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In our article of March 2018 we considered whether regulation of cryptocurrencies was on the horizon. The creation of a UK Cryptoassets Taskforce has brought this horizon closer into view, but this space remains unregulated in the UK - with some limited exceptions.
Developments
The potential risks associated with cryptoassets are regularly highlighted in the press.
The Financial Conduct Authority (FCA) recently reported that £27 million was lost as a result of crypto and forex scams in 2018/2019, with the number of incidents reported to the FCA doubling from the previous year.
There have other been instances of consumers being exposed to potential fraud. The coin exchange, Quadriga CX, held US$180 million of cryptocurrencies on behalf of 115,000 customers. The founder and owner of Quadriga CX had sole responsibility for handling the exchange. Upon the owner’s death in December 2018, auditors found that all of the funds of the 115,000 customers were missing and auditors have thus far been unable to discover what happened.
Questions have also been raised about the fairness of trading in cryptocurrency exchanges. The underlying premise is that cryptocurrencies are decentralised, not requiring a traditional central authority such as a bank, and can be transparently traded between individual traders. A recent study into crypto trading found that computer bots are being used in exchanges to obtain information in advance of other traders and therefore beating other users to certain trades, raising ethical issues and increasing the call for regulation from some quarters.
Cryptocurrencies also remain highly volatile. For example, Bitcoin has fluctuated in value from US$20,000 to US$5,000 in the last 18 months. Despite this, interest remains high and the use of cryptoassets continues to expand in to the consumer space, as evidenced by Facebook recently announcing that it is planning to launch its own cryptocurrency in early 2020.
UK regulation
The UK government created a “UK Cryptoasset Taskforce” in 2018. This Taskforce comprises HM Treasury, the Bank of England and the FCA.
The purpose of the Taskforce is to investigate the potential harm these products could cause, but also to encourage innovation. The Taskforce has identified three major risks from cryptoassets:
- Market integrity
- Financial crime
- To consumers
In January 2019, the FCA issued guidance about cryptoassets and defined these as being “cryptographically secured digital representations of value or contractual rights that use some type of distributed ledger technology (DLT) and can be transferred, stored or traded electronically”.
In this guidance, the FCA has sought to categorise cryptoassets based on their intrinsic structure, as well as use. It has identified three categories of tokens:
- Exchange tokens (e.g. cryptocurrencies)
- Security tokens
- Utility tokens
The FCA stated that exchange and utility tokens are usually outside the regulatory perimeter. However, certain security tokens may amount to a “specified investment” under the Regulated Activities Order (RAO) or transferrable securities or other financial instrument under the Markets in Financial Instruments Directive II (MiFID II). Therefore, while the FCA has recognised that the complex nature of many of these tokens may make it difficult to determine whether a token meets the definition of a specified investment, they may still fall within the regulatory perimeter.
To better understand the potential harms of cryptoassets, the FCA has recently published two pieces of consumer research. The research found that many consumers did not fully understand cryptoassets, but the current scale of harm may not be as large as anticipated because very few consumers had actually bought cryptoassets (only 3% of those surveyed) and, of those that did, they were generally investing relatively small amounts.
The research also found that the majority of people who had invested in cryptoassets did not use financial advisors. Although the use of advisors is currently low, in January 2019, the FCA published rules for advising on cryptoassets. Advisors will need to be aware of these rules, particularly when considering that the FCA considers that some cryptoassets already fall within the regulatory perimeter.
Comment
Governments and regulators have recognised that DLT has the potential to deliver significant benefits in the future, including in relation to capital raising or international money transfers. However, they continue to investigate to what extent regulation is required to protect consumers and deal with the potential risks from cryptoassets such as financial crime, market integrity, and financial stability.
Financial institutions are also investigating, and in some cases seeking to utilise, the potential benefits. JP Morgan, for example, announced the first US bank-backed cryptocurrency in February 2019 to be used to help settle payments between institutional clients.
The FCA is currently consulting on guidance to clarify the types of cryptoassets that fall within the existing regulatory perimeter and, later in 2019, the FCA is due to consult on banning the sale of certain crypto derivatives to retail investors. HM Treasury is also exploring legislative changes to potentially broaden the FCA’s regulatory remit to bring further types of cryptoassets within the regulatory perimeter.
Given the potential regulatory activity in the UK, it will be important to keep aware of any future developments which could impact on investor claims in respect of cryptoassets and/or against financial advisors. These claims could potentially trigger cover under D&O, E&O, cyber liability and crime, and professional liability policies.
Read other items in Professions and Financial Lines Brief - June 2019
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