CAI0070

Written evidence submitted by the Financial Conduct Authority

Role and remit of the FCA

The FCA supports innovation in financial services, including cryptoassets and their underlying technology. We have built a world-leading reputation for regulatory innovation, with our programmes such as the Regulatory Sandbox and Tech Sprints copied around the world. Firms using Distributed Ledger Technology (DLT) to launch innovative products and services have for many years been supported by the FCA.

We are a member of the Cryptoasset Taskforce (CATF) alongside HM Treasury and the Bank of England. CATF is considering how to assess the potential impact of cryptoassets and DLT in the UK and considering appropriate policy and legislative responses.

We are leading international work, coordinating with other securities regulators globally via the International Organization of Securities Commissions (IOSCO), which is considering high-level and broadly drafted principles relating to cryptoassets, as well as facilitating cooperation across multiple jurisdictions.

Following legislation, in January 2020 we became responsible for registration of certain UK based cryptoasset firms under the Money Laundering Regulations. As part of the Anti-Money Laundering (AML) regime, firms must meet the minimum standards of anti-money laundering and terrorist financing controls we expect – we require that those who run these firms are fit and proper and that firms have adequate systems to identify and prevent flows of money from crime. So far, 37 cryptoasset firms have been able to meet our standards. We will continue to supervise them against those standards, and we continue to see applications at the gateway.

Cryptoassets and cryptoasset service providers largely sit outside of financial services regulation, except where we have jurisdiction for AML purposes or they are financial instruments that reference cryptoassets, like derivatives (detail on the regulatory perimeter can be found in Annex 1). This means we do not currently have powers to address market conduct, prudential or consumer protection concerns within the industry.

To extend our remit to include more crypto-related activities within it will require new legislation.

The Government confirmed in January 2022 that it would be legislating to bring ‘qualifying cryptoassets’ into the scope of the financial promotions regime. It is important that this legislation also gives the FCA supervision and enforcement powers to mitigate harm from misleading financial promotions. We expect to take an approach to cryptoasset promotions consistent with that taken for other high-risk investments once new legislation is made to bring crypto advertising within our remit.

Significant gaps remain within the UK regulatory regime. We are working with HM Treasury to develop our regime for stablecoins used as payments and are planning to consult on changes to the payments perimeter and a new regime for custody of stablecoins for payment. The Government also announced in April it intends to consult on the wider regulation of cryptoassets by the end of this year and we will continue working closely with them and other parties through CATF to design a UK approach to regulation that balances innovation and competition alongside the need for orderly markets and consumer protection.

Overview

We consider cryptoassets through three broad categories based on their purpose and the activity for which they are used: (1) cryptoassets that are used for the purpose of payments (within the definition of the PSRs) as well as those used for settlement; (2) cryptoassets or DLT used to support financial services and; (3) cryptoassets used for investment purposes. The extent of potential benefits compared with the potential risks will vary from one category and indeed one token or product to another.

We can see the potential in stablecoins for example, when referencing a fiat currency, to provide an alternative method of payments which is potentially faster and cheaper and has the ability to facilitate international trade and help cross-border payments. We also see opportunities for cryptoassets or DLT to support financial services both in the wholesale sector and in other traditional financial services. It may offer opportunities to increase efficiency in compliance, monitoring and reporting and to help reduce costs, as well as allow greater ability to track the movement of value through the financial system. We also understand that some institutional investors see diversification benefits in allocating small parts of portfolios to certain types of cryptoassets.

Some of the key risks we see mirror those in ‘traditional’ financial services, like fraud, poor customer services and poor market conduct. Some risks, however, are new, such as those relating to token custody, or conflicts of interest created by service providers performing multiple activities along the value chain.

Our research in 2021 estimated that 2.3 million people in the UK are holding cryptoassets. Their profile with consumers has increased, and some may see them as an alternative or complement to mainstream investments. However, we have repeatedly made clear to consumers that cryptoassets when used as an investment are speculative, very high risk and they should be prepared to lose all of their money. This has been demonstrated by the recent volatility in the market and failures of a number of individual firms. We continue to make clear to consumers they are very unlikely to have access to consumer protections such as the Financial Ombudsman Service or the Financial Services Compensation Scheme.

