Crypto Regulation

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In October 2023 finally the UK government finally brought crypto assets into regulation, after much discussion over the preceding several months.

This has been achieved via provisions, implemented by the Financial Services and Markets Act 2000 (Financial Promotion) (Amendment) Order 2023, which apply aspects of the UK’s financial promotion restriction under section 21 FSMA to certain species of crypto asset.

Prior to this time, crypto assets were not regulated per se. The prior position could be summarised as follows:

A crypto-representation of a conventional investment (a share or bond, for example) was and still is regulated as the old-order asset that it represented.

Cryptocurrencies, such as bitcoin, were not, and still are not regulated investments; however, Financial Conduct Authority has jurisdiction under the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 [MLRs] to require exchanges processing trades in cryptocurrencies and wallet custodians supporting those who trade, to register with FCA.

The FCA treats these registrations as substantially merit-based, and has rejected many applications since the jurisdiction first came into force in 2020.

Subject to these points, until now there has been no specific regulatory regime for crypto assets. In particular, issues of trade utility tokens or non-fungible tokens are outside of regulation, except where used to create a collective investment scheme, where different regulatory considerations apply.

So, what is changing?

Changes have now been made to aspects of the FSMA 2000 (Financial Promotion) Order 2005 [the FPO’] which serves to bring promotion of what will be termed “qualifying crypto assets” within a much greater degree of statutory control.

The FCA in its policy statement 23/6 sets out certain financial promotion rules for crypto assets and details of the near-final rules for the FCA handbook, which will only affect the activities of firms that FCA itself already regulates.

The application of the FPO is not something that the FCA has statutory powers to affect. The FPO is part of the general law, and it applies to provide exemptions for regulated and unregulated firms alike in the manner in which they make financial promotions of relevant types of investment to selected audience

The FCA’s power to make its own rules applies only to those firms engaging in investment business that it directly regulates (that is, firms that hold licences issued under part 4A FSMA).

It follows that the FCA’s approach in PS23/6 relates entirely to the regulated firms in the UK, and not to crypto exchanges and wallet custodians merely registered with FCA under the MLRs.

The proposed rule changes suggested by FCA will therefore affect the capacity of regulated investment firms to make financial promotions of crypto assets should they extend their operations into this field from their existing business in conventional investments.

Changes to the FPO

The legislation that brings the promotion of qualifying crypto assets within scope of the financial promotion regime is the FSMA 2000 (Financial Promotion) (Amendment) Order 2023, which came into effect on October 8, 2023.

The legislation, that defines crypto assets for the purposes of financial promotion as “any cryptographically secured digital representation of value or contractual rights that: (a) can be transferred, stored or traded electronically; and (b) uses technology supporting the recording or storage of data (which may include distributed ledger technology)”.

Layered on top of this is a further significant definition: a qualifying crypto asset is any crypto asset that is fungible (that is, mutually interchangeable with other crypto assets of the same kind) and transferable. But excluded from the definition are the following:

    crypto assets representing what one may call conventional investments (for example, shares, bonds, options, futures etc);

    e-money;

    fiat currency;

    fiat currency issued in digital form and

    non-transferable crypto assets issued by a goods or services provider in return for the provision of goods or services, eg that can only be used in a limited way.

A financial promotion of a qualifying crypto asset can only be communicated if:

    it is communicated by an FCA-authorised person;

    it is communicated by an FCA-registered person (under MLRs);

    the content of the communication has been approved by an FCA-authorised person; or

    if the communication can rely on one of the relevant exemptions in the FPO.

The amendments to the FPO equate the treatment of qualifying crypto assets with the existing treatment of promotion of other types of investment.

The new regulation clearly applies to firms that are promoting cryptocurrency such as bitcoin, because this is both transferable and fungible (and is not treated as e-money).

However, many promotions will not be caught by this definition, for example NFTs (which are not fungible, as the name suggests) and utility tokens that have limited use and are not issued with a view to their being transferred.

Please note those following comments on the broad application of the FPO:

    Exemptions for promotion to investment professionals (art. 19) and substantial corporate, unincorporated and trustee investors (art. 49) remain, as does the normal premise that promotions overseas (art. 12) are not UK-regulated.

    Exemptions for promotion to certified high-net-worth individuals and self-certified sophisticated investors will not be available, and thus it will become very difficult for an unregulated person to promote a qualifying crypto asset to individual investors.

    One important innovation is that the FPO has been given extraterritorial effect, to oblige firms outside the UK who seek to promote into the UK to comply with relevant exemptions. This will be of specific importance to non-UK crypto exchanges seeking to promote to UK clients. How the UK authorities plan to enforce this extraterritorial level of control remains to be seen.

FCA’s proposals

The FCA’s approach is to treat qualifying crypto assets in the same, highly-restricted manner as applies under its existing rules that restrict the promotion by FCA-regulated firms of certain other investment types that are considered to be exceptionally high risk and not therefore to be made easily available to retail investors.

For the purposes of firms that the FCA regulates, promotion of qualifying crypto assets will be subject to the more stringent provisions in Cobs 4.12A of the FCA handbook, which relates to the promotion of what are termed “restricted mass-market investments”.

Cobs 4.12A contains provisions that require firms promoting restricted mass-market investments to provide personalised risk warnings, grant investors a cooling-off period and apply a rigorous form of appropriateness testing to those investors ahead of making such promotions.

Firms with no previous experience of promoting restricted mass-market investments and that have not had to comply with the associated regime are strongly recommended to seek advice as to the consequences of becoming involved with this set of FCA rules.

Where do crypto exchange registered under MLRs stand?

These types of firm have not been required to obtain a part 4A permission, and this is not changing, as the crypto assets with which such firms are concerned are not investments of the sort that the FCA regulates.

It is clear that an exchange or a wallet custodian registered under the MLRs formally acquires the right to make exempt financial promotions of qualifying crypto assets, as noted above.

But realistically, this should be treated as amounting to a restriction to the capacity to promote the sort of cryptocurrencies that such an exchange or wallet custodian is handling as a matter of its business.

These businesses will not be allowed to approve the content of financial promotions for other concerns – and, in passing, we should mention that under a separate initiative, the FCA is clamping down on the capacity for firms that it regulates to approve third-party financial promotions in any case.

Conclusion

The effect of the changes to the FPO limits the promotion of qualifying crypto asset investments to institutional and professional investors.

Access for retail investors to cryptocurrency has ceased to be available, other than for registered clients of a crypto exchange or wallet custodian that has itself registered with the FCA under the MLRs.

It is notable that only a few businesses have successfully applied to register with the FCA to date, which has taken a stringent, merits-based approach to these applications.

A list of the companies that have successfully registered with FCA is available here.

Subject to the resources at its disposal, the FCA can be expected to police this market sector, to ensure that firms that ought to have registered under the MLRs, but have not done so, are kept out of the market.

And there will clearly now be more of a drive towards firms seeking to be FCA-regulated to ensure they can engage in crypto asset activities as adjuncts to their other business.

How easy this will be in practice will depend upon the approach the FCA takes to such applications under part 4A because, as stated, there is still currently no statutory framework for the FCA to regulate the investment activities of such persons insofar as this involves crypto assets.

The NFT market is not within scope of these regulations. It will be interesting to see how inventive market participants become in using NFTs as vehicles for the packaging of investment propositions, and in turn how willing the FCA and government are to intervene further if this is thought to be an abuse.

By way of a warning, using NFTs to create a fractional ownership structure for another asset requires considerable care to ensure that this does not create a collective investment scheme, the formation and running of which are regulated activities on their own, by virtue of section 235 FSMA.