The UK’s Financial Conduct Authority has issued its consultation paper “Guidance On Cryptoassets” — the first draft of what will become the official FCA guidance in this area.

The FCA wants comments on the guidance, as it tries to shape its response in line with existing and forthcoming law.

The guidance includes a number of questions the FCA wants stakeholder views on. You have until 5 April to get your responses in!

Even if you’re not in the UK — this will affect you. Because all the regulators talk to each other, as they try to understand crypto.

This paper is the FCA’s response to the Cryptoassets Taskforce’s Final Report, for the Treasury’s Digital Currencies inquiry. The Taskforce’s Final Report is quite good, and I’m not just saying that because my submission to the inquiry was quoted. This paper’s not bad either.

Why this consultation?

The FCA has been slow to move on cryptoassets (which is apparently a single word now) — I am told in gossip that they’ve been reluctant to put stringent rules on crypto shenanigans, specifically in case Brexit goes full CASE NIGHTMARE GAMMON and the United Kingdom of England and Wales has to live off the sort of financial offerings that bring to mind the phrase “banana republic.”

However — the Treasury report made it pretty clear that the FCA has to clean up the most egregious offenders.

The UK is not a big player in the crypto markets — but “there is growing evidence at a global level of increasing harm” — and British citizens are exposed to this stuff.

So the FCA has to look into all of this, and provide clarity to the players … and protect the public.

The Treasury is also exploring broadening the FCA’s regulatory remit concerning cryptoassets.

The FCA’s regulatory perimeter

The “regulatory perimeter” sets out what activities you need prior permission to undertake:

Activities that fall within the FCA’s perimeter are regulated and require authorisation from us (or the Prudential Regulatory Authority if they relate to certain deposit-taking/insurance activities) before a firm can carry them out. The perimeter includes specified activities and investments set out in the FSMA and the RAO. Regulated activities can also be set through EU law, which is then transposed into domestic law or can apply directly.

The FSMA is the Financial Services and Markets Act, 2000. The RAO is the Regulated Activities Order.

This guidance paper intends to clarify where the various classes of cryptoassets fall in this regard.

The FCA puts tradeable tokens into three broad categories:

Exchange tokens — cryptocurrencies as we know them — Bitcoin, Litecoin, and so on. The FCA puts these outside the perimeter. Security tokens — that “meet the definition of a Specified Investment like a share or a debt instrument” — these are within the perimeter Utility tokens — tokens that don’t quite meet the definition of Specified Investment in UK law — which is rather narrower than the US Howey Test for whether something is a security. These are outside the perimeter. Note that some utility tokens might be regulated as “e-money,” which is inside the perimeter.

The FCA is quite aware that claims of “utility” can’t be taken at face value:

The majority of tokens that are issued through ICOs to the market tend to be marketed as utility tokens, although it is difficult to comment on whether those tokens are true utility tokens, or whether they are marketed as utility tokens despite having the intrinsic structure of tokens that we would consider securities.

The use cases the FCA sees for tokens are:

As a means of exchange — the ones that can be used a bit like currency. Investment — what happens on the crypto exchanges. Raising capital — typically in an ICO.

“The harm we have observed”

Well, that’s a blunt subheading!

Retail-level consumers — “mum and dad” investors — are at particular risk from cryptoassets.

Cryptoassets include such ridiculously terrible products as Contracts for Difference on cryptoasset prices. The FCA is not happy with CFDs being sold to retail customers at all.

The advertising is frequently trash — it implies you can get easy money, plays upon Fear of Missing Out, and doesn’t warn properly about the risks. The FCA has warned about crypto scams previously.

Consumers think they understand crypto much more than they do — “with some respondents believing that, due to language such as ‘mining’ and ‘coins’, they were investing in tangible assets.”

Retail buyers don’t realise that a lot of this stuff isn’t within the remit of the FCA, the Financial Services Compensation Scheme or the Financial Ombudsman Service. “We would always expect a regulated firm selling unregulated products to be clear with consumers about this.”

ICO white papers “are not standardised and often feature information considered to be exaggerated or misleading … These documents are not prospectuses, are not approved by a regulatory authority and do not, generally, provide the level of detail contained in a prospectus in relation to the company, the business and the product.”

And this is before we get to straight-up fraud — particularly around ICOs — and poor computer security on the part of buyers, and custodians such as exchanges.

Market integrity is bad — immaturity, volatility and lack of transparency and oversight leads to market manipulation, and exchange platforms don’t have the systems and controls in place to deal with this.

