Views from Hogan Lovells Global Digital Assets and Blockchain Practice

Commenting on the consultation response, John Salmon, Co-Head of the Hogan Lovells Global Digital Assets and Blockchain Practice and Lavan Thasarathakumar, Senior Advisor in the Global Digital Assets and Blockchain Practice provided their views:

“The overall sentiment towards the HMT Consultation response is a positive one, as it represents a decisive step towards establishing the UK’s regime for digital assets and certainly sets the UK up well for it ambitions to become a global hub for cryptoassets. However, to do so, the UK needs to act fast. Whilst the UK legislative process is quicker than some other jurisdictions , there are still obstacles ahead. When the initial consultation was published in February 2023, the narrative surrounding the timings was that something would be laid before Parliament very quickly and before the end of 2023. The tone in this response to the consultation has changed slightly—the government now states that draft legislation will be laid when Parliamentary time allows, with the timeline moving into 2024. Although in the grand scheme of things, this shift in time frame does not represent a major issue, it does bring with it some risk of further delays. With a General Election looming next year, Parliamentary time could be limited and there may well be other priorities. Whilst we do not consider that a change in government will have an effect on secondary legislation being laid before parliament, it will likely slow down the legislative process and, accordingly, move back the date of implementation.

The HM Treasury’s decision to take a phased approach is a sensible one—it is prudent to first address those matters that are of higher risk and of immediate concern. However, to be able to assure the industry that the entirety of their business can operate in the UK and for the UK to represent an attractive location for cryptoassets businesses to establish their headquarters, there needs to be clarity on how the UK is looking to approach all phases of implementation. Furthermore, the timeframe between the phases needs to be compressed. That being said, it is also important that there is not a “cliff edge” in relation to regulatory compliance for those already providing services in the UK. The response does go some way to provide assurances that there will be sufficient time between the laying of the legislation and the regulatory regime becoming effective—however, it is short on detail and we will likely have to wait until the relevant FCA consultation on how it will implement this regime is published.

It is important that the UK continues to be involved in shaping the global narrative, as it has been through IOSCO, and through the FCA chairing the crypto and digital asset workstream. However, there is also an argument for being a trailblazer—the industry is fast moving and the pace of international discussions does not keep up with it. As outlined in a recent European Central Bank report, the lack of clarity in the legal status of decentralised autonomous organisations has arguably stymied its adoption and development. Aspects of the approach taken in this consultation response, whilst level headed, perhaps could be slightly more ambitious and seek to dictate where the international community could go.

Global cooperation and coordination is necessary for this industry, however, the UK has clearly set out its objectives of being a global cryptoasset hub. Whilst other jurisdictions may have put regimes in place already, this prize is still up for grabs and the UK will need to act fast if it wants to seize it.”

Background

Following on from the consultation and call for evidence which ran from 1 February 2023 to 30 April 2023 (the “Consultation”), HM Treasury has now provided its response to the consultation feedback and confirmed its final proposals for the UK’s financial services regulatory regime for cryptoassets (the “Response”), which seek to create a regulatory environment in which cryptoasset firms can innovate, while maintaining financial stability and clear regulatory standards to enable the safe use of new technologies.

The original Consultation set out the government’s plans to regulate certain cryptoasset activities such as custody and lending within scope of the existing financial services regulatory framework established by FSMA. The Consultation also described the proposed phased approach to be taken by the government in developing cryptoasset legislation, where phase 1 would cover the regulation of activities relating to fiat-backed stablecoins used for payment, while phase 2 would cover the broader cryptoasset regime. This Response relates primarily to the regulation of cryptoassets under Phase 2. Out of the 131 total number of responses received, HM Treasury noted that around 80% of the responses were broadly supportive of the government’s approach, with 10% giving mixed/neutral feedback and with the remaining 10% being critical of the proposals.

Notably, since the publication of the original proposals, the Financial Services and Markets Act 2023 (FSMA 2023) has received Royal Assent—FSMA 2023 contains the powers for the government to specify cryptoasset activities within the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO), and to designate activities as part of the Designated Activities Regime (DAR).

Definition of cryptoassets and legislative approach

The government intends to proceed as broadly proposed in the Consultation, by expanding the list of ‘specified investments’ in Part III of the RAO and thereby requiring firms undertaking relevant activities involving cryptoassets by way of business to be authorised by the FCA under Part 4A of FSMA. Additionally, there is no intention to expand the definition of “financial instruments” in Part 1 of Schedule 2 of the RAO to include presently unregulated cryptoassets (but cryptoassets that already qualify as financial instruments such as security tokens will continue to do so).

