Written evidence submitted by the Investment Association
The Investment Association (IA) champions UK investment management, supporting British savers, investors and businesses. Our 250 members range from smaller, specialist UK firms to European and global investment managers with a UK base and manage £10 trillion of assets. The investment management industry supports 122,000 jobs across the UK. Our mission is to make investment better. Better for clients, so they achieve their financial goals. Better for companies, so they get the capital they need to grow. And better for the economy, so everyone prospers.
Our purpose is to ensure investment managers are in the best possible position to:
• Build people’s resilience to financial adversity;
• Help people achieve their financial aspirations;
• Enable people to maintain a decent standard of living as they grow older;
• Contribute to economic growth through the efficient allocation of capital.
The money our members manage is in a wide variety of investment vehicles including authorised investment funds, pension funds and stocks and shares ISAs. The UK is the second largest investment management centre in the world, after the US and manages over a third (37%) of all assets managed in Europe.
In our general positioning on the issues raised in this inquiry, we make a number of critical distinctions.
The first is between the role of blockchain technology as part of a delivery infrastructure for products such as investment funds, and the role of blockchain in facilitating the development and evolution of digital assets. While we have a rising degree of confidence that blockchain will gradually prove transformative for the delivery of investment funds, our confidence about the likely shape of the digital assets universe is much lower.
With respect to digital assets, we make a second critical distinction between the tokenisation of mainstream assets such as shares, bonds, property or infrastructure and native digital assets, which include non-fungible tokens (NFTs). Both would be expected to make use of blockchain technology for core functions. Here, we have a rising degree of confidence about acceleration in tokenisation of mainstream assets, but much less certainty about how the native digital assets environment will evolve.
A third distinction is between different kinds of native digital assets. Unlike cryptocurrencies, the main functions of NFTs currently are as unique digital collectibles, items for use in gaming or the metaverse, or as outright speculative tools. They are therefore not something made available by IA members or which otherwise form part of their business activities. Increasingly, though, native digital assets of a broader nature are starting to become a feature of some investment portfolios and experience of cryptocurrencies is increasing.
In summary, therefore, NFTs are currently not high on the investment management industry’s blockchain agenda, although we are alert to the possibility that this will change. Future investment portfolios could contain NFTs, and NFTs may themselves potentially become a structure to house an investment portfolio as an alternative to an investment fund.
In the meantime, we recognise the appetite from UK consumers to access various categories of cryptoassets, including NFTs. This underlines the importance of a clear policy and regulatory approach. It also raises questions around the effectiveness of the messaging provided by UK policymakers on the risks of such exposure and shows the current difficulties being experienced in encouraging consumers to invest for their future through mainstream investments in a well-diversified way via investment professionals.
In this context, our response concentrates on three of the four questions posed.
Naturally, any unregulated sector will be subject to abusive practices by bad actors and the NFT and wider cryptoasset sectors have proven to be a case in point. Nevertheless, the NFT market has been attractive to investors and speculators across the globe. According to a Chainalysis report, in Q1 2022, 950,000 unique addresses bought or sold an NFT in transactions worth $30bn, almost reaching the $40bn total for the whole of 2021[1]. This has been a global phenomenon (lead by Central and Southern Asia, followed by North America and Western Europe) with no region making up more than 40% of all web traffic since the beginning of 2021.
However, this enthusiasm seems to have waned more recently as valuations have fallen significantly and many NFTs are now described as worthless[2], causing losses and harm to many consumers. In this context, the UK regulatory authorities are understandably focused on risk mitigation and consumer protection.
Our recent report[3] recommends that the level of knowledge and experience within industry and policymaker bodies keeps pace with developments in the emerging Decentralised Finance (DeFi) arena, incorporating NFT / blockchain, in order to understand and pre-empt potential harm. There is a need to adequately resource and develop technical expertise to address these transformative changes and to demonstrate the UK’s ability to lead and shape global regulatory standards. Additionally, we recommend that HM Treasury establishes a DeFi Taskforce in partnership with industry to assess the overall policy implications for the investment management sector from the opportunities already identified – and those yet to materialise.
In this respect, the IA strongly supports HM Treasury’s commitment to promote competition, innovation, and support UK competitiveness across the financial services sector. Consumer protection is paramount and those wishing to gain exposure to NFTs should be able to do so in a safe manner, with a full understanding of the risks involved. This is particularly the case because consumers who hold NFTs are not protected by the Financial Ombudsman Service or Financial Services Compensation Scheme (FSCS).
