The United Kingdom’s Financial Conduct Authority (the “FCA”) recently published a Consultation Paper (CP19/3), titled “Guidance on Crypto-assets”. The Consultation Paper provides draft guidance as to which financial services and activities related to crypto-assets are regulated and which are unregulated. The FCA’s preferred definition of a crypto-asset, for this purpose, is “a cryptographically secured digital representation of value or contractual rights that is powered by forms of distributed ledger technology and can be stored, transferred or traded electronically”. In setting out when crypto-assets may interact with the FCA’s regulatory perimeter, the Consultation Paper focuses on whether and when crypto-assets could be considered “specified investments” under the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (the “RAO”), “financial instruments” under the MiFID II Directive, or whether they fall within the scope of the Payment Services Regulations 2017 (the PSR”) or the Electric-Money Regulations 2011 (the “EMR”).
The FCA has invited stakeholders to give feedback on questions posed in the Consultation Paper by 5 April 2019 and aims to publish final guidance on the existing regulatory perimeter in relation to crypto-assets no later than summer 2019.
Harm Associated with Crypto-assets
The Consultation Paper notes the different potential harms that can be involved with crypto-assets. Consumers are often misinformed about the nature of crypto-assets and may invest in crypto-assets without being aware of the limited regulatory protections. There is also a high risk of initial coin offerings (“ICOs”) proving to be fraudulent.
The FCA also highlights the risk of crypto-assets being used to enable financial crime. It states “Crypto-assets can sometimes offer potential anonymity and the ability to move money between countries and individuals”, meaning that crypto-assets can be used in money laundering and for the financing of crime and terrorism.
Lastly, the FCA notes that market volatility and the lack of transparency and oversight heighten the risk of market manipulation and insider dealing.
In order to mitigate these potential harms, the UK is taking the following steps:
The Consultation Paper categorises crypto-assets into three categories: security tokens, exchange tokens and utility tokens.
The FCA views security tokens as tokens with characteristics that bring them under the definition of a “specified investment” under the RAO and thus within the FCA’s regulatory perimeter. For example, these tokens would have one or more features that are indicative of securities, such as shares, debentures or units in a collective investment scheme. Such features include:
Statements in a “white paper” that suggest the token is intended to function as an investment would tend to indicate the existence of a specified investment, but the substance of the token, rather than the label, will be determinative in this regard.
In addition, the FCA points out that a security token can constitute a transferable security under the MiFID regime if the token is capable of being traded on the capital markets.
The FCA considers that the most relevant specified investments to consider, in categorising a token, are:
If tokens give the holders similar rights to shareholders, such as rights to ownership or control of the issuer, then these are likely to be considered specified investments. Examples include voting rights, access to dividends or the distribution of capital on liquidation. In regard to voting rights, the FCA states that voting rights that give the ability to make “control-like” decisions on the future of the firm would indicate a security akin to a share, as opposed to voting rights in respect of a specific element of a firm’s direction, which may not necessarily result in control. For example, a token that confers rights to vote on future ICOs that a firm could invest in (assuming the token confers no other rights) would not be likely to be considered as a share.
b) Debt Instruments
The FCA states that a token that creates or acknowledges indebtedness by representing money owed to the token-holder would likely be considered a security token. An example of this is a token that gives the holder the right to be repaid in full at a certain date and with regular interest payments.
The FCA states that a token that gives the holder a right to subscribe for future security tokens is likely to be classified as a security as well.
d) Units in Collective Investment Schemes
Where a token acts as a vehicle through which profits or income are shared or pooled or if a person, such as the issuer, manages the investment as a whole, it would likely indicate a security token. If a white paper indicates pooled investments, contributions or profits, they could also be a factor in classifying the token as a security.
e) Rights and Interests in Investments
If a token gives a holder a right in a security, such as a share, this would represent a security token – despite the token itself not having the characteristics of a share.
An exchange token is the term used by the FCA to describe what is sometimes termed as a “crypto-coin”, “payment token” or “crypto-currency”. It is not issued or backed by any central authority and is intended and designed to be used as a means of exchange, including through exchanges or organisations that facilitate transactions of Bitcoins or other exchange tokens between participants. These tokens usually fall outside the FCA’s regulatory perimeter, as they do not tend to grant the token-holder any of the rights associated with security tokens. This means that the transferring, buying and selling of exchange tokens – including the operation of crypto-asset exchanges for exchange tokens – are currently unregulated by the FCA.
The Consultation Paper notes, however, that – pending formal consultation by the UK Treasury in 2019 – the transposition of the recent amendment to the Anti-Money Laundering Directive (“5AMLD”) into UK law by the end of 2019 will extend anti-money-laundering and counter-terrorist-funding regulations to entities that carry on the following activities: exchanges between crypto-assets and fiat currencies, crypto-asset exchanges, the transfer of crypto-assets, the safekeeping or administration of crypto-assets or instruments enabling control over crypto-assets, and the participation in and the provision of financial services related to an issuer’s offer and/or sale of a crypto-asset.
Utility tokens give holders access to a current or prospective product or service and often give rights similar to pre-payment vouchers. The holder of a utility token does not have the same rights as a holder of a security token, and such a token would normally fall outside the FCA’s regulatory perimeter. Although utility tokens, like exchange tokens, can often be traded on secondary markets and can be used for speculative purposes, these facts alone do not constitute security tokens as specified investments. The FCA views this as akin to holding a fiat currency or commodity for investment purposes – both of which remain unregulated.
Payment Services and E-money
The Consultation Paper also outlines how tokens could be affected by the EMRs and PSRs. In regard to the EMRs, the draft guidance notes that, while most exchange tokens are not likely to fall under the definition of “e-money” under the EMRs, tokens that are pegged to a fiat currency (such as a “stablecoin”) and used for the payment of goods and services could meet this definition.
In regard to the PSRs, the FCA states that crypto-assets are not covered within the scope of those regulations, because the PSRs apply only to banknotes and coins, scriptural money and electronic money.
Future Direction of Regulation
The Consultation Paper also notes the future direction of UK regulation in 2019. In addition to transposing and expanding the ambit of 5AMLD, the UK Treasury will be consulting on possibly expanding the regulatory perimeter to include other crypto-asset activities, such as making ICOs and providing crypto-asset exchange services. The FCA will also consult on the potential prohibition of the sale to retail customers of derivatives and transferable securities that reference certain types of crypto-assets, such as exchange tokens.
Given the complexity of many crypto-asset tokens, the FCA acknowledged that concluding whether a token is within the FCA’s regulatory perimeter can be difficult and recommends consulting professional advisers if any doubts remain.
Matthew Rodin, London Trainee Solicitor, contributed to the drafting of this alert.
 It seems unlikely that mere transferability, by itself, would be considered by the FCA as determinative of whether the token is a security. In addition, there are many assets (outside the crypto-asset universe) that can be traded on an exchange but that are clearly not securities.