Crypto firms put on notice

The proposed new regime for regulating crypto assets is potentially the most comprehensive in the world. The UK regulators are showing their willingness to encourage innovation and, where possible, are building on existing regulation to help firms grow as soon as possible. It may be early days in the consultation process, but the changes will be far reaching. Anyone planning to be a key player in the crypto market would be wise to understand the proposed changes and get ahead where they can.

Between the Bank of England, FCA and HM Treasury, the UK regulators have accelerated their approach to regulating crypto currencies through the launch of their Future financial services regulatory regime for cryptoassets last month. They are moving from a focus on money laundering, terrorist financing and payment of funds to a much more comprehensive approach.

The intention is to build on existing regulation, enabling a “fast-track” approach. The regulators will focus on several areas:

  • Marketing materials – Imposing obligations on cryptoasset issuers regarding the marketing materials they publish
  • Crypto trading  – Formalising trading of cryptoassets through exchanges
  • Intermediaries – Increasing regulation of intermediaries
  • Custody – Providing increased safeguarding measures for custodians of cryptoassets
  • Lending – Increased regulation of lenders of cryptoassets to protect client assets
  • Market abuse – participants will be subject to additional regulations around market abuse.

The regulators (ultimately the FCA) have laid down a number of challenges to crypto issuers, trading venues, intermediaries, custodians and crypto lenders. These challenges haven’t existed in the past and firms should consider what impact they are likely to have on their activities, their resources their ability to comply.

Marketing materials

The FCA is concerned that the level of disclosure provided to investors is inadequate. It therefore intends to impose rules similar to those used for regulated markets or MTFs.

Before issuing marketing material or documents relating to a crypto issue, you should realise that the bar on disclosure and transparency will be raised and investors could have recourse where the contents are considered misleading. You will also need to comply with financial promotions regulations.

An issuer will be responsible for information provided to investors and the crypto assets can only be traded on a regulated market.
This should encourage issuers to provide better and clearer information to potential investors and provide some comfort that trading will be subject to tighter controls.

Crypto trading

As a crypto exchange you will be subject to much stricter regulation as you become a regulated entity and will fall under the Financial Services and Markets Act 2000 (Regulated Activities) Order. Before you apply for registration, you will need to ensure you meet minimum requirements such as capital, liquidity and prudential. You will also need to have in place processes to comply with consumer protection, sufficient resources to be resilient and ability to provide transactional data.

Crypto exchanges or trading venues will be regulated and subject to much stricter rules. This means that exchanges will have to establish effective controls to avoid solvency issues, the key problems highlighted by the recent collapse of FTX.

The FCA intends to provide investors with some comfort by insisting that crypto exchanges would have to adopt prudential rules and various other requirements including consumer protection, operational resilience, data reporting, and address a range of other risks such as counterparty credit, market, exchange rate and operational risks.

The role of intermediaries

As an intermediary, you will have a greater regulatory burden as you will need to obtain FCA approval and this will include a number of additional steps. As the rules will likely be derived from MIFIDPRU, you need to consider how to meet the FCA’s thresholds for capital and liquidity; also, additional processes to manage conflicts of interest and to demonstrate best execution.

Once fully regulated, intermediaries are likely to see their regulatory burden substantially increase, including additional regulatory reporting requirements.

Custody of crypto assets

Recent bankruptcies of crypto custodians have highlighted issues such as commingling customers’ digital assets with the debtor’s and the right of the debtor to control these assets.

The FCA intend to address these issues by obliging custodians to safeguard investors’ rights (for example by restricting commingling of investors’ and firm’s assets), and ensuring adequate financial strength and redress where cryptoassets held in custody are lost. This should introduce a further level of control and require intermediaries to comply with client asset regulations (e.g. CASS).

As a custodian you will face stricter regulations and you will need to establish policies and processes aimed at safeguarding your clients’ crypto assets. Also, you need to consider how you will meet the FCA’s financial thresholds and ability to wind down your business without endangering your clients or disturbing the crypto markets.

Orderly wind-down (and a wind-down plan) is likely to be a priority to the FCA, as they are particularly focused on the effect this may have on clients or the markets.

Cryptoasset lenders

The lack of regulation and accountability has contributed to recent cases where depositors find that their assets are difficult to recover on bankruptcy of the lender. Also, as their assets may have been commingled, they are indistinguishable from the lender’s.

As a cryptoasset lending platform you will face new challenges as you will need to segregate client assets, operate robust risk management processes, establish policies and procedures regarding consumer protection and be able to meet the FCA’s threshold requirements.

The FCA is proposing that lending platforms should have sufficient resources to prevent disorderly wind-down. They also focus on credit risk as this has been a significant driver of cryptoasset firm failure.

The FCA’s approach is likely to focus on the lender’s financial resilience, segregation of client assets, treatment of counterparty risk and handling of collateral.

Market abuse

Finally, admission of a cryptoasset to a UK cryptoasset trading venue will trigger the Market Abuse Regulations. The FCA is keen that market participants should understand the concept of market abuse, their obligations to prevent, detect and take action against these practices.

All participants in the crypto markets need to understand what constitutes market abuse and should establish policies and procedures to align to market abuse regulations.

What crypto participants need to do

Firms have been asked to provide feedback by 30th April 2023. The regulators will then have a number consultations once responses have been received.

The regulators haven’t set an implementation date, but they are focussed on addressing the current weaknesses as soon as possible. Firms should try to get ahead of the curve by starting to work on how they will address the inevitable changes.

You should start with analysing operations against the FCA’s key objectives, addressing the gaps including establishing appropriate policies and procedures, enhancing resources and ensuring that data can be collected and reported frequently.

We can help

We regularly work with firms to ensure their arrangements and risk frameworks are up to speed and assessing the impact of forthcoming regulations.

Our team of regulatory experts can help you understand, prepare for and align your business to the regulators’ crypto expectations, whether it is capital and liquidity requirements under IFPR, financial crime, market abuse, conflict of interests, consumer protection, safeguarding, CASS or SM&CR.