Written evidence submitted by Atrum

Introduction

We at Atrum are a global private investment firm with a focus on investing in growth stage companies and start-ups. Our investment advisory team is based in London.

In recent years we have invested in a number of opportunities in the crypto-asset industry, and firmly believe that the sector has the potential to revolutionise many aspects of the financial system. We strongly support the Government’s positive attitude towards making the UK an attractive jurisdiction for crypto-asset businesses, and welcome the chance to contribute to the regulatory debate.

We have provided written submissions on the various issues set out in the call for evidence. Overall, our view is that the UK is moving in the right direction in terms of making itself an important global crypto hub, but it is important to build on the UK’s existing advantages and accelerate the pace of regulation in order to maintain and build on this position.

In particular, we recommend establishing a regulatory taxonomy of the largest crypto-assets as a matter of urgency, since this would make the UK a clear market leader in this regard. We also support the establishment by the Bank of England of its own digital currency, as a means of helping to enhance trust in crypto-assets and reduce risks of anti-money laundering and terrorist financing. We further recommend that the tax treatment of crypto-assets is given a thorough overhaul in order to encourage the growth of the crypto-asset industry in the UK.

That said, it is clearly important to balance any regulatory enhancements with the clear risks of the crypto-asset industry, including the opportunities it provides to criminals and the risks entailed for certain vulnerable members of society in terms of becoming exposed to crypto-assets (including stablecoins) which may have unacceptable levels of volatility as compared to their risk tolerance. The clear way forward here is for a sensible level of regulation to protect retail investors, while also encouraging a more democratised and innovative financial system.

Other jurisdictions, in particular the USA and EU, have already started to move towards regulatory environments which will provide much needed clarity in the crypto space. The UK can learn from these developments to create a best-in-class ecosystem which encourages the growth of start-ups and attracts established players to the jurisdiction.

Submissions

• To what extent are crypto-assets when used as digital currencies (such as Stablecoin) likely to replace traditional currencies?

“Traditional currencies” have evolved over time and will continue to do so. A currency is normally regarded as a medium of exchange which is supported by a particular political, social and economic system. Historically, currencies were associated with a physical form, which originally had some intrinsic value (coinage), before progressing to on-demand promissory notes in paper form (bank notes). Recent decades have seen increasing progression towards the digitalisation of money, with physical cash payments representing only 15% of monetary transactions in the UK in 2021.[1]

Traditional currencies in this context represent the currencies that are issued and supported by nation states as legal tender, supported by a system which designates the state as the sole holder of a monopoly on violence. Being able to issue such currencies grants a state certain powerful and unique rights, in particular the right of seigniorage: the ability to profit on the difference between the face value of a currency and the cost of its production.

Seen in this light, other potential mediums of exchange only retain their value at the will of governments, and subject to applicable regulation. For example, gold and luxury goods may serve as useful stores of value, and can be exchanged for (among other things) traditional currency, but their value would be erased overnight if governments were to declare possession and/or transacting in such items illegal.

Overall, since the growing digitalisation of traditional or “fiat” currencies seems inevitable, the question is whether digital currencies based on the use of distributed ledger technology (e.g. stablecoins or other crypto-assets) will replace digital forms of traditional currencies, which rely on centralised payment systems. In this case, it is important to distinguish between: (i) digital currencies which are issued by nation states (e.g. central bank digital currencies or “CBDCs”); and (ii) those which are issued by private actors (e.g. USD Coin and Tether) or privately created decentralised networks (e.g. DAI).

In respect of type (i), CBDCs may become the most prevalent form of currency if they possess certain technological advantages over other forms of digitalised money (see the response to the next question for further detail on why this might be the case).

In respect of type (ii), it seems unlikely that digital currencies issued by private actors would ever replace state-backed currencies, even if suitably regulated, at least so long as our current political, social and economy system prevails. This is because their value will rely on government non-interference, and modern nation states will not permit a scenario where they lose their ability to profit from seigniorage rights, and these rights instead aggregate to private actors or decentralised networks.