However, and despite well-publicised volatility, many UK consumers have direct exposure to cryptoassets without first having built up sufficient deposit savings or mainstream investments. Increasing demand for cryptoasset exposure has meant that the associated risks have become demonstrably greater. Without further changes to the existing regulatory sphere, many investors seeking out exposure to cryptoassets will continue to be driven to unregulated avenues.
These can encourage more high-risk investment or speculation and can be characterised by the presence of asymmetric information, a prevalence of scams and lack of consumer protections in the event of firm failures. At present, some unregulated cryptoasset firms engage in practices that are not aligned with the statutory objectives of regulatory bodies, in turn producing negative outcomes for consumers.
By carefully widening the regulatory perimeter, regulatory bodies will be better placed to deliver on their objectives of protecting financial stability, market integrity and consumer protection. Expanding the regulatory framework to cover an appropriate range of cryptoassets – notably stablecoins as intended – should produce better governance and higher standards across cryptoasset firms via robust and effective authorisation and supervision throughout the regulatory lifecycle. In time, it may also be appropriate for regulated investment funds to offer a small allocation to the crypto market as part of a well-diversified portfolio.
In developing a robust regulatory architecture for cryptoassets, it is essential to consider the impact on the FSCS to ensure that it remains a compensation scheme of last resort. Firms with similar business models, regulatory environments and likelihood of failure resulting on a call on the FSCS should be ‘pooled’ in a way that reflects the actual level of risk. Well-run firms should not be paying for the cost of failure of ill-equipped or poorly managed ones.
The IA supports the formation of a clearer UK regulatory approach across the range of cryptoassets that balances the prioritisation of investment into the UK economy and the fostering an innovative marketplace, with regulated access routes into a wider range of markets and increased investor protection.
It is very much easier and quicker for consumers to gain access to the unregulated cryptoasset market than it is to a regulated investment fund, or to regulated financial advice. It follows that there is an increased likelihood that consumers, including vulnerable people, are exposed to a number of well-documented potential harms as a result of NFT speculation, notably significant capital loss and undisclosed gas fee costs of failed attempts to buy newly-minted NFTs from over-subscribed collections. However, the opportunity cost of not putting the value of the investment to better use is often overlooked. Consumers demonstrably benefit from the long-term returns that a diversified portfolio of well-regulated investment products brings, helping them achieve lifetime goals while at the same time providing greater growth capital for the economy. Catalysing retail participation in mainstream capital markets, even at a time of economic uncertainty, will help to lay a foundation which will deliver benefits for decades to come.
We are clear that heavily-concentrated NFT speculation does not form part of a responsible investment strategy and in most cases is likely to be unsuitable for UK consumers, particularly vulnerable people. It is unfortunately the case that the ease with which the cryptoasset market can be accessed is in marked contrast to the protective frictions inherent in the mainstream investment market onboarding process. Some aspects of this friction appear disproportionate when compared to how straightforward it is to access other capital investments.
A particular challenge exists in the area of advice and guidance. One of the important functions in attracting investors to mainstream investment is the ability of regulated firms to provide appropriate, tailored support at different stages of an individual’s life. However, FCA research indicates that fewer than 8% of the UK adult population receive regulated financial advice. When combined with the legislative barriers that prevent financial services firms from engaging and supporting non-advised consumers, this results in the vast majority of the population being under served and exposed to detrimental financial outcomes. There is a risk that this portion of the population is vulnerable to being attracted to cryptoasset speculation.
Unfortunately, the advice gap debate is not a new one. Cryptoassets, and the relative ease with which they are currently available to consumers, does bring a fresh urgency to ensuring that consumers are fully informed on the best ways to invest to support themselves in the long term:
• As highlighted by the FCA’s Consumer Investments Strategy[4], there is a large proportion of the population holding excess cash balances with long term time horizons who are exposed to the detriment of high inflation, and who are unable to access affordable and appropriate financial advice.
• The FCA has recently published its new Consumer Duty, obliging firms to support good customer outcomes, but there is widespread concern across the financial services industry that the legislative framework around financial advice (which originates from MiFID) will restrict firms’ ability to meet the objectives of the new Duty.
• In this digital age, it is possible for financial services firms to develop a greater understanding of an individual’s financial circumstances and use those insights to offer people meaningful support with the financial challenges people face, thereby allowing firms to support good customer outcomes.
