 and Payment Service Regulations 2017 bringing stablecoins more firmly within the perimeter of e-money and payments regulation and imposing FCA authorisation, governance and organisation, and conduct requirements on issuers of stablecoins and entities providing related services;
- introducing a new regulated custodial activity to capture providing and arranging custody with related FCA authorisation, governance and organisation, and safeguarding requirements;
- extending the applicability of Part 5 of the Banking Act 2009 to include stablecoin activities to apply in cases where the risks posed have the potential to be systemic and so meet the threshold for Bank of England supervision; and
- extending the scope of the Financial Services (Banking Reform) Act 2013 to ensure relevant stablecoin-based payment systems are subject to appropriate competition regulation by the Payment Systems Regulator.
These changes are of little direct relevance to investment managers. They do, however, point to increased regulatory duties, especially the duty to protect against the loss of cryptoassets through proper technology. Linking in to the points above on appropriate systems and controls and custody considerations, technological integrity and senior manager understanding of technology, both one’s own and that of third party service providers, are themes that can only grow in importance for anyone managing cryptoassets.