That said, it is possible to imagine a scenario where private digital currencies form an important component of the international financial system, particularly where they have advantages over traditional currencies. For example, private digital currencies are likely to be useful in international payment flows where the traditional banking system has failed to keep pace with demands for efficiency (e.g. real time settlement) and low cost (although this advantage is likely to be eroded over time by competition, including from non-crypto fintechs). Alternatively, individuals in certain countries where there is less trust in the national fiat currency may view some of the largest and most liquid private digital currencies as a safer, more stable alternative to holding assets in their own local currency.

• What opportunities and risks would the introduction of a Bank of England Digital Currency bring?

Firstly, the Bank of England will need to establish exactly what its CBDC would look like and how it would operate. For example, the CBDC could be issued via customers depositing GBP cash with the Bank of England, and in exchange receiving the CBDC in an equivalent GBP amount. The CBDC could be tokenised, with tokens being issued onto a number of supported blockchains (e.g. Ethereum, Avalanche, Solana) – similar to how USDC currently operates as a privately issued stablecoin – or alternatively it could simply operate its own centralised ledger.

The exact usefulness of the CBDC will depend on how widely it is supported and the extent to which it can be used instead of privately issued stablecoins. Users of crypto apps and exchanges are likely to be keenly interested in being able to utilise a trusted currency backed by a central bank as a medium of exchange and store of value. The future of the crypto market clearly lies in an appropriate mix between centralisation and decentralisation, and this would be a positive step in that direction.

The involvement of a state actor in the crypto market with the ability to impose appropriate authentication / identification measures could help enhance trust in crypto-assets and reduce risks of anti-money laundering and terrorist financing. Moreover, a truly useful and interoperable CBDC could improve the UK’s current account position by increasing international demand for GBP (with the concomitant benefits and drawbacks from having a strengthening currency).

Against these opportunities, there would be significant reputational risks if the CBDC was to fail or be attacked in some way. Furthermore, if there are significant GBP inflows into the CBDC, thereby reducing the amount of GBP in circulation within the traditional banking system, this could destabilise the fiat currency in ways that are difficult to predict.

In order to mitigate the above risks, it will be important for the Bank of England to invest heavily in the architecture underpinning any CBDC and to ensure that it is thoroughly audited and stress-tested before launch. To the extent possible, a phased introduction of the CBDC would help identify potential vulnerabilities and attack vectors. Due to the risk of attacks and adverse reputational implications, our assumption is that the CBDC would have its own centralised ledger, with any support from and interoperability with other blockchain ecoystems being accessed through privately sourced bridging and cross-chain communication protocol technology.

• What impact could the use of crypto-assets have on social inclusion?

Crypto-assets have the potential to improve social inclusion by giving lower earners and minority groups access to cheaper, more transparent financial tools to enable them to save and invest for the long term. However the counterpoint to this is the ever-present risk that such individuals are exploited by nefarious actors taking advantage of the anonymity that crypto-assets can provide, and/or that such individuals become exposed to crypto-assets (including stablecoins) which transpire to have unacceptable levels of volatility as compared to their risk tolerance. The clear way forward here is for a sensible level of regulation to protect retail investors, while also encouraging a more democratised and innovative financial system.

That said, it may be possible to overstate the risk to less advantaged members of society from decentralised ledger technology, since scams are unfortunately already common in the traditional financial system. The immutable and public nature of the blockchain should put criminals on notice that in some circumstances it may be far easier to track them down than using more traditional methods.

• Are the Government and regulators suitably equipped to grasp the opportunities presented by crypto-assets, whilst at the same time mitigating against the risks?

Since the market is so complex and fast-paced in its evolution, Government and regulators will need to listen carefully to the industry in order to ensure that regulation develops down an appropriate path. HM Treasury’s actions in issuing this call for evidence should be praised in this context.

• What opportunities and risks could the use of crypto-assets—including Non-Fungible Tokens—pose for individuals, the economy, and the workings of both the public and private sectors?