Activity in wholesale markets is still developing. As noted by the Bank of England in their recent Financial Stability in Focus, the Fidelity Institutional Investor Digital Assets Survey suggests that as of September 2021, 13% of US and 23% of European ‘traditional’ hedge funds held cryptoassets in their funds. However, given that cryptoassets currently account for only 0.4% of global financial assets, in aggregate, they are likely to represent only a small fraction of these investor portfolios. Exposures of other institutional investors are reportedly small. The survey indicates 3% of US and European Union pension funds and endowments are either directly or indirectly invested in cryptoassets and associated markets.

Given the increasing holding of cryptoassets by UK consumers and the potential benefits of the technology, it is important to look at the wider regulation of the cryptoasset market. There is a fine balance to be struck between acting quickly to address risks and opportunities and moving at a pace that means the approach is robust and fully thought out. Regulation also needs to make sense in the global market and be aligned with global standards, reducing the risk of future arbitrage. Careful consideration should also be given to the consumer protections that should apply to cryptoassets compared with mainstream investments. Any future regulatory regime for cryptoassets will also need to address the market risks they pose.

Response to specific issues

Below we have responded to the specific questions posed by the Committee that relate to our work and remit (questions 1, 3, 4, 5, 6, 9, 11, 12 and 13). A number of the questions, such as on government processes for example, sit with others and we have not responded here.

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

We support HM Treasury’s decision to bring fiat-backed stablecoins within the payments perimeter. They are linked to one (or a basket of) fiat currency, making their value less volatile than other types of crypto, such as Bitcoin, and other types of self-described “stablecoins” such as Terra Luna (which is backed by an algorithm rather than a fiat currency), which saw its value plummet earlier this year.

Where used for payments, we regard stablecoins with a 1:1 backing to fiat currency as having essentially the same characteristics as electronic money, therefore possessing the potential to be used as a mainstream method of payment. We do not regard other types of cryptoasset including other types of non-fiat backed stablecoins as well suited to use in payments, in large part because of the volatility in their own prices, which could lead to questions over whether they are correctly defined as “stable” coins.

Fiat-backed stablecoins, where used for payments, may benefit consumers and merchants through lower fees, faster transfer of funds and fast international transfers. If widely adopted, they could become an additional method of payment, complementary to existing forms. That could support competition and encourage innovation in the market, as well as offering more choice for consumers.

HM Treasury’s proposal to extend the FCA payments perimeter to include stablecoins and create a new custody activity will help protect customers who use these coins for payments from harm such as firm failure or loss of assets. We think this will enable an appropriate balance between innovation and risk mitigation for consumers and the market.

We believe the current uptake of stablecoins used as means of payment (as defined in the Payment Services Regulation) is very low, if present at all, although it is difficult to determine given the unregulated nature of the activity at present. We do not currently see stablecoins or other cryptoassets being used for payments of the type covered by existing payments regulations - most of the activities seemingly focus more on investment and trading, although this may well evolve. We have also seen numerous firms who are innovating in this space and would like to offer such services to UK consumers.

While we support innovative alternatives for payments, such as stablecoins, the FCA remains committed to helping maintain access to cash across the UK. In June 2022 we published our most recent consultation paper on Branch and ATM closures or conversions aimed at providing clearer guidance for existing regulated firms and enhancing protection for consumers, especially those with vulnerable characteristics. The ability to withdraw and deposit cash continues to be essential for many people and our data show that most people currently have reasonable access to cash and we welcome upcoming legislation to protect access to cash. Our work on access to cash shows that digital exclusion can affect some consumers and we need to find a way to mitigate that.

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

The developers and pioneers of cryptoassets such as Bitcoin envisioned them leading to a new democratised and decentralised money system but this has not happened yet. Their monetary use has not taken off globally to date, except for the two countries (Central African Republic and El Salvador) where Bitcoin has been declared legal tender. However, cryptoasset decentralised governance structures have evolved and there are many offerings giving consumers control and voting power over the assets that they would be unlikely to have over most corporate assets or central bank money. While this may be providing greater social inclusion there remain risks such as lack of transparency over persons holding large amounts of voting rights or collusion.