The Response notes that developing a fully bespoke regime outside of the FSMA framework would risk creating an un-level playing field between cryptoasset firms and the traditional financial sector.

In response to feedback that the definition of cryptoassets in the Consultation was overly broad, the Response notes that future financial services regulation of cryptoassets will apply to a particular subset of cryptoassets depending on the matter being regulated, and will accordingly use a narrower definition to capture these. The precise legal mechanism for distinguishing between tokens that are in and out of scope will be set out in the relevant secondary legislation and FCA rules – however, as a general principle, the government’s intention is that cryptoassets not being used for one of the regulated activities within financial services markets or used as a financial services instrument, product or investment should fall outside the future financial services regulatory regime.

The Response also acknowledges the feedback the government has received suggesting that certain cryptoassets should be banned or treated as gambling—however, as set out in its response to the Treasury Select Committee, the government firmly disagrees with the suggestion that retail trading and investment activity in unbacked cryptoassets should be regulated as gambling rather than a financial service, on the basis that such an approach would lead to misalignment with international standards, overlapping mandates between financial regulators and the Gambling Commission, and a failure to appropriately address the risks associated with the cryptoasset industry

Authorisation process: Cryptoasset firms registered under the MLRs

The Response confirms the expectation that firms undertaking regulated cryptoasset activities would need to adhere to the same financial crime standards and rules under FSMA that apply to traditional financial services activities. This means that crypto firms already registered with the FCA under the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs) will also need to seek authorisation under the new FSMA-based regime, given that the rules in the new regime will be broader in scope than the current MLR registration regime. Authorisation is not automatically granted to MLR registered firms, but the FCA will take into account the regulatory history of applicants and will provide additional detail in due course.

Authorisation process: Firms with Part 4A permissions

Firms already authorised under Part 4A of FSMA would be expected to apply for a Variation of Permission (VoP) to enable them to undertake newly regulated cryptoasset activities. The same would apply to a firm which had established FSMA authorised status for phase 1 regulated activities relating to fiat-backed stablecoins.

(Territorial) scope of regulated cryptoasset activities

A person will generally be required to obtain Part 4A authorisation from the FCA if it undertakes by way of business one of the following regulated activities in or to the UK:

• Issuance activities;
• Exchange activities;
• Investment and risk management activities (e.g. dealing in cryptoassets as principal or agent, arranging deals in cryptoassets, and making arrangements with a view to transactions in cryptoassets);
• Lending, borrowing and leverage activities; and
• Safeguarding and/or administration (i.e. custody) activities

The government intends to implement the broad territorial scope as proposed in the Consultation. In relation to market access, the government is committed to working with international partners to work towards deference/equivalence type arrangements.

Additionally, the government does not intend to expand the Overseas Persons Exemption (OPE) to cover cryptoassets—its position is that firms dealing with UK retail consumers should be authorised irrespective of the firms’ location.

Vertically integrated business models

The Response clarifies that vertical integration should be permitted, but vertically integrated businesses should be required to follow the regulatory rules for each regulated activity undertaken. The government will continue to consider whether and how firms undertaking several regulated activities should be subject to proportionate prudential requirements.

Asset-referenced tokens and algorithmic stablecoins

The Response confirms that asset-referenced tokens, to the extent that they don’t fall within existing definitions of specified instruments or collective investment schemes but do meet the definition of a cryptoasset, will be regulated as unbacked cryptoassets. Similarly, algorithmic or crypto-backed stablecoins will be regulated under the wider framework for unbacked cryptoassets rather than within the forthcoming regime for fiat-backed stablecoins.

NFTs and Utility Tokens

The Response reiterates the government’s position that when assessing whether a NFT or utility token falls within the future financial services regulatory regime, the government’s focus will be on whether the token is used for one of the regulated activities in Table 4A of the Consultation within financial services markets or as a financial services instrument (in the general sense) or product, rather than how the product is described or marketed, or the purpose for which it was originally designed.

Issuance and disclosures regime

The government generally intends to take the approach as proposed in the Consultation to establish an issuance and disclosures regime for cryptoassets based on the intended reform of the UK Prospectus Regime: the Public Offers and Admissions to Trading Regime (POATR):

• For admission of cryptoassets to a UK cryptoasset trading venue, the government proposed to adapt the MTF model from the POATR where venues would write detailed requirements for disclosure documents required for admission.
• For public offers, the current Prospectus Regime applies to offers of cryptoassets where those cryptoassets fall within the definition of securities in scope of the regime.  For public offers of other cryptoassets the government is considering an alternative route (e.g. using the DAR).