Non-Fungible Tokens (NFTs) are as yet an unproven technology in terms of providing long-term store of value for (e.g.) artistic works, although given the increasingly digital nature of the economy, it seems likely that some means of tokenising digital and real world assets will be a useful financial tool. Due to their non-fungibility and resultant difficulties in achieving market depth and price discovery, NFTs are similar to art or other collectibles, and so at least in their current form it is difficult to see how they could have a significant impact on the economy.

One potential use case for NFTs is in terms of what are imaginatively referred to as “soul-bond tokens” (SBTs), as proposed in a paper by Eric Glen Weyl, Puja Ohlhaver and the Ethereum creator Vitalik Buterin.[2] SBTs would allow individuals to manage their digital profiles and straightforwardly establish their credentials when transacting digitally. For example, trusted providers of credentials (e.g. governments, universities, financial institutions), could issue SBTs to users who possess those credentials. SBTs could facilitate the development of an international KYC/AML standard where financial transactions are no longer subject to lengthy, inefficient compliance processes.

That said, SBTs carry their own risks. A purely token-based method of conducting KYC and proving identity is likely to accrue benefits to those who are best able to manage their own SBT profile (i.e. those with the greatest economic resources), and could result in those deemed to have poor track records as evidenced by SBTs being effectively frozen out of the financial system. This is already a risk in the traditional financial system with credit scoring etc. but SBTs could expand into a social scoring system that goes beyond simply access to credit. As a result, if they do emerge as an important part of the crypto market, it will be important for governments to ensure that SBTs are appropriately regulated and that they are not used as a means of penalising the most disadvantaged in society.

• How can distributed ledger technology be applied in the financial services sector?

Distributed ledger technology will not be the solution to every problem in the financial sector, and in some cases centralised databases will be far more efficient. Distributed ledgers are most likely to be of use where transparent and open source technologies have potential advantages.

Examples of this might include:

• international payments and remittances;
   
• storage of digital value (whether in fungible or non-fungible form); and
   
• decentralised exchanges (DEXs) where automated market making technology can facilitate trustless transactions (although for systemically important exchanges, it may always be necessary to have an element of centralisation to avoid rendering the entire financial system unstable via contagion risk).

• How might the Government’s processes – for instance the tax system – adapt should crypto-assets be adopted more widely?

The treatment of crypto-assets by the tax system is complex, unwieldy and needs a radical overhaul. This is largely caused by the tension within the crypto-asset space between two fundamental use cases: (i) as a medium of exchange; and (ii) as a speculative investment.

In general, crypto-assets that are being held for speculative investment purposes should be subject to similar tax treatment as other investments, with capital gains being taxable in keeping with the usual thresholds. But crypto-assets are being used as a medium of exchange in order to pay for digital and/or real world products, it is simply too complex to assess every single conversion of one asset into another as involving a realisation of that asset that should count towards an individual’s capital gains tax allowance.

There is no straightforward solution to this problem, as it will not be possible in all cases to distinguish between speculative and ordinary transactional activity. One possible answer being explored in certain jurisdictions (e.g. via the Lummis-Gillibrand bill in the USA[3]), is to set a de minimis threshold below which transactions in crypto-assets are deemed to be personal and so entirely exempt from taxation.

In addition to the general tax treatment of crypto-assets, HM Treasury could also explore groundbreaking ways in which the tax system could be used to incentivise crypto-asset activity and accelerate growth of the crypto industry in the UK. For example, a temporary tax “holiday” for crypto-assets could encourage market participants to establish themselves in the UK, and potentially existing crypto-asset transactions that have taken place at a time when the regulatory regime for crypto-assets was less certain could be grandfathered into such a regime, wiping the slate clean for future development in the UK.

As part of its ongoing review of free ports and the establishment of UK special economic zones, HM Treasury could consider providing tax breaks to crypto start-ups which base themselves in free ports, thereby increasing economic activity in these areas and encouraging prominent crypto-asset players to locate themselves in these areas and thereby stimulate local employment and investment.