Cryptoassets may have some potential to increase financial inclusion in countries where access to mainstream financial services is currently very low. However, in the UK, it is difficult to see more than limited benefits. The FCA’s Financial Lives Survey in June 2021 showed that 96% of UK consumers have a current account with a bank or building society. For those that are unable to obtain a bank account, cryptoassets are unlikely to be a viable alternative. For example, ID is required to purchase cryptoassets from a UK FCA-registered exchange and they usually have to be paid for with a bank card. Cryptoassets are also not fully integrated into the financial system and therefore, do not provide the same financial benefits as a bank account for example by improving credit scores or providing cheaper utility bills via direct debits. They are not currently widely accepted as a means of payment.

It is possible that some cryptoassets, where used as a means of payment, could help with social inclusion if widely adopted and accepted, particularly for retail cross-border and remittance payments. When used for payments they may benefit consumers and merchants through lower fees, faster transfer of funds and quicker international transfers. However, there are also risks related to using cryptoassets as payments such as likely immutable transactions if sent to the wrong address, cyber-attacks, operational resilience issues and lack of consumer protection and redress when things go wrong that regulation would help to mitigate.

In addition, there are other initiatives we are taking on payments in relation to social inclusion, including our work to maintain access to cash.

Additional social risks are also posed by cryptoassets due to the current lack of regulations to mitigate against consumer harm and volatile prices. Scams are prevalent in the sector; crypto gambling addictions are rising and there are limited controls in place to protect vulnerable consumers. Therefore, at present, cryptoassets can pose a significant risk to UK consumers, with limited social benefits.

4. Are the Government and regulators suitably equipped to grasp the opportunities presented by cryptoassets, whilst at the same time mitigating against the risks?

While cryptoasset activities are not currently regulated in the UK, there are several steps the UK government and regulators have taken to harness the opportunities while adequately mitigating the risks. This includes introducing an anti-money laundering (AML) regime, proposed amendments to the Financial Promotions regime as well as working with HM Treasury to develop our regime for stablecoins used as payments. However, there remain significant gaps in the regulatory regime in relation to crypto, limiting the FCA’s ability to take robust and assertive action to protect consumers and mitigate harms arising.

AML regime

The Government brought in legislation on 10 January 2020 to bring UK based firms carrying out specific crypto related activity into the AML regime. From January 2020 those firms needed to be registered with us and to show that those who run these firms are fit and proper and that firms have adequate systems to identify and prevent flows of money from crime. 73% of firms who were carrying out crypto business in the UK and had applied for FCA registration were not able to demonstrate this. We identified significant failures in relation to key controls such as customer due diligence, risk assessments, transaction and ongoing monitoring, governance and Management Information. In a number of cases, key personnel lacked appropriate knowledge, skills and experience to carry out allocated roles and control risks effectively. We also gathered intelligence and worked with law enforcement agencies on a small number of cases with direct links to organised crime. To date 37 cryptoasset firms have been able to meet our standards and are registered with us. We will continue to supervise them against those standards, and we continue to see applications at the gateway. Throughout the registration process when we decide a firm does not meet the standard for registration, we are clear with them where they are going wrong.

However, our powers are restricted to enforcing Anti-Money Laundering and Counter Terrorist Financing standards. Unlike other types of investment products and services, we do not have conduct, prudential or consumer protection powers over the industry at present as we would for a regulated firm under the Financial Services and Markets Act (FSMA). This prevents us from intervening to mitigate specific risks which are crystallising in the sector. We have set out some of these below in context.

On 11 August 2022 a new amendment to the Money Laundering Regulations (MLRs) also came into force. This includes bringing cryptoasset firms registered by us into the Change in Control Regime. This means that anyone seeking to acquire 25% or more of an FCA registered cryptoasset firm must seek FCA approval before the transaction can proceed. As cryptoasset firms are supervised under the MLRs the basis upon which a change in control application can progress is limited to the applicant's ability to mitigate money laundering and terrorist financing risk. This contrasts with the wider change in control regime for FSMA regulated firms which consider wider prudential and conduct issues. The amendments to the MLRs also implement the Financial Action Taskforce ‘travel rule’ for cryptoasset firms from 1 September 2023 which requires cryptoasset exchanges to share some details of the sender and recipient when making qualifying transactions. The amendments also improve provisions for information sharing with Companies' House and others.

In addition, just because a firm interacts with UK customers, does not mean it needs to be registered with us and adhere to the MLRs under the regime. The current regulatory scope for cryptoasset activities, which is set out in legislation, means overseas firms can relatively easily undertake cryptoasset activity in the UK but remain outside of the FCA’s remit – which has created risks of regulatory arbitrage and a confusing position for consumers and firms.

