Regulation of crypto-assets: challenges for regulators and the path forwards

• United Kingdom

• Crypto assets
• Financial services disputes and investigations
• Financial services
• Financial services - Digital Financial Services
• Financial services - Payment services

25-11-2021

Prior to the announcement of his resignation from the role of Chair of the Financial Conduct Authority (“FCA”) and Payment Systems Regulator last month, Charles Randell delivered a speech to the Cambridge International Symposium on Economic Crime warning of risks of consumer harm arising from the use of crypto-assets.[1] Randell considered the limited role of the regulator today and what he considers this should be going forwards.

Harms arising from crypto-assets

It is unsurprising that Randell’s speech focuses on the harms of crypto-assets from a consumer protection perspective. According to FCA research, 2.3 million adults in the UK own crypto-assets, so there is good reason for his concerns.[2]

The anonymity, lack of traceability and global reach of crypto-assets make them an ideal tool with which bad actors can perpetrate financial crime. Consumers are therefore at risk of fraud/scams, cybercrime, theft and, potentially less directly, money laundering and terrorism financing. For example, from April 2020 to March 2021 the FCA received over 500 inquiries about scams relating to crypto-assets (a 222% increase from a year earlier).[3] The fact that the sector is broadly unregulated is therefore a major cause for concern.

Consumer harms are not the only harms arising from the sector. Concerns over the integrity of the crypto-asset market, born out of a “combination of market immaturity, volatility, and a lack of credible information or oversight”, were explained in a recent speech from Jon Cunliffe (Deputy Governor, Bank of England).[4] The result is a market vulnerable to manipulation. The GameStop saga during January 2021 – in which members of a Reddit forum pushed up the stock price of the video game retailer by nearly 30 times its original value – is an extreme but fitting example. Cunliffe ends with the morbid prediction that, going forwards, crypto-asset innovations could even threaten the financial stability of the wider economy. The case for regulation seems clear.

The regulatory position today

Today, the UK crypto-asset sector remains largely unregulated. However since its appointment as sectoral supervisor on 10 January 2020, the FCA has steadily chipped away at this position through a series of measures aimed at reducing crypto-assets’ vulnerability to financial crime and the resulting risk of harm to consumers:

• From the date of the FCA’s supervisory appointment, all UK firms which undertake crypto-asset activities have been required to register with the regulator for anti-money laundering purposes or face criminal consequences (subject to a temporary exception for firms who applied for registration prior to 15 December 2020 and whose applications have not yet been assessed by the FCA). According to the FCA, a “significantly high number” of applicants considered so far have not met the standards required under the Money Laundering Regulations and were accordingly rejected or withdrew.[5] To allow consumers to steer clear of firms suspected to be operating in the UK without having registered, the FCA has published a list of wrongdoing firms on its website.
• From 6 January 2021, the FCA banned the sale of crypto-asset derivatives to retail customers on the basis that they were “ill-suited” to this segment of investors.[6]
• In March 2021, the FCA extended the requirement to submit annual financial crime reports to crypto-asset exchanges and customer wallet providers. These firms must now report information to the FCA to assist with its supervisory powers, including the number of high-risk customers of the firm and the number of suspicious activity reports issued.
• More recently, in June 2021 the FCA banned Binance, one of the world’s largest crypto-asset exchanges, from carrying out regulated activities in the UK. The FCA justified the move on grounds that the exchange had failed to provide to responses to basic queries relating to its operations. Binance remains able to continue its (non-regulated) crypto-asset exchange business.
• Whilst the FCA currently lacks a general remit from Parliament to regulate the trading of crypto-assets directly, activities relating to ‘security tokens’ (not to be confused with exchange tokens) constitute specified investments under the Regulated Activities Order because they share characteristics with traditional regulated instruments such as shares, debentures and units in collective investment schemes. Accordingly any firm wishing to trade in crypto-asset derivatives, for example, requires authorisation from the FCA.

Evidently, the regulatory perimeter around crypto-assets is slowly but surely widening. This trend is likely to continue, too. To give one example, the Treasury recently consulted on proposals to implement the ‘travel rule’ under the retained EU Funds Transfer Regulation (requiring the originator and beneficiary of transfers to pass on their identity details with the transfer) to crypto-asset firms.[7] The proposals mark yet another attempt to mitigate the serious money laundering and terrorism financing risks which arise when market participants can trade anonymously (or using a pseudonym). The appetite of the regulator is there for all to see. So what is the problem?

Challenges for regulators

Whilst Randell calls for “same risk, same regulation”, the reality is that crypto-assets bring a number of novel and significant hurdles to regulators.

As Randell himself recognises, the decentralised way in which crypto-assets are created means that effective regulation depends on firms bringing themselves within reach of the regulator. Whilst the FCA has adopted the measures set out above, at the time of writing over 200 firms were included on its list of firms suspected of carrying out crypto-asset activities whilst unregulated.

