Charles Proctor, Partner, Fladgate LLP (firstname.lastname@example.org)
Katherine Foweather, Senior Associate, Fladgate LLP (email@example.com)
The appetite of governments and supervisors to regulate the crypto-world is increasing and, although short-term the position remains uncertain, it is clear that regulation is on its way.
Within the UK, Mark Carney, the Governor of the Bank of England, said in a speech in March 2018 that, although he does not currently consider cryptocurrencies pose material risks to financial stability, he considers that regulation is desirable to hold activities involving cryptocurrencies to the same standards as other financial activities and “to combat illicit activities, promote market integrity, and protect the safety and soundness of the financial system”.
The UK Treasury has also launched a review of the role of digital currencies in the UK and the potential impact of distributed ledger technology on financial institutions. The inquiry will consider how to balance the benefits of innovation in this area with the need for regulation to protect consumers and businesses.
From an EU perspective, the European Commission and the European Banking Authority have issued papers outlining their current thinking on fintech. It is not likely that any concrete proposals will be made until later this year at the earliest but it is likely that these will involve some sort of pan-EU regulatory regime.
At the moment it is the smaller jurisdictions which are taking the lead in regulation. In January, Gibraltar’s distributed ledger technology regulations entered into force. These require firms making use of distributed ledger technology to be licensed. Belarus has also established a legal framework for cryptocurrencies and blockchain which permits persons to hold and trade cryptocurrencies subject to registration requirements. As discussed below, Switzerland has also introduced its own ICO regime.
Finally, as previously predicted, in the absence of regulation in many areas, fintech businesses are turning to a form of self-regulation. 2018 saw the establishment of CryptoUK as the first self-regulatory trade association for the UK cryptocurrency industry, and we think that we are likely to see further self-regulatory bodies as the market develops.
While other jurisdictions (including the UK and Japan) are still considering how to regulate ICOs, Switzerland has come out and shown its hand and even come up with a new category of token: Payment Tokens. The Swiss regulator (FINMA) has divided ICO tokens into three types: Payment Tokens (generally unregulated), Utility Tokens (which could be regulated as Securities) and Securities (generally regulated). The news that Utility Tokens could be considered to be Securities will be a concern for some. However, the fact that Switzerland has come forward and provided some certainty on the position of ICOs is likely to help it in its ambition to be the “crypto-nation”. Similarly, Gibraltar is also working on its own token legislation.
By contrast, the US Securities and Exchange Commission is continuing its own tough approach to ICOs, including ongoing enforcement action and a statement from its chairman that “I believe every ICO I’ve seen is a security”.
The SEC is also reportedly starting to scrutinise an increasingly popular development in ICOs: simple agreements for future tokens (SAFTs). SAFTs are arrangements entered into by companies intending to engage in ICOs under which the investor makes its investment and the company promises to issue tokens at a date in the future. SAFTs are particularly attractive for companies which need initial capital to develop their proposition before launching a formal ICO. However, great care needs to be taken by companies contemplating SAFTs as, apart from the SEC’s scrutiny, there is a real risk that certain types of SAFTs could fall within the scope of regulation in other jurisdictions e.g. as derivatives.
Crypto-investments and ICOs in particular are being seen as a high risk investment and only suitable for sophisticated investors. It will be interesting to see if any regulation that is ultimately issued takes the view that these should be dealt with in the same way as other high risk investments, with strong restrictions on marketing such as the limitations that apply to the distribution of unauthorised funds.
For example, the International Organization of Securities Commissions issued a warning regarding fraudulent and illegal ICOs as well as ICOs targeted at retail investors and, within the EU, the European Securities and Markets Authority, the European Banking Authority and the European Insurance and Occupational Pensions Authority also issued their own joint warning to consumers on the high risks of buying and/or holding cryptocurrencies.
More broadly, Google, Twitter and Snapchat have followed Facebook’s lead and prohibited advertisements for initial coin offerings and cryptocurrencies on the basis that these are frequently associated with misleading or deceptive promotional practices.
One area of uncertainty that we have encountered is the regulatory status of derivatives involving cryptocurrencies. Some EU regulators have started to provide their own views including the FCA and the AMF in France which have stated that they consider that crypto-derivatives potentially fall within the scope of MIFID II. This will have important implications for persons seeking to deal in, arrange transactions in, or advise on such instruments. The FCA has also clarified that derivatives which reference tokens issued as part of an ICO may also potentially be regulated investments.
Finally, one of the biggest issues for persons accepting cryptocurrencies as payment is the ability to convert them to cash and then to move that cash into the traditional banking system. There is a general reluctance by banks, particularly in the UK, to accept money which has originated from cryptocurrencies. This is of particular concern given the recent volatility of bitcoin.
The Chairperson of the European Banking Authority has also mooted the possibility of preventing regulated financial institutions from buying, holding or selling cryptocurrencies or establishing direct or indirect connections with persons managing cryptocurrencies, to avoid contagion between traditional banking and the crypto-world. If this strategy is adopted then it is likely to increase the current problems for cryptocurrency holders, as it would make it harder for them to access banking facilities.
We are aware of some banks that are starting to consider accepting cash from businesses dealing in cryptocurrencies but in our view this remains one of the biggest hurdles for business seeking to operate in this area today.