Some examples of areas where there is no current regulation where there are potential risks arising include:

Firms offering cryptoasset custody and exchange services under the MLRs are required to register with the FCA for supervision of AML controls. Firms are not required to demonstrate how cyber security risks are managed, there are no safeguarding measures for cryptoassets, and consumers are unlikely to have access to the Financial Services Compensation Scheme or the Financial Ombudsman Service. There are no requirements for firms to provide advice when selling complex products to retail investors, or rules about how assets can be distributed.

 The lack of safeguarding for cryptoassets may allow firms to lend consumer assets to third parties to generate revenue, these strategies may attract risks and result in the loss of consumer assets, particularly in times of market volatility. There are no specific requirements in relation to how firms should treat custody of underlying assets, or the accounting treatment that must be applied when they hold those assets on a balance sheet. This leads to uncertainty as to whether those assets are adequately ringfenced from general creditors of the firm in the event of insolvency.

 It is difficult for consumers to understand the risks associated with investing in cryptoassets and the FCA has advised that anyone investing in cryptoassets should be prepared to lose all of their money. Cryptoassets are made available to most retail consumers through exchanges and consumers may trust an exchange to have performed due diligence on a cryptoasset before making it available for sale. The FCA may intervene if an exchange admits a token that presents significant money laundering risks.

 Cryptoasset firms are not subject to prudential or conduct requirements that are expected of firms within the wider FSMA perimeter. While the UK regime requires a firm’s controllers to be ‘fit and proper’ to administer the firm’s financial crime control framework, and to act with probity, this is a narrower requirement than for regulated firms.

 As trading and other activities relating to cryptoassets are not regulated the market may be more vulnerable to traditional forms of market manipulation and abusive practices i.e. insider trading or the creation of false markets (so-called pump and dump). The lack of regulatory framework means the traditional tools for identifying and regulating inside information (transaction reporting, maintenance of insider lists etc.) do not exist to provide protection from such abuses.

 Scams and fraud associated with cryptoassets have become an increasing concern and features such as the irreversible nature of transactions and the pseudonymity of wallet addresses can be abused by bad actors to commit crimes and launder the proceeds. While firms within the perimeter are supervised to ensure that financial crime controls are robust, firms which operate without registration and firms offering services to UK consumers from outside the perimeter present significant challenge.

The perimeter of our regulation is determined by Parliament, and it is a matter for the Government to determine the scope and objectives of a new regime.

Financial promotions

As cryptoassets are not currently regulated, they are also not in scope of the financial promotions regime. This means that our rules do not apply and there are no restrictions on the marketing of these investments to UK retail consumers from the UK or abroad. To address this, the Government is bringing forward legislation to bring ‘qualifying crypto assets’ into the scope of the regime. This will bring it into line with other financial products. We have set out more detail on this in our response to Q9.

Development of a regime and building expertise

We continue our work with HM Treasury and the Bank of England to assess the market and develop policy proposals that seek to harness the opportunities while mitigating the risks as HM Treasury considers the scope and objectives of regulation of cryptoassets.

Our ambition is to grow our resources and expertise to monitor and act appropriately in response to trends within the fast-evolving cryptoasset market as we develop policy for further regulation. We want to:

act quickly to address risks we see building with consumers and in the market;

move at a pace that means industry can adapt, the approach is robust and sufficiently thought-out, and;

introduce regulation that makes sense in the global market, such that it is aligned with emerging global standards to help reduce future risk of arbitrage.

We used our policy based CryptoSprints earlier this year to help prepare for the future of cryptoassets markets by convening industry expertise to consider key regulatory questions. We collaborated with almost 200 industry members in workshops across the days, both in person and virtually. Discussions focused on three key problem statements that are fundamental in building a future cryptoasset regulatory regime: issuance and disclosure; regulatory hooks, and; custody of assets. Common policy proposal themes included the introduction of tiered/incremental regulation which is agile to meet the needs of a fast-evolving sector, being technology neutral rather than regulating the technology directly (which is consistent with FSMA) and tailoring existing regulation where possible rather than developing something bespoke. We will keep the discussion going with industry as to how we build and develop a regulatory framework.

We are also continuing to engage internationally with other jurisdictions and organisations who are preparing and developing future regimes or approaches to risk, such as the European Union, the USA, Singapore and Australia.

