Following a recent rise, the price of Bitcoin once again exceeds $10,000, a key resistance level which, if sustained, could see it rising even further. Interest in cryptocurrencies is, according to some observers, likely to rise as measures taken by Central Banks to combat the effects of the coronavirus pandemic result in the devaluing of their own fiat currencies, and while Central Banks themselves experiment with digital currencies. The Libra Association continues to work on Libra, a token designed to be used on Facebook. Rumors swirl of imminent support by the global payments giant PayPal for cryptocurrencies, supported by recent job listings for cryptocurrency engineers. Whilst it might not yet have returned to the levels of mania seen during 2017-2018, cryptocurrency appears likely to continue to grow in both maturity and usage. Such a rise will inevitably be marked with a corresponding increase in the debate over the extent of regulation needed in the area. Should it be a case of caveat emptor or should government regulators take greater steps to introduce guard rails in this area?
In October 2018, the UK Government Cryptoassets Taskforce – comprising HM Treasury (HMT), the UK Financial Conduct Authority (UK FCA) and the Bank of England – published its final report (Taskforce Report) on the UK’s policy and regulatory approach to cryptoassets and distributed ledger technology (i.e., independent computers used to record, share and synchronize transactions in their respective electronic ledgers; blockchain being one example of such technology) in financial services. The Taskforce Report identified three broad types of cryptoasset:
- Exchange tokens – often referred to as cryptocurrencies, these tokens use a distributed ledger technology platform and are not issued or backed by a Central Bank or other central body;
- Security tokens – these amount to a “specified investment” under the Financial Services and Markets Act (2000) (Regulated Activities) Order (RAO) and may provide tangible rights such as future entitlement to shares or payment of a sum of money; and
- Utility tokens – these can be redeemed for access to a specific product or service that is typically provided using a distributed ledger technology platform.
The Taskforce Report notes that cryptoassets are not considered to be currency or money, in keeping with the view of both the Bank of England and G20 Finance Ministers, too volatile to be a good store of value and not widely accepted as a means of exchange. It further notes that while the UK cryptoasset market has grown, it is not (as of 2018) one of the major markets for global cryptoasset trading, with only 15 of 206 global cryptoasset spot exchanges headquartered in the UK.
The UK has neither a blanket ban on cryptocurrencies nor a bespoke financial regulatory regime. Instead, government policy on cryptocurrencies continues to evolve and a number of government bodies have run consultations in the area. In January 2019 the UK FCA opened a consultation on cryptoassets that resulted in the publication in July 2019 of a policy statement (UK FCA Statement). The same month the UK FCA ran a separate consultation on a prohibition on the sale to retail clients of investment products that reference cryptoassets due to a perceived inability on the part of such clients to reliably assess the value and risks of such products. The proposed ban would extend to derivatives (i.e. contracts for difference, options and futures) and exchange traded notes. The results of this consultation have not yet been made public.
Broadly speaking, the UK FCA Statement categorizes cryptoassets as either regulated or unregulated. The definition of regulated assets includes security tokens and also e-money tokens; tokens that satisfy the definition of e-money within the Electronic Money Regulations. Unregulated tokens, by contrast, comprises both exchange tokens and utility tokens, i.e. Bitcoin, Ethereum, Bitcoin Cash and other common cryptocurrencies. All these coins constitute examples of tokens that are not “centrally issued” for the purposes of the UK FCA Statement, and which provide no rights or entitlements to the holder. For the purposes of this categorization, the intended use of the cryptocurrency, nature of the underlying network, etc. are all irrelevant.
The UK FCA Statement further states that exchange tokens fall outside the current regulatory perimeter; the transferring, buying and selling of such tokens are not activities regulated by the FCA. Additionally, running a cryptocurrency exchange to facilitate such transferring, buying and selling also is not regulated by the UK FCA. Almost all respondents to the initial consultation agreed with the UK FCA’s assessment.
As a result, many of the most commonly known cryptocurrencies are not subject to financial regulation in the UK. Complexities arise, however, with other types of cryptoassets which in certain circumstances may constitute a specified investment. “Proof of stake” mechanisms, where validators receive benefits based on the number of tokens they “stake” rather than for conducting “proof of work” calculations, or decentralized finance applications or interest-bearing cryptocurrency wallets that pay the holders of the cryptoasset a fee that could be characterized as a “dividend.” These too could be classed as specified investments and subject to regulation, depending on how they are structured.