The Response acknowledges that, for tokens that have already been issued, sufficient transitional time periods are needed between laying the legislation and the regime becoming effective to reduce the risks of “cliff edges” and removals from trading.

The government intends to take forward the proposal for trading venues to define detailed content requirements for admission disclosure documents. That being said, the government is supportive in principle of a centralised coordinating body (i.e. industry association) to coordinate, with FCA oversight, the efforts to define detailed content requirements for admission disclosure documents in order to ensure consistency across the industry. The government also agrees, in principle, with the idea that disclosure requirements would differ – and be less prescriptive – for venues which only admit institutional investors.

In terms of liability, the government maintains the position that all firms required to publish cryptoasset disclosure documents should be liable for their accuracy, except that cryptoasset exchanges (which choose to take responsibility for disclosure documents) should not be held liable for all types of losses arising to events relating to a token provided they have taken reasonable care to identify and describe the risks.

In order to mitigate barriers to entry, the Response clarifies that disclosure / admission requirements will apply only to tokens that are made available to the UK public; appropriate exceptions will apply; disclosure/admission documents would be fit-for-purpose and would not need to take the same form as long equity prospectus-like documents; and, in relation to prudential requirements on issuers, alternatives to own financial resources requirements will be considered.

Cryptoasset trading venues

The government intends to establish a regulatory framework for persons operating a cryptoasset trading venue which would be based on existing RAO activities of regulated trading venues—the Response reiterates the need, however, to take into consideration specific characteristics and risks of cryptoasset trading activities.

The Response also clarifies that the government is not intending to explicitly endorse or prohibit specific business models or execution protocols in legislation (e.g. OTFs / matched principal trading and proprietary trading), but the expectation is for firms to be able to evidence that conflicts of interests and risks to market integrity are appropriately managed within the context of their business models when firms seek authorisation from the FCA.

The Response notes that a number of other issues (such as operational resilience requirements) will need to be addressed through future regulator consultations and firm-facing rules.

Cryptoasset intermediation activities

The government intends to proceed with the proposal that requirements applying to analogous regulated activities – such as ‘dealing in investments as agent’ and ‘dealing in investments as principal’ set out in Article 25 of the RAO – would be adapted for cryptoasset market intermediation activities. The Response reiterates that the legislative approach and subsequent FCA rules will need to take into account specific aspects of crypto markets.

In terms of location requirements, the Response notes that if all overseas cryptoasset exchanges were to seek authorisation in the UK as intermediaries rather than cryptoasset trading venues, this would be problematic as the issuance and market abuse regimes are linked to the regulatory trigger points controlled by cryptoasset trading venues. The government therefore intends to require a disclosure / admission document to be lodged on the National Storage Mechanism (NSM) by a trading venue prior to any intermediary being able to deal or arrange deals in a given token.

Cryptoasset custody

The government intends to take forward the proposal to apply and adapt existing frameworks for traditional finance custodians under Article 40 of the RAO for cryptoasset custody activities—specifically the new regulated activity for custody covering the (i) safeguarding, (ii) safeguarding and administration, or (iii) the arranging of safeguarding or safeguarding and administration, of a cryptoasset. The Response notes that the government will consider the Law Commission’s Final Report on Digital Assets (which provides recommendations to clarify the concept of ‘control) in its forthcoming work on custody. 

On liability, the government confirms the intention not to impose full, uncapped liability on the custodian in the event of a malfunction or hack that was not within the custodian’s control.

Self-hosted wallets

The Response also clarifies that the provision of self-hosted wallets are not expected to fall within the new regulated activity for custody. However, regulators will continue to monitor this matter and will consider whether aspects of such products (in particular in relation to operational resilience) could be addressed through the FCA’s outsourcing and third parties rules and guidance.

Custody of security tokens

Although security tokens which meet the definition of an existing specified investment will, for the most part, continue to be regulated in line with existing rules and regulations, the custody of security tokens will instead fall within the new regulated activity due to the fundamental differences between how cryptoasset custody and traditional custody operate.

Market Abuse regime

The government intends to take forward the proposal to introduce a cryptoassets market abuse regime based on elements of the Market Abuse Regulation (MAR) regime for financial instruments. The market abuse offences would apply to all persons committing market abuse on a cryptoasset that is admitted (or requested to be admitted) to trading on a UK cryptoasset trading venue.