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

The potential opportunities

We recognise the transformative and positive impact that cryptoassets and innovative technologies like DLT and blockchain could have across financial services. DLT and crypto technology can be used to reduce costs, increase efficiency for firms and allow greater ability to track the movement of value through the system (both for the retail and wholesale markets).

Cryptoassets and DLT is an extremely broad topic. It spans many different sectors, can be used in many different ways, and the associated risks and benefits are extremely varied as a result.

To break things down, we approach cryptoassets with three very broad categories, largely centred around the purpose for which crypto and its underlying technology is used.

Cryptoassets that are used in payments. On the payments side, this could include stablecoins used to pay for goods or services, using blockchain technology, and potentially making international/cross-border payment rails faster and cheaper. On the settlement side, this could include cryptoassets used to improve wholesale settlement, for example in securities markets.

Cryptoassets or DLT used to support financial services. This can include asset tokenisation and bringing more operability and transparency to fragmented value chains; it could include applications of blockchain for digital ID and compliance, monitoring and reporting; and novel ways of approaching more traditional custody services.

Cryptoassets used as a speculative investment and to generate returns. This is where the media’s attention, as well as social media activity, has focused over the past few years. Although we appreciate that there is interest in crypto used for these purposes, we also see some significant risks and are conscious that crypto continues to be an attractive medium or vehicle for scammers.

The potential risks

As well as the potential benefits of crypto and DLT, there are a number of risks to both consumers and markets. These risks, as well as potential benefits, will need to be considered carefully as the UK authorities looks at what the future regulatory regime should look like.

Market integrity

In the absence of rules governing how crypto markets operate there is a high risk of their being disorderly, inefficient or inaccessible, leading to difficulties in establishing fair valuations and pricing and allowing opportunities for those wishing to conduct abusive practices. This could damage confidence in traditional financial markets as participation in crypto grows and as more regulated firms grow their unregulated crypto activity. There are obvious risks of harm to consumers.

As this is new and evolving technology, it creates new cyber and operational risks, especially to markets infrastructure, that we need to understand. Some cyber and operational risks we have identified are:

cyber-attacks, operational and security issues;

potential legal ambiguity around settlement finality;

ineffective governance frameworks, and;

issues related to data integrity, immutability and privacy.

Consumer protection

The FCA has taken ongoing action to monitor the trends and impact of cryptoassets on consumers. In 2021, the first consumer research note on crypto asset ownership was published. This indicated a growing use of cryptoassets as a form of speculative investment. It found that 2.3 million UK adults held crypto in June 2021, compared with 1.9 million the year before. This was an increase from 3.9% to 4.4% of adults in the UK in just a year. At the same time the research found that the level of understanding of cryptocurrencies is declining, suggesting that some crypto users may not fully understand what they are buying. A further survey we undertook last year of younger high risk investors found that 69% of them incorrectly believed cryptoassets to be regulated by the FCA.

Cryptoassets used for investment creates a range of risks of harm to consumers and markets, and these could increase rapidly as the sector grows. These include scams, loss of money due to volatility, misunderstanding of high levels of risk, firm failure and comingling of funds by custodians. The complexity of products also puts consumers at greater risk of being misled by advertisements.

Some of these risks mirror those for ‘traditional’ financial services (for example fraud and firm failure). Some though are new, such as those that relate to token custody or conflicts of interest created by service providers performing multiple activities along the value chain, so there is no separation of services in ways that are typical in traditional finance. We have regularly issued warnings to the public that there are high risks involved with investing in cryptoassets, or investments linked to them.

We are continuing to observe the trends among consumers, and we are conducting an update to the research with an intention of publishing it by the end of this year.

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

Firm Support

The FCA provides several market-facing services that provide us valuable insights into how financial markets are innovating. Many of the firms that we support are those that use DLT to augment traditional financial services business models, as well as to deliver innovative new products to consumers.

The FCA was the first regulator in the world to establish a regulatory Sandbox, through which financial services firms can test innovative propositions, with real customers, in a controlled environment.

Firms that are accepted into the regulatory sandbox have access to regulatory expertise and a set of tools to facilitate testing. The tools provided to firms depend on the nature of their business and test. We may provide restricted authorisation to firms for the purpose of the test, or an informal steer to help firms understand the potential regulatory implications of their innovative product or business model.

