A deep dive into the UK crypto regulatory consultation
The current crypto regulatory frameworks in the UK and other countries could be considered inadequate for both protecting consumers and supporting innovation, writes Helen Femi Williams in her first article for AltFi.
The widespread fallout from the collapse of FTX's has brought the UK's crypto regulatory position into sharp focus.
It has also made it increasingly difficult to argue for light-touch regulation and led to calls for stronger regulation and protection of both institutional and retail investors.
This is because the failure of FTX has highlighted a number of shortcomings in the current regulatory framework, such as a lack of investor protection and inadequate enforcement of existing rules.
According to bankruptcy court filings, FTX owes money to more than a million individuals and companies. An estimated 80,000 are in the UK.
This highlights the rush regulators now face to prove they have legislation in place to protect consumers and raised serious questions about the adequacy of existing regulations.
As a response the UK government launched a consultation and call for evidence on February 1, 2023, for the future financial service regulation of crypto-assets.
The consultation lays over the government's intentions for the sector and sets clear expectations which should give firms the confidence needed to come to the UK and innovate.
Previous announcements have addressed the topic, including a plan by former UK Economic Secretary John Glen, MP, in April 2022 to make Britain a global hub for crypto asset technology.
A second objective is to clarify how crypto assets are regulated and promote the UK as a financial regulatory sandbox and a destination for crypto asset investment.
In this article we take a deeper look at the crypto regulatory consultation, including what's in the consultation, the UK's competitive advantage, and what's next in the wider regulatory landscape.
"The consultation is a critical starting point for enabling the UK to play a role as a leading innovator in the crypto space,” said David Carlisle, Vice President of Policy and Regulatory Affairs at Elliptic.
“The UK crypto industry has been eager for the UK government to start articulating its approach to crypto regulation in real detail - and this is a great start in that direction,” he said."
“The UK government wants to strengthen its position as a world leader in fintech. To do so, it has to manage risk-taking, which is an integral part of any innovative progression, in a careful and considered way. The government's objective to establish a proportionate, clear regulatory framework which enables firms to innovate at pace is a sound one." said Dina White, General Counsel at Zodia Markets,
The consultation has three major themes, according to White:
Adaption of existing frameworks
The UK has adapted and modified the rules that already apply to various aspects of traditional financial services and markets. This will be implemented by including crypto assets within the regulatory framework established by the Financial Services and Markets Act 2000 (FSMA), a well-established feature of the UK's legal framework for financial services.
Similarly, the government is proposing a framework for addressing market abuses in crypto assets based on existing frameworks for managing financial transactions. This would define and prohibit insider dealing, unlawful disclosure of inside information, and market manipulation.
A focus on activities rather than assets
Where a person is engaged in certain specified activities underpinning crypto asset use, they will need to be authorised by the FCA and comply with relevant rules.
Each regulated activity would have to be separately authorised, and where a business that provides multiple services and business lines would be subject to similar prudential and conduct regulation as traditional financial institutions. In some cases, this may mean that particular functions are segregated.
The proposal is for the new regulations to cover crypto asset activities provided in or to the UK. This will impact UK firms providing services to customers in the UK or overseas, as well as overseas firms providing services to UK customers. Any entity conducting crypto asset business in or from the UK will need to pay attention and adapt its business models accordingly.
As much as this proposal clarifies the direction the government is heading, there is still much more work to be done.
Another factor to consider is the need to identify how this would affect Britain's position as a global leader. As a result of Brexit, the talent gap, and the decrease in the economy, the UK had the most significant decline in competitiveness GDP among the G7 in 2020 (-11.0 per cent).
"Having this regulatory framework in place should stimulate growth and innovation in the sector by giving responsible actors the regulatory certainty and confidence to participate in crypto-asset markets. Alongside the existing Investment Management Exemption, this will give global investors the confidence to invest in the UK for the long-term," White said.
How does the UK compare to Its Neighbours?
The legislation proposed by its closest neighbour the EU is the Markets in Cryptoassets Regulation (MiCA).
Carlisle says the consultation puts the UK on an equal footing with the EU.
"So far, there's been a perception that the EU and other jurisdictions have been out in front of the UK and that the UK hasn't been proactive enough in articulating its stance, so this new move is critical to getting the UK more on par with regulatory developments in other financial centres."
Additionally, the UK has a second-mover advantage compared to the EU, allowing it to be first in some areas, like regulating crypto-lending platforms.
Manuel Fajardo Senior Executive and Digital Assets Practice Lead at Plenitude Consulting sees the size of the UK as a disadvantage when compared to the EU.
"Will regulatory differences make industry participants choose one over the other? Can an equivalence agreement be achieved to make it easier for firms to operate in both?" Fajardo said.
Timo Lehes, co-founder and managing director of DeFi platform Swarm, agrees that the UK’s regulations may be less impactful than the EU and may need to take some guidance from it.
“The UK Government will be at particular pains at the moment to prove it has a regulatory Brexit dividend to cash in, but in reality, thanks to the 'Brussels Effect' of regulatory innovation, it is still taking some cues from EU lawmakers despite its new-found rule-making powers," said Lehes.
We see a similar movement towards establishing regulatory frameworks in most major financial markets, with the scope expanding from the current obligations in terms of financial crime to other topics like consumer protection, governance, segregation of assets, etc, as well as the regulation of stablecoins, and the emergence of a baseline of globally agreed standards.
Farjado contrasts the UK's regulation with Hong Kong's tightening approach to crypto.
"The consultation strikes a relatively open-minded note by avoiding outright bans. For example, in the case of algorithmic stablecoins. Or calling for evidence on DeFi before proceeding further. So that also sends a signal of being open to these and other innovations in crypto."
In the aftermath of FTX, Hong Kong's legislative council passed a new amendment to its Anti-Money Laundering (AML) and terrorist financing system to include virtual asset service providers.
The latest legislation will require virtual asset service providers to obtain a new licensing regime starting on June 1, 2023. As a result of the recent amendment, crypto exchanges will be subject to the same financial regulations as traditional financial institutions. Virtual exchanges must comply with rigorous AML guidelines and investor protection laws to operate in Hong Kong.
The collapse of FTX and the rapid growth scale of crypto-assets has driven regulators to consider how best to mitigate the risks and protect both institutional and retail investors.
The current crypto regulatory frameworks in the UK and other countries could be considered inadequate for protecting consumers and supporting innovation. Despite this, the UK's consultation indicates that the country is moving in the right direction.
However, given how quickly the industry is evolving, it is difficult to determine how it compares with its neighbours and which country will get crypto regulation right.