Overall, the development of a forward-thinking, enlightened approach to taxation of crypto-assets represents an excellent opportunity to ensure that crypto-asset economic activity aggregates towards the UK as an international crypto hub.

• How effective have the regulatory measures introduced by the Government - for instance around advertising and money laundering - been in increasing consumer protection around crypto-assets?

We believe existing advertising regulations are sufficient, and any further regulation is unlikely to have a significant impact on the market. That said, it is important to ensure that regulations are appropriately enforced, and that highly speculative and volatile crypto-asset investments are not given a veneer of regulatory acceptability by being advertised e.g. on public transport.

In respect of anti money laundering, anecdotally crypto-asset owners have encountered difficulties in transacting with retail banks due to anti money laundering measures. These difficulties would be reduced by a clear regulatory framework which recognises the nature of the crypto-asset industry and facilitates a sensible approach towards KYC.

• Is the Government striking the right balance between regulating crypto-assets to provide adequate protection for consumers and businesses and not stifling innovation?

Currently the UK is seen as a market leader in terms of its regulatory transparency and thoughtful approach towards crypto-assets. It is vitally important that the UK continues to build upon and enhance this reputation, in particular by clearly communicating its appetite for crypto business, and by making regulatory onboarding as clear as possible to firms looking to set up operations in the country.

• Could regulation benefit crypto-asset start-ups by improving consumer trust and resilience?

Over-regulation of the industry is likely to harm start-ups and aggregate power towards the largest existing players due to their greater ability to pay for the compliance and advisory overheads which are associated with increased regulation. This tendency can be seen in web2 (i.e. the form of the internet which has been dominated by large platforms for the aggregation of user-generated content), where an oligopoly has emerged thanks to the tech giants with the deepest pockets being best able to finance large compliance divisions. Relatively light-touch regulation is therefore most likely to benefit start-ups and encourage innovation.

That said, it will be vital for the UK to strike the right regulatory balance in order to allow consumers to feel comfortable using the services provided by crypto-asset start-ups.

• How are Governments and regulators in other countries approaching crypto-assets, and what lessons can the UK learn from overseas?

In the USA, the most important regulatory development in recent months has been the publication of the draft Lummis-Gillibrand Bill to regulate the crypto market.[4] The general view among crypto specialists has been that this legislation appears to represent a helpful step in the right direction in terms of bringing clarity to the market, in particular by ensuring that a large number of crypto-assets will be regulated as commodities as opposed to being securities (with securities being in general subject to stricter regulations, which could be impracticable e.g. in the case of pure utility and governance tokens). This legislation will be subject to lobbying and amendment before it is finally passed.

The USA has also seen certain regulatory developments which have had a more chilling effect on crypto markets. One of these was the US Department of the Treasury’s Office of Foreign Assets Control (OFAC) sanctioning addresses associated with Tornado Cash.[5] Tornado Cash is a cryptocurrency mixing service, which can be used to anonymise crypto transactions by making it difficult to trace them back to their source.

The imposition of sanctions was on the basis that Tornado Cash was being used by malicious cyber actors to launder the proceeds of their activities. However Tornado Cash itself is essentially a smart contract protocol, with no necessary connection to a particular organisation. The sanctioning of Tornado Cash had rippling contagion effects, as crypto protocols froze the activity of numerous addresses which were associated with it, even where it appeared that these addresses had non-consensually received tokens tainted by their association with Tornado Cash. In our view, this shows that sanctioning of software code may carry unpredictable risks for market participants who have done nothing wrong, and governments should act with caution when using such powerful tools to maintain regulatory compliance.