These concerns are why the Treasury is looking at expanding the FCA’s remit in terms of cryptoassets — and why the FCA will be banning sales of certain crypto derivatives to retail.

Exchange tokens

“Exchange tokens” — the Bitcoin-like things — will not usually be considered Specified Investments … because decentralised tokens don’t have an issuer. Even if you buy them as an investment, the FCA considers this like buying a commodity.

It’s not clear how this would apply to cryptocurrencies with a central administrating organisation, such as XRP — possibly XRP would be a utility token being used as “e-money” (see below).

The FCA classes fiat-backed stablecoins with the exchange tokens — but these may also be e-money, or even Specified Investments, under present law.

Take care, though — the Fifth Anti-Money Laundering Directive (5AMLD) is being transposed into UK law by the end of 2019, covering exchange between cryptos and fiat, exchange between different cryptos, transfer of cryptos and so on. This definitely covers exchange tokens.

If an exchange token is used for a payment or remittance service, that service will generally be regulated in the usual manner.

Security tokens

Are your tokens Specified Investments per the RAO? The UK doesn’t have something simple and direct like the US’s Howey test for whether something is a security — but the paper includes a summary of the factors you’ll need to consider.

Security tokens are “those tokens that meet the definition of a Specified Investment as set out in the RAO, and possibly also a Financial Instrument under MiFID II” (the EU’s Markets in Financial Investments Directive):

We consider a security to refer broadly to an instrument (i.e. a record, whether written or not) which indicates an ownership position in an entity, a creditor relationship with an entity, or other rights to ownership or profit.

Security tokens are mostly going to be Specified Investments. The paper gives detailed worked examples as guidance in determining this.

Utility tokens

Utility tokens can be traded on exchanges and invested in — but this doesn’t necessarily make them Specified Investments. So they generally won’t be security tokens.

But — they may be within the FCA’s regulatory perimeter if they meet the definition of e-money.

E-money is electronically stored monetary value as represented by a claim on the electronic

money issuer which is: • issued on receipt of funds for the purpose of making payment transactions

• accepted by a person other than the electronic money issuer

• not excluded by regulation 3 of the EMRs. … any category of cryptoasset has the potential to be e-money depending on its structure and whether it meets the definition of e-money explained above.

What regulations affect you

Section 3.66 on sets out what the FCA expects of a compliant business — for example, what you’d need to look at if you were setting up an exchange:

… arranging deals in investments (article 25(1) of the RAO), and making arrangements with a view to investments (article 25 (2) of the RAO). If the tokens also constitute Financial Instruments under MiFID, the firm may also need to have permission to operate a multi-lateral trading facility or, an organised trading facility (article 25D and 25DA of the RAO), depending on how the exchange operates. In the cryptoasset space, these firms often provide custody services as wallet providers too. The provision of custody services in relation to securities may be a regulated activity, and firms must make sure they have the relevant permissions like safeguarding and administering investments (article 40 of the RAO). Of course, these exchanges and trading platforms may be carrying out a whole host of related regulated activities and firms should consult PERG to get the full list of regulated activities that exchanges and trading platforms may be carrying on and the permissions required.

Examples include token issuers, financial advisers and intermediaries, exchanges, wallet providers and custodians, and payment providers.

If you issue a token, you will need to issue a proper prospectus — not just a handwavey ICO white paper — unless you are specifically exempted.

Questions for the reader

Finally, we have the questions the FCA wants stakeholders to answer.

Mostly these are questions of how to map the crypto world onto existing law:

Do you agree that exchange tokens do not constitute specified investments and do not fall within the FCA’s regulatory perimeter? If not, please explain why. Do you agree with our assessment of how security tokens can be categorised as a specified investment or financial instrument? If not, please explain why. Do you agree with our assessment of utility tokens? If not, please explain why. Do you agree with our assessment that exchange tokens could be used to facilitate regulated payments? Are there other use cases of cryptoassets being used to facilitate payments where further Guidance could be beneficial? If so, please state what they are. Do you agree with our assessment of stablecoins in respect of the perimeter? Do all the sections above cover the main types of business models and tokens that are being developed in the market? Are there other significant tokens or models that we haven’t considered? Are there other key market participants that are a part of the cryptoasset market value chain? Are there activities that market participants carry on in the cryptoasset market that do not map neatly into traditional securities?

You have until 5 April. Get started on your answers!