Recent announcements, from the FCA in its intention to perform a holistic review of the financial advice-guidance boundary, and from HM Treasury to empower the FCA to deliver a new UK retail disclosure regime, are welcome developments. Providing high quality, clear, accessible information is a foundation for increasing consumer confidence in mainstream investment and developing a simple and consistent framework for consumer disclosures must be a priority.
A key element of the change expected across the financial services industry in the coming years will involve the greater use of technological innovations, such as blockchain to offer potential benefits such as reduced settlement timeframes, greater market liquidity, and more efficient financial markets.
Used correctly, there are two core features of blockchain technology that provide substantial security to business investors: peer-peer consensus and transaction immutability.
Depending on the type and protocol of the blockchain, for any transaction to be authorised, it first requires peer-peer authorisation from the majority of network participants. Transactions are initiated through the use of private keys. This generates a unique digital signature which confirms it came from them. Unless a malicious actor has access to another person’s private key, the digital signature generated will not match where the transaction supposedly came from and will not receive peer-peer approval. Therefore, permitting participants take adequate steps to protect their private keys from others, investors’ transactions are protected from unauthorised access.
For those transactions that are correctly authorised, these transactions are collated into blocks which have predetermined storage capacities and, when filled, are closed and linked to the previously filled block, forming a chain of data. These chains are held together via an algorithmic signature, a hash, that is equivalent to the former block. Therefore, due to the cryptographic element of blockchains which means that no participant can change or tamper with a transaction after it has been recorded to the shared ledger, investors are secure from things such as double spending and single points of failure.
In principle, blockchains are governed by a set of protocols that are conditioned by the type of blockchain itself. These establish who in the network is allowed to validate transactions, as well as to maintain and observe transactions recorded on the shared ledger.
As explained in a recent working paper produced by the Bank for International Settlements (BIS)[5], the extent of risk is conditioned, partially at least, by the type of any given blockchain. In permissioned blockchains, network trust is placed in the limited coordinating body that approves and records transactions. This is similar to the extent of trust that is placed in intermediaries operating in the traditional financial ecosystem, such as custodians and brokers. Accordingly, the extent of security coverage on these blockchains is broadly the same as that offered by centralised registries as have been deployed traditionally.
However, in permissionless blockchains, investors do not rely on trust in any individual validator, but rather all network participants. Since anyone can become a validator in a permissionless blockchain, the system is potentially vulnerable to network participants to validators with malicious intentions. The greatest impact of such is the potential increase in exposure to cyber risks, notably 51% and Sybil attacks. In both cases, an adversary subverts the network by creating a large number of pseudonymous validators and uses them to gain disproportionately large influence over the consensus protocol. If, and only if, sufficient computational power can be achieved so to dominate the consensus protocol, this may enable a malicious actor to breach the security of investors for their own gain.
To combat the likelihood of such, permissionless blockchains have resorted to two types of protocols as a means of protecting against these risks: Proof-of-Work (PoW) and Proof-of-Stake (PoS) protocols. Without going into the technicalities of either protocol, the main idea behind both approaches for validating transactions is to provide validators with a financial reward for acting faithfully. Assuming that validators seek to maximise their accumulation of these rewards, then it follows that they will be incentivised to maximise the number of transactions that they can verify in the long run. All other things equal, this provides a reinforcing financial incentive to maintain the integrity of the blockchain and ensure protection for investors.
Furthermore, the financial cost of acquiring the sufficient computational power to undertake cyber-attacks of this nature are vast and are positively correlated with the size of the blockchain network itself. Accordingly, the World Economic Forum has previously commented that the fixed costs for validators to jeopardise investor protection are too high, which makes attacks of this nature highly unlikely.
The IA considers that blockchain technology could offer substantial benefits to firms and investors. When assets reside and trade on permissioned or permissionless blockchains, asset owners are reliant upon the blockchain systems for access to their digital property. Permitting that the standards for mitigating operational risks are as robust as those in regulated markets, the IA considers that one of the greatest benefits is in greater investor security afforded by the underlying consensus mechanism(s) and immutability of blockchains.
6 January 2023
Ends
The Investment Association 5
[1] Chainalysis: State of Web3 Report June 2022
[2] The Guardian: Investors convert ‘totally worthless’ NFTs into tax write-offs December 2022
[3] Investment Association: Investing for the Future July 2022
[4] Financial Conduct Authority: Consumer Investment Strategy – 1 year update October 2022
[5] Bank for International Settlements BIS Working Paper No 1061 Cryptocurrencies and Decentralized Finance December 2022