Of course, like any other financial product, cryptoassets will need to be subject to a whole raft of other regulations and surveillance. In April 2019 HMT initiated a consultation on the transposition of the Fifth Money Laundering Directive (5MLD) – which contains provisions on the prevention of the use of the financial system for the purposes of money laundering and terrorist financing – noting that 5MLD introduced for the first time requirements on cryptoasset exchanges and custodian wallet providers. Observing the rapidly changing risk profile of cryptoassets and increasing usage of cryptoassets to launder illicit proceeds of non-cyber crime, HMT consulted on whether merely to transpose 5MLD provisions into UK legislation or include additional regulatory provisions. Consultation responses have led to legislative changes, e.g. to the definition of virtual currencies and bringing firms offering crypto-to-crypto and crypto-to-fiat exchange services within the scope of the UK Money Laundering Regulations.
In keeping with the general trajectory of consultation responses and also 5MLD, in August 2020 the UK FCA announced proposals that would render cryptoasset exchanges and custodian wallet providers subject to anti-money laundering requirements and require them to submit annual financial crime reports. The UK FCA is seeking comments on this particular proposal by 23 November.
Further regulation in the money laundering and terrorist financing areas may be forthcoming, and other areas such as sales regulation and taxation may see more cryptoasset-related regulatory discussion.
The US landscape differs, both because of the variety of regulators involved and the lack of standardized guidance from the US securities regulator. First and foremost, the US does not use or recognize the three-part typology for tokens (Exchange, Security, Utility) generally recognized across Europe and Asia. Instead, the US Securities and Exchange Commission (SEC), through a mix of speeches, guidance documents, and enforcement actions, has applied the traditional test for “investment contracts” from a 1946 US Supreme Court case to determine whether a token that does not provide tangible rights (e.g. dividends, profit rights, etc.) might nevertheless be a security under US law because it represents an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. This test considers a variety of factors relating to the token, including its manner of sale, the functionality of the token at the time of its sale, and its utility upon purchase. The SEC’s reliance on a “facts and circumstances” test to examine each individual token has led to a lack of regulatory clarity in the US concerning the applicability of US securities laws to any specific token. This uncertainty carries over to whether such tokens can be offered for exchange without requiring the exchange to register with the SEC and comply with broker-dealer requirements, what kinds of entities can or must provide custody for such tokens when held as an investment, and a variety of related issues. The Chairman of the Commodity Futures Trading Commission (CFTC) has followed a policy of allowing the SEC to first determine whether a cryptoasset is a security as an “initial threshold determination” before assessing whether the cryptoasset is a commodity, currency, or other type of asset.
That said, regulation in other areas is much clearer. The Financial Crimes Enforcement Network, an agency of the US Department of the Treasury that enforces anti-money laundering requirements under the Bank Secrecy Act (BSA), has steadily issued guidance and administrative rulings that clarify whether BSA requirements apply to the use, administration, or exchange of cryptoassets regardless of their status under US securities law. The CFTC has clarified rules concerning derivative instruments (swaps, futures, and options), margin trading, and other issues relating to cryptoassets, although it lacks jurisdiction to regulate spot markets except for instances of fraud or market manipulation. The Internal Revenue Service (IRS) has issued general guidance concerning tax treatment for cryptocurrencies, and has begun to issue additional guidance pertaining to specific scenarios. The IRS is currently working on guidance relating to tax reporting by crypto-asset exchanges. While US states also regulate the sale of cryptocurrencies under their money transmission license rules, there is increasing clarity as to how these rules apply to cryptoassets, and even states like New York that have issued very strict guidance have begun to adjust their guidance to enable more cryptoasset-related activity.
For all the questions they have posed and regulations they have spawned, it must be borne in mind that cryptoassets remain a nascent technology. The longest and most widely recognized cryptocurrency, Bitcoin, is but 12 years old. Ethereum, the second largest cryptocurrency by market capitalization, is only five years old. The early years of cryptoassets have required regulators to grapple with novel problems and remain alert to new developments. The technology continues to gain in prominence, such that it now prompts serious consideration by central banks: Federal Reserve Governor Lael Brainard recently announced that the Fed is building a hypothetical digital currency (whilst also acknowledging the difficult legal questions that would arise if the Fed ever wanted to use a digital currency). Similarly, European Central Bank President Christine Lagarde recently said that the bank will soon publish a report on a possible European digital currency and seek public feedback. Meanwhile, the technology itself and its uses also continue to evolve – ‘DeFi’ – decentralized finance – and yield farming (earning more cryptoassets by putting existing cryptoassets at the disposal of lending marketplaces) have grown dramatically over the summer of 2020. The future development of cryptoassets and which direction they may head in may be difficult to foresee – but what seems an altogether easier prediction is that they will continue to keep regulators on their toes and pose a host of novel issues.