The proposed regime would impose obligations for certain market participants, for example cryptoasset trading venues (who would be expected to detect and disrupt market abuse behaviours) and cryptoasset market intermediaries (who would have obligations placed on them, in particular those around the handling of inside information).

Additionally, the government is supportive of a central organisation (with FCA oversight) to coordinate and harmonise information sharing.

Lavan Thasarathakumar also noted: “The market abuse regime was a topic of great discussion throughout the consultation process. Notably, the government’s proposed approach arguably puts a greater onus on trading venues as opposed to the FCA itself on running the market abuse regime. Whilst the rationale was understood, industry respondents highlighted a number of concerns around this, including data protection and privacy issues. It is encouraging to see HM Treasury take industry feedback on board and, in addition to championing the use of innovative RegTech solutions, to see HM Treasury looking to work with the FCA, industry and external stakeholders in developing a industry led market abuse information sharing platform.”

Cryptoasset lending platforms

In relation to cryptoasset lending firms, the government intends to create a newly defined regulated activity of “operating a cryptoasset lending platform” and to establish a bespoke set of rules. Such lending platforms would be subject to requirements to put in place adequate risk warnings, adequate financial resourcing and clear contractual terms of ownership. The Response clarifies that the government intends to prioritise regulation of retail-facing lending business models, given the concerns around retail consumer risks.

Call for evidence

Decentralised finance (DeFi)

The Response explicitly states that the government does not intend to ban DeFi, although the government reiterates that it would be premature and ineffective to regulate DeFi activities currently. Instead, the government will support efforts at the international level (e.g. through work being undertaken at the FSB and by standard setting bodies). The government also agrees with respondents to the Consultation that a spectrum of decentralisation needs to be recognised within the DeFi ecosystem rather than a binary between centralised or decentralised.

Other cryptoasset activities

The Response clarifies the government’s position relating to a number of other cryptoasset activities, including:

• In relation to the activity of cryptoassets investment advice and portfolio management, the government will continue to keep this activity under review rather than bringing it within scope of phase 2 legislation;
• The government does not intend to bring mining within scope of the perimeter as a regulated activity at this stage;
• HM Treasury intends to accelerate its work in relation to clarifying the regulatory treatment of staking in the UK due to industry concerns, including: (i) developing a clear definition of cryptoasset staking on a Proof of Stake (PoS) blockchain and distinguishing this from other activities which may be referred to as ‘staking’; (ii) establishing a taxonomy of the different PoS staking business models currently in the market; and (iii) identifying how to mitigate the associated risks and take advantage of the potential benefits of a permitted form of staking in the UK.

Staking

The Response sets out a proposed definition of staking and HM Treasury’s thinking on existing business models for the purposes of informing its policy approach, such as solo staking, delegated staking, decentralised pool staking and centralised pool staking. The Response notes that although there is no intention to ban staking, there is recognition that many activities performed by intermediaries in pool staking presents risks for consumers that should be addressed by regulation, and such risks are potentially captured by other regimes including financial promotions, custody, lending and intermediation, without the need for further regulation. Additionally, existing rules for collective investment schemes may capture on-chain staking services. HM Treasury is therefore signalling an intent to carve out certain types of staking from CIS rules, provided that the risks are appropriately captured in other cryptoasset regulatory regimes, or alternatively to introduce a new regulatory regime for “operating a staking platform” outside of the CIS framework.

On this topic, Lavan Thasarathakumar notes: “Over the course of the consultation process, there has been a lot of discussion on what the UK should do regarding staking. It was largely accepted as something that was missed in the MiCA regime and something that will no doubt be addressed in its review. It was clear from our own discussions with HMT and, as highlighted further in this response, that HMT considered this to be an important issue. As such, HMT has sought to propose a workable solution by carving out certain types of staking from falling within the rules applicable to collective investment schemes and seeking to put in place a new regime for operating a staking platform. It remains to be seen what this will mean in practice—however, it should be seen as a positive step forward and, if implemented correctly, such a development could attract a lot of business to the UK.”

Sustainability

Sustainability issues will be addressed primarily through disclosures in the first instance. The Response also highlights the government’s intention to develop international and interoperable metrics through existing international forums (e.g. IOSCO).

Next Steps

In terms of timeline, the government’s aim is for phase 2 secondary legislation to be laid in 2024, subject to parliamentary time.