A test in the Regulatory Sandbox gives firms:

the ability to test products and services in a controlled environment.

the opportunity to find out whether a business model is attractive to consumers, or how a particular technology works in the market.

a reduced time to market at a potentially lower cost.

support in identifying consumer protection safeguards that can be built into new products and services.

We also support firms through our Innovation Pathways service, which provides bespoke advice to firms with innovative business models working to deliver positive outcomes for consumers.

Our Innovation Pathways service includes:

guiding firms through regulation through one-to-one discussions with a dedicated case manager assigned to provide insight, clarity, and feedback on their business model.

explaining our expectations of regulated firms in a clear and understandable way, making the process less complex and burdensome. To help firms in this area, we can offer pre-authorisation meetings to clarify the authorisation process and the standards firms must meet.

helping firms who need authorisation to get assigned a case handler after they submit their application.

providing dedicated supervisory support for the first year after authorisation to ensure a seamless experience of our regulatory processes.

As of April 2022, we have supported 57 firms with cryptoasset or DLT-based business models in our Regulatory Sandbox service, and around 80 firms in our Innovation Pathways service.

We have observed a number of use-cases within the market; primarily, but not limited to, the payments and wholesale sector. Examples include:

A blockchain solution that can be integrated into financial services firms' systems to automate and tokenise bond issuance. Here, the underlying DLT creates efficiencies for the administration of the bonds and data management. This is a wholesale scenario.

A blockchain infrastructure solution for on-chain issuance of GBP Stablecoins that are fully collateralised by cash deposits and safeguarded from the firm’s operational capital to ensure its redemption for fiat. Consumers and merchants are onboarded to the platform and can use the blockchain based payment system to reduce both costs and transaction time. This is a payments scenario.

A technology provider that allows users to create an encrypted, biometric, digital identity linked to their government issued personal identification card. The use case here is that digital ID might provide new enhanced security and optimisation solutions for financial institutions looking to carry out their AML and ‘Know Your Customer’ obligations. This is a non-regulated firm supporting financial service scenario.

What we have seen through our firm support function is that the potential uses of DLT within financial services are wide-ranging. Firms are using the efficiencies gained through DLT to enhance traditional financial services offerings, in addition to providing new, innovate products and services.

Early and High Growth Oversight

In addition to the Regulatory Sandbox, it is important that we look at how new services and propositions are being implemented within financial services. This is where our Early and High Growth Oversight (EHGO) programme comes in. Fintech and innovative firms come into this programme where we can oversee and monitor how these new propositions are implemented in the market in a safe way.

The EHGO programme launched its pilot in October 2021 where it took in approximately 30 newly FCA authorised firms from across a range of portfolios. Following the successful pilot, the FCA launched phase 2 in April 2022, where the programme is currently being extended to up to 300 firms. Firms which have been identified as growing rapidly will also enter the programme. Early and High Growth Oversight provides additional supervisory support to these firms. It helps us to achieve our key areas of commitment in the Business Plan of reducing and preventing serious harm, setting and testing higher standards and promoting competition and positive change.

While we currently do not have cryptoasset or DLT firms in Early and High Growth Oversight, we anticipate such firms could enter the programme once authorised where they will receive supervisory support as they start out.

Financial Markets Infrastructure (FMI) Sandbox

The FCA is also supporting HM Treasury’s development of a new ‘FMI Sandbox’ aimed at facilitating the testing of new technologies and practices. The primary use case is to allow Multilateral Trading Facilities to test the use of DLT to settle the transactions on their markets without reliance on a separate Central Securities Depository.

The FMI Sandbox will allow firms to conduct limited testing of this business model against a temporarily revised set of rules in the Central Securities Depository Regulation and other legislation that could create barriers to settlement using DLT. If the tests are successful, these rule changes could then be made permanent.

The FMI Sandbox is therefore also a new and potentially more flexible way of making policy – testing potential rule changes in a limited environment before consulting on making these changes permanent. The powers for HM Treasury and the regulators to create the Sandbox and make permanent any successful rule-changes will be included in the up-coming Financial Services Bill.

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?

Financial promotions

In January 2022 the Government confirmed its intention to legislate to bring certain cryptoassets into the scope of the financial promotion regime.

