The FCA has published a consultation paper setting out draft guidance to help market participants understand which types of cryptoassets fall in and out of the regulatory perimeter. The guidance provides clarity on some interesting questions, drawing on experiences from the FCA’s regulatory sandbox. Stakeholders are invited to provide feedback by 5 April 2019, with a view to publishing a final policy statement this summer.

What’s the background to this consultation?

The UK Cryptoasset Taskforce report published last October committed the FCA to providing guidance on the existing regulatory perimeter, in order to provide more clarity to the market. It also committed the Treasury to consulting on potentially expanding the regulatory perimeter (among other things). This consultation paper sets out the FCA’s draft guidance on the existing regulatory perimeter, for stakeholder feedback.  

Overview of regulatory perimeter

As per the Taskforce report, the consultation paper divides cryptoassets into:

• Security tokens: tokens with specific characteristics that mean they meet the definition of a Specified Investment (under the Regulated Activities Order).
• Exchange tokens: tokens intended and designed to be used as a means of exchange, which are not issued or backed by any central authority; usually a decentralised tool for buying and selling goods and services without traditional intermediaries.
• Utility tokens: tokens which grant holders access to a current or prospective product or service but do not grant holders rights that are the same as those granted by Specified Investments.

The draft guidance indicates that:

• Security tokens are, by definition, regulated as securities, whereas pure utility and exchange tokens are not.
• Appropriate authorisations will also be required if the token (whatever category it falls into) constitutes e-money or is used to facilitate regulated payment services.
• Security tokens which constitute “transferable securities” (under MiFID) may be subject to additional regulatory requirements, such as an obligation on issuers to provide an approved prospectus.
• The Fifth Anti-Money Laundering Directive (5AMLD) will, once transposed into UK law later this year, impose new AML requirements on many entities carrying out cryptoasset-related activities, such as exchange, transfer or custody services or financial services supporting ICOs.
• Products that reference any types of cryptoassets, like derivatives, are very likely to fall within the regulatory perimeter, as options, futures or contracts for difference.

What is a security?

As noted above, security tokens are tokens that meet the definition of a Specified Investment. Broadly, the FCA considers a security to refer to an instrument (i.e. a record, whether written or not) which indicates an ownership position in an entity, a creditor relationship with an entity or other rights to ownership or profit. 

The draft guidance provides some helpful indicators and case studies, along with a Q&A, to illustrate the line between security tokens and other tokens. A few of the themes emerging around the FCA’s views are:

Pure exchange or utility tokens should not be treated as securities

• The FCA’s view is that pure exchange tokens and utility tokens are not securities, even if they are acquired and held for speculation purposes. The FCA considers this activity akin to holding a different fiat currency or commodity, both of which are unregulated, in the hope of gain.

Tokens sharing the characteristics of securities should be treated as securities

For example, the FCA expresses views that:

• Tokens that confer rights to participate in the profits of the platform are likely to constitute shares, even if the tokens are primarily used for other purposes, e.g. as a means of exchange.
• Voting rights that give the token holder control of the entity are likely to be indicative of a security (although not all voting rights give control – e.g. if the whitepaper expressly states that the issuer is not obliged to honour the outcome of the vote).
• A contractual entitlement to a payment flow, even if that payment flow is derived exclusively from the secondary market and not directly from the issuer, is likely to be considered a security.
• Tokens that give their holders the right to be paid their investment in full by a certain date are likely to constitute debt instruments, and thus be regulated as securities.
• Tokens that give their holders rights to subscribe for other security tokens in the future are likely to constitute warrants, and thus be regulated as securities.
• Tokens that entitle holders to a share of fees or profits generated from a pool of assets (e.g. fine art) are likely to constitute units in a collective investment scheme, and thus be regulated as securities.

Other factors are generally not relevant

For example, the FCA indicates that:

• The nature of the network – e.g. whether or not it is fully decentralised – does not have a bearing on whether or not a token is a security or not.
• A token can be considered a security even if nothing is received for it (e.g. in an airdrop).
• Labelling a token a “pure utility token” in a whitepaper is not sufficient to demonstrate that is the case – the FCA will look to the relevant rights and obligations granted (although statements in a whitepaper which suggest to investors that they will get ownership rights could be indicative of a security).

What is a “transferable security”?

The term “transferable security” has the meaning given to it in MiFID. This requires the security to be negotiable on the capital markets. The FCA takes a fairly broad view of this definition – essentially that ownership and debt tokens that can be transferred to another person in a way that gives that person good legal title to them may be considered transferable securities.

What is e-money?

Under the E-money Regulations, e-money is electronically stored monetary value as represented by a claim on the electronic money issuer which is:

• issued on receipt of funds for the purpose of making payments;
• accepted by a person other than the issuer; and
• not excluded under the Regulations.

The draft guidance notes that whilst most exchange tokens are unlikely to represent e-money (because they are not centrally issued and do not represent a claim against an issuer), tokens that are pegged to a fiat currency and used for the payment of goods or services could potentially meet the definition.

It also acknowledges that e-money will include fiat balances in various types of online wallets or prepaid cards.

How might cryptoassets be used to facilitate regulated payment services?

Regulated payment services are those covered within the scope of the Payment Services Regulations (PSRs). The FCA’s view is that the use of cryptoassets is not covered within this scope, because it only covers activities involving banknotes and coins, scriptural money and electronic money. 

However, it notes that cryptoassets may be used to facilitate regulated payment services. For example, various new players are offering international money remittance services which involve the firm receiving fiat funds in one jurisdiction, converting them into a cryptocurrency to make the international transfer at a low cost and high speed, and then converting them again into the fiat currency of the recipient’s jurisdiction. The draft guidance clarifies that the PSRs cover either side of the remittance, but not the use of cryptoassets in between. 

Guidance not binding but persuasive

Carrying out a regulated activity without the relevant permissions is a criminal offence and carries a maximum penalty of two years’ imprisonment or an unlimited fine, or both.

If a firm acts in accordance with the guidance (once final), the FCA will consider it to have complied with the relevant requirements. The guidance will not bind the courts, but may be persuasive in any determination.

What’s happening next?

The FCA has invited stakeholders to give feedback on specific questions in the draft guidance by 5 April 2019. Comments may be sent online or by post. It plans to publish its final policy statement this summer. Feel free to contact us should you have any questions regarding feedback.

Separately, we are also awaiting the results of the Treasury’s consultations on expanding the regulatory perimeter and new anti-money laundering/ counter-terrorism regulation in respect of cryptoassets, as well as the FCA’s consultation on a potential prohibition on the sale to retail consumers of derivative products and transferable securities linked to certain cryptoassets.

As ever, we will keep you posted.