Today, crypto-asset services are offered in both a ‘centralised’ and ‘decentralised’ manner. One of the features of decentralised finance (or ‘DeFi’) is the capability for peer to peer transactions which are delivered in the absence of intermediaries. For example, self-hosted wallets allow individuals to make and receive transfers of crypto-assets which do not pass via a middle man capable of being regulated and held accountable (such as a bank or exchange). The approach of the FCA so far, targeting UK-based exchanges, therefore leaves a concerning gap in the regulatory perimeter and a free passage for bad actors seeking to disguise the origins of their funds.

Whilst DeFi remains a relatively small sub-set of the crypto-asset sector today, regulators should take note of its rapid growth and massive scope for innovation. In fact, they already have. In his speech Cunliffe noted his concerns around DeFi, including the possibility that it could become completely decentralised “with no identifiable legal entity, ownership nor even a point of human contact”. He further explained that regulators must work to ensure that the risks arising from DeFi are managed to the same standards as traditional finance. Whilst this should always be the aim, regulators face an uphill battle to achieve this.

An additional challenge arises from the global scope of crypto-asset trading, which means that the regulatory issues described above span beyond the remit of any one regulator or jurisdiction. They demand a coordinated, international regulatory response. Anything short of this effectively allows firms to circumvent regulation at will by relocating their operations to jurisdictions with lower regulatory standards and lower compliance costs.

Further, whilst crypto-assets often represent a volatile and risky investment, they have also shown themselves to be resistant to regulatory shocks. For example, the sharp fall in a number of high profile crypto-assets that followed the Chinese ban on crypto-asset mining and crypto-asset transactions in September was not sustained, suggesting that the fall merely represented ‘buy the dip’ opportunities for wily investors located elsewhere.

The path forwards

Notwithstanding these challenges, the FCA can still play an important role by regulating crypto-assets – recently described by a member of the Financial Policy Committee as the “bedrock of the emerging financial ecosystem”.[8] The measures adopted so far, whilst somewhat limited, are sensible. They aim to promote the UK as a safe and sound place for crypto firms to do business. In fact, stronger regulation may lead some to gravitate towards the UK in order to demonstrate their legitimacy.

Looking forwards, the case for further action is undeniable. Consumers who invest in crypto-assets remain at risk of significant harm from fraudsters and cybercriminals, which the regulator needs to address. However it must be cognisant of the challenges presented by the sector, including in particular the difficulties of effectively enforcing standards against firms who choose not to comply. For regulation to be enforceable is essential – anything short of this would constitute what Randell fittingly describes as “token regulation”.

What is required is a measured response which mitigates the harms which arise whilst equally promoting sustainable growth of the sector. The FCA will need to deploy other tools in its toolbox to achieve this, for example by driving campaigns to educate consumers of these risks and lobbying online providers to act to prevent the dissemination of misleading advertisements around crypto investing. Improving public awareness and making piecemeal interventions which target the most problematic features of crypto-assets may prove to be the most pragmatic approach.

[1]                 Speech by Charles Randell, ‘The risks of token regulation’ delivered 6 September 2021 (https://www.fca.org.uk/news/speeches/risks-token-regulation)

[2]                 FCA, ‘Research Note: Cryptoasset consumer research 2021’ published 17 June 2021 (https://www.fca.org.uk/publications/research/research-note-cryptoasset-consumer-research-2021)

[3]                 FCA, ‘Consumer Investments: Strategy and Feedback Statement’ dated 14 September 2021 (https://www.fca.org.uk/publications/corporate-documents/consumer-investments-strategy)

[4]                 Speech by Jon Cunliffe, ‘Is ‘crypto’ a financial stability risk?’ dated 13 October 2021 (https://www.bankofengland.co.uk/speech/2021/october/jon-cunliffe-swifts-sibos-2021?sf152750285=1)

[5]                 FCA, ‘Temporary Registration Regime extended for cryptoasset businesses’ dated 3 June 2021 (https://www.fca.org.uk/news/press-releases/temporary-registration-regime-extended-cryptoasset-businesses)

[6]                 FCA, ‘FCA bans the sale of crypto-derivatives to retail consumers’ dates 6 October 2020 (https://www.fca.org.uk/news/press-releases/fca-bans-sale-crypto-derivatives-retail-consumers)

[7]                 HM Treasury, ‘Consultation on Amendments to the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 Statutory Instrument 2022’ open from 22 July 2021 to 14 October 2021

[8]                 Speech by Carolyn A Wilkins, ‘Under the western sky: the crypto frontier’ dated 22 November 2021 (https://www.bankofengland.co.uk/speech/2021/november/carolyn-a-wilkins-keynote-speaker-at-autorite-des-marches-financiers-annual-meeting)