We continue to believe this measure is important to protect consumers. Financial promotions are often a consumer’s first interaction with cryptoassets. The form and content of the promotion can have a significant impact on a consumer’s decision to purchase a cryptoasset. For example, our research found that 31% of cryptoasset users who saw an advert were encouraged or led to buy as a result. Those consumers wrongly believing they had regulatory protection were much more likely to have been led/encouraged to invest due to advertising (71% compared with the benchmark of 31%). Those led/encouraged to buy were also much more likely to regret their purchase.

We continue to see poor quality financial promotions from cryptoasset firms. The Advertising Standards Authority (ASA) has issued over 50 Enforcement Notices to cryptoasset firms over misleading advertising. While we wait for cryptoasset promotions to come into our remit we will continue to work closely with the ASA on this issue.

It is important that the legislation that brings cryptoassets within our financial promotion remit also gives the FCA the appropriate supervisory and enforcement powers to take action against misleading promotions. These powers are critical to enabling us to protect consumers and address the harm from misleading promotions.

In January 2022 we consulted (CP 22/2) on the proposed rules that will apply to cryptoasset promotions once the Government legislates to bring them into our remit. We consider cryptoassets used as speculative investments to be high‑risk, and our proposed rules are focused on addressing the resulting harms to consumers. As with other high‑risk investments, we want consumers to only access them knowingly, and after they have been assessed as having sufficient knowledge and experience to understand the risks involved. We will publish our final rules for cryptoasset promotions once the relevant legislation has been made. Subject to any changes in circumstances, we expect to take a consistent approach to cryptoassets to that taken for other high‑risk investments.

Money laundering

The MLRs do not include any provisions which confer consumer protection powers on the FCA. We do not currently have the tools, powers or remit to intervene and protect consumers or prevent serious harm and are working closely with HM Treasury to scope and design an appropriate regulatory regime. The perimeter of UK regulation is a matter for Parliament.

Further detailed examples of gaps and issues arising can be seen in our response to Q4.

Guidance, Education and Interventions

While cryptoassets are not directly regulated, we have been proactive in helping consumers understand the risks associated with investing in them, reaching millions of younger investors through our new InvestSmart campaign.

The InvestSmart campaign uses a gaming theme to engage consumers and help them make better informed decisions about high-risk investments such as cryptoassets. This is a five-year campaign to reach younger investors in the places they are researching and discussing investments, including social media (e.g. TikTok and Instagram) and online video platforms (e.g. YouTube and Twitch). This audience has lower levels of financial resilience, lower levels of investment knowledge and a higher propensity to invest in high risk, high return investments. From our survey of 18-40 year olds last year, we know that 58% cited hype on social media and in the news as driving their decision to take up high risk investments.

Scams and fraud associated with cryptoassets have also become an increasing concern, as the threat generally from online fraud continues to grow. Our ScamSmart campaign helps consumers protect themselves from fraudsters and to warn them about common scams, such as cryptoasset investment scams. Currently cryptocurrencies are the most searched investment scam on the Scamsmart website.

And we act where we see the risk of illegal activity, for example warning operators of crypto ATMs to shut down if unregistered and therefore non-compliant with the AML regime.

However, substantial and permanent change also requires clear legal obligations to be placed on platform operators to protect consumers. The Online Safety Bill includes vital measures to tackle fraud related offences in user generated content and on search engines. This includes:

Designation of content relating to fraud-related offences as priority illegal content, and;

Inclusion of a standalone duty on certain platforms to tackle fraudulent content contained within paid-for advertising.

We look forward to continuing to work with the Government to support the Bill continuing its passage through Parliament at the earliest opportunity in the autumn.

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

Although several factors may impact consumer behaviours, particularly trust and resilience, we can expect the regulation of crypto assets will have some influence on consumer confidence to invest and engage with cryptoasset services and businesses. The objectives of our regulation are to protect consumers, market stability and integrity and promote competition. In fulfilling these aims crypto firms and start-ups will be likely to benefit indirectly as a consequence.

Standards imposed on firms through our regulation should help sift out bad actors within the market and create an environment which consumers will overall be more confident to participate.

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

Different jurisdictions globally are developing their regimes, with notable examples including the EU, the US, Japan, and Singapore. The approach taken by jurisdictions internationally can be grouped – some countries are looking to apply existing regulations, with adaptions where needed, while others are considering introducing bespoke legislation. Other countries, notably China, India and Saudi Arabia, have taken far more restrictive approaches, with China banning cryptocurrency transactions. Our work on a domestic approach has been informed by our engagement with other jurisdictions, including those who have either adapted existing legislation or introduced bespoke legislation.