The EU has meanwhile published its draft Markets in Crypto-Assets (MiCA) regulation.[6] This piece of legislation seems poised to bring helpful clarity to EU crypto markets, and is likely to improve market and investor confidence by specifying regulatory requirements for crypto-asset issuers and bringing crypto-assets within the ambit of the market abuse regime. Still, MiCA could potentially restrict innovation in a number of areas:

• MiCA does not permit the payment of interest in respect of stablecoins which are classed as e-money tokens. This seems to unnecessarily close off certain potentially useful features of decentralised finance, such as the ability of a protocol to pay incentives to holders of stablecoins for “staking” their tokens (i.e. agreeing to lock them up for a period of time, thereby supporting the network through rewarding long term holding and the generation of scarcity).

• Crypto-asset issuers will need to produce a white paper and submit this to the regulatory authorities. Although this could help improve market confidence in terms of increased disclosure, compliance costs will increase barriers to entry for smaller market participants.
   
• In keeping with EU securities laws more broadly, the “qualified investor” standard is applied, permitting greater freedom in offering crypto-assets to investors who meet certain regulatory thresholds regarding their sophistication and ability to suffer losses. This is likely to restrict retail investor participation in the crypto market, which will help protect less sophisticated investors, but is likely to undermine one of the primary use cases for crypto-assets (i.e. giving retail investors access to certain financial tools).

Overall, MiCA seems like a sensible and forward-thinking piece of legislation, but where it veers towards over-regulation it could provide an opportunity for the UK to become the pre-eminent European crypto hub.

One of the most pressing needs in the crypto space that could make the UK a global market leader is the publication of a clear regulatory taxonomy of the largest crypto-assets. Currently the FCA’s guidance on crypto-assets refers market participants to the definitions of securities under MiFID, definitions of e-money, etc., and relies on market participants to conduct their own analysis.[7] This suggests that the UK regulatory process will rely on case law and regulatory decisions to establish its crypto-asset taxonomy in an incremental, organic fashion, similar to how UK law and regulation usually develops. However this process is likely to be too slow given the rapid pace of change in crypto-asset technology, and is also not helpful to smaller market participants who are not equipped with the sophistication and advisory support in order to truly understand the nature of the assets they are buying and selling.

A clear, regularly updated public taxonomy may have the minor disadvantage of transpiring to be incorrect in certain cases where the utility or economic purposes of a particular crypto-asset only become clear over time, but this would be heavily outweighed by the advantage of categorising the largest crypto-assets in a sensible and transparent fashion. To fund such a system, crypto-asset providers could apply for categorisation in the taxonomy and pay registration fees to the regulators for doing so.

• The environmental and resource intensity of using crypto-asset technology.

In a fundamental sense, the value of a resource is connected to its usefulness, its scarcity and the amount of energy required to extract that resource. Traditionally in crypto-assets, beginning with Bitcoin, their value has been enhanced via rewarding those who are prepared to invest significant energy into the network (i.e. the miners). This is how so-called proof-of-work (PoW) blockchains are operated, and there has been much attention on the energy usage of these networks and their possible environmental impacts.

There is a growing trend away from PoW blockchains towards less resource-intensive proof-of-stake (PoS) blockchains, as seen in the upcoming Ethereum merger, which will involve the largest crypto ecosystem moving from PoW to PoS. PoS technology is less energy intensive, since it relies on evidencing ownership of the relevant cryptocurrency to allow the operation of the network rather than performing complex computations. The trend towards PoS suggests that cultural and regulatory pressures are likely to improve the environmental and resource intensity of crypto-asset technology over time.

That said, there may still be a place for PoW blockchains in a diverse crypto market. A number of resource extraction industries are exceptionally dirty and polluting, and since crypto-assets represent a digital store of value, it may be possible to tailor their production in such a way that it is environmentally superior to various real-world assets. For example, miners on PoW blockchains could be financially incentivised to mop up excess electricity produced by renewables (e.g. North Sea wind, solar, hydroelectric power), increasing the efficiency of the grid while creating a positive feedback loop into the UK financial sector.

Regardless of how crypto-asset technology develops in the coming years, it is vitally important that if the Bank of England issues any digital currency, it undertakes a comprehensive analysis of the energy usage implications.

September 2022