Our work has also been informed by our proactive international engagement with global standard setting bodies. The FCA is taking a leading role in IOSCO to drive forward work on market and conduct issues related to cryptoassets. Additionally, the FCA is playing an active role in other global fora, such as the FSB, to help shape international principles both on globally systemic stablecoins and unbacked crypto assets. Our work in this area will allow us to influence the global landscape in a way that complements the future domestic regulatory regime.

The formulation of international rules is at an early stage of development and is subject to change and debate. The UK authorities will stay close to international discussions, so that any global standards that emerge work for UK consumers and the UK market.

The European Union has developed a bespoke cryptoassets regime. Its recently agreed Markets in Crypto Assets legislation will apply to certain stablecoins and payment and utility tokens, although much of the technical detail is to be consolidated in ‘Phase Two’ discussions.

Relevant provisions include stating that there will be an authorisation regime consisting of a program of operations, internal control mechanisms, a procedure for risk assessment and a business continuity plan, and proof that the applicant meets the relevant prudential safeguards. Once authorised, firms would be obliged to act honestly, fairly, and professionally, including making their pricing policies available; to have prudential safeguards and an insurance policy; and to have resilient and secure ICT systems.

The United States is in the process of determining its regulatory approach but acknowledges that cryptoassets need to be regulated. The US Securities and Exchanges Commission (SEC) currently requires registration of all those financial instruments which qualify as ‘securities’, in accordance with the ‘Howey’ test in US case law. Should a given cryptoasset be judged to be a security, it will fall under the SEC’s jurisdiction.

Separately, the Responsible Financial Innovation Bill aims to further embed the ‘Howey’ test for determining a security. The Commodities and Futures Trading Commission (CFTC) will also have exclusive spot market jurisdiction over other fungible digital assets, including Bitcoin and Ether, as well as the ability to impose fees on digital asset exchanges. The Bill also requires digital asset service providers to disclose certain information to customers and to agree on terms of settlement finality. Issuers of payment stablecoins must maintain high-quality liquid assets, provide public disclosures on those assets, and have the ability to redeem all payment stablecoins at par in legal fiat tender. The Bill will need to be assessed by the US Congressional Committees before progressing any further.

Singapore has expanded its existing payments regulations to capture stablecoins. The Monetary Authority of Singapore (MAS) has implemented the Payment Services Act (PSA) and the Securities and Futures Act (SFA). MAS has also restricted digital payment token service providers from conducting certain marketing activities or promotional campaigns. MAS’ Managing Director in a recent speech praised innovation around tokenisation and DLT for its transformative economic potential, especially in cross-border payments, but said that MAS strongly discourages speculation in cryptocurrencies.

The PSA contains provisions aimed at tackling money laundering and terrorism financing, as well as rules around safeguarding of funds, interoperability, and technology and cyber security risks. Should a cryptoasset constitute a capital market product, it will fall under the SFA, in which case the legislation requires the preparation of a prospectus and registration with MAS. Entities seeking to establish or operate a Digital Payment Token Exchange will be required to be licensed as an approved exchange or capital market services licence holder.

Japan has taken a multifaceted approach, where different legislation applies depending on the kind of token. Cryptocurrencies and utility tokens such as Bitcoin and Ethereum are regulated as Crypto Assets under the Payment Services Act, while ‘Security Tokens’, which include shares, bonds, or fund interests in tokens, are regulated under the Financial Instruments and Exchange Act.

Depending on how a cryptoasset is classified, requirements may include notification requirements, the protection of user property including segregation from other funds, the safeguarding of personal information, disclosure requirements, advertisement and solicitation rules, as well as internal control measures to deal with any complaints.

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

We are aware of environmental concerns that have been raised regarding the resource intensity of certain types of cryptoasset, in particular those that use a proof-of-work consensus mechanism.

We are carrying out an internal analysis of resource-intensive crypto-assets in the context of the FCA’s objectives and the FCA’s Environmental Social and Governance strategy.

We intend for the outcomes of this work to help guide our understanding of the potential risks of harm from resource-intensive crypto-assets and inform our future approach to mitigating these risks where necessary.