Alert 01.17.23
How Are Digital Assets Regulated in the United States and Elsewhere?
Continuing instability in the crypto sector highlights the need for clear regulation for efficient development, but how best to regulate is an ongoing debate.
Alert
Alert
08.29.23
Effective August 29, 2023, the Financial Services and Markets Act 2023 (Commencement No. 1) Regulations (SI 2023/779) (FSMA 2023) explicitly brings digital assets within the regulatory perimeter, creates a new designated activities regime (DAR), introduces regulations for stablecoins used as a means of payment (Payment Stablecoins), and creates a framework to establish financial market infrastructure sandboxes.
Regulated Activities
Amendments under FSMA 2023 clarify that cryptoassets are subject to the regulated activities and financial promotion orders. This supports the Financial Conduct Authority’s (FCA) guidance released in July 2019, which divided cryptoassets into those which are (i) regulated; security and e-money tokens, and (ii) unregulated; utility and exchange tokens.
Section 69 of FSMA 2023 amends the definition of “investment” to include, “where an asset, right or interest is, or comprises or represents, a cryptoasset,” in sections 21 (Restrictions on Financial Promotions) and 22 (Regulated Activities) of the Financial Services and Markets Act 2000 (FSMA 2000).
“Cryptoasset” is defined under section 69(4) of FSMA 2023 as follows:
“Cryptoasset” means any cryptographically secured digital representation of value or contractual rights that (a) can be transferred, stored or traded electronically, and (b) uses technology supporting the recording or storage of data (which may include distributed ledger technology).
This definition has a broad application due to the description of the underlying technology and is similar to that used in the EU’s Markets in Crypto Assets Regulation (MiCA) in line with the Financial Action Task Force’s (FATF) recommended definition of “virtual asset.” In recognition of the pace at which technologies are evolving, the definition has also been accompanied by a power to update the definition through secondary legislation.
Firms marketing regulated activities to UK consumers are required to have a UK establishment and be authorized in the UK. Unauthorized firms intending to undertake cryptoasset activities constituting a regulated activity must first apply for permission from the FCA, and authorized firms will need to apply to vary their permission accordingly.
Designated Activities Regime
A new designated activities regime has also been introduced under section 8 of FSMA 2023. Activities falling within DAR will be subject to requirements set out in the FCA Rulebook or by HM Treasury in secondary legislation. However, such activities will not require prior authorization as for Regulated Activities.
As shown by the examples of activities listed in Schedule 3 to FSMA 2023, DAR has initially been used to capture activities regulated under retained EU laws. However, while the Financial Services and Markets Bill was being debated in the Houses of Parliament, various crypto-related activities were considered for inclusion under DAR. HM Treasury also issued guidance in February 2023 on proposed activity categories to be regulated, including:[1]
Firms engaged in cryptoasset activities should monitor the activities designated by HM Treasury to understand whether their activities will fall under DAR and what regulations will apply. Entities combining designated and/or regulated activities are to comply with all relevant rules.
Cryptoasset businesses registered with the FCA pursuant to the Money Laundering Regulations 2019 will need to re-register under the new regime. To mitigate duplicating efforts, the FCA has advised they will take all readily available information and the regulatory history of entities into consideration. In the future, cryptoasset businesses will only be required to apply for authorization under FSMA 2000.
Payment Stablecoins
New provisions under FSMA 2023 also specifically address Payment Stablecoins through the introduction of digital settlement assets (DSA). (See Section 86 FSMA 2023.) Section 23(2) of FSMA 2023 defines a DSA as a digital representation of value or rights, whether or not cryptographically secured, which:
The explanatory notes to FSMA 2023 clarify that the definition is intended to encompass a range of digital assets. HM Treasury also has the power to amend the definition to reflect changes to attributes, underlying technology, and/or the usage of DSAs.
The new regulations encompass stablecoins which reference fiat currencies and/or instruments with the same effect. Tokens not in scope include security tokens and e-money tokens which already fall under existing regulations, utility tokens, and algorithmic stablecoins. Cryptoassets which reference assets such as commodities are also unlikely to be classed as a Payment Stablecoin and are more likely to be subject to collective investment scheme rules.
FSMA 2023 empowers HM Treasury to regulate: (i) payments which include DSAs, (ii) payment systems using DSAs, (iii) recognised DSA service providers (in accordance with Part 5 of the Banking Act 2009 as amended—see below for further details), (iv) service providers connected with or related to the aforementioned systems and providers, and (v) restructuring, administration and insolvency arrangements in respect of the above systems and providers. Pursuant to section 23(3) of FSMA 2023, such regulations may include:
HM Treasury may also designate DSA operators and service providers as systemically important and subject them to the regulation of and supervision by the Bank of England (BoE). FSMA 2023 extends the application of Part 5 of the Banking Act 2009 and Part 5 of the Financial Services (Banking Reform) Act 2013 (FSBRA 2013) to include systemic stablecoin-based payment systems (in Schedule 6, FSMA 2023). Thus, stablecoin activities may be (i) subject to dual regulation by the BoE and FCA, and (ii) enhanced requirements set out in the Principles for Financial Market Infrastructures.
To mitigate systemic risks to financial stability, FSMA 2023 also amends the Financial Market Infrastructure Special Administration Regime (FMI SAR) to cover the failure of systemic stablecoin firms. The primary focus of FMI SAR is the continuity of services and proposals that have been made to create a second objective for the return of client funds and assets. It is intended that the BoE, in consultation with the FCA, will have powers to direct administrators as to which objective should take precedence in administration proceedings.
Digital Securities Sandbox
HM Treasury also has the power to establish financial markets infrastructure (FMI) sandboxes under FSMA 2023. The first to be established under this new power will be the digital securities sandbox (DSS). The DSS aims to:
The consultation on the DSS closed on August 22, 2023, and is intended to be finalized later this year. Under HM Treasury’s proposals, firms established in the UK may apply to participate in the DSS to test the use of digital asset technology in (i) functions currently performed by central security depositories such as settlement, notary and maintenance activities, and (ii) operating trading venues, in relation to security tokens (subject to applicable limits based upon the applicant’s ability to meet requirements and manage risks). FSMA 2023 enables HM Treasury to apply a modified legislative framework to enable the testing and make such modifications permanent if considered appropriate through secondary legislation.
Conclusion
The new regime directly impacts (i) issuers, (ii) system operators responsible for the managing of on- and off-chain activities including updates, infrastructure, burning and minting tokens, and (iii) service providers such as exchanges and those providing wallet services, custodial services and management of private keys.
In contrast to MiCA, the UK is taking a phased approach to the regulation of cryptoassets. Regulations for Payment Stablecoins have been prioritized in the first phase of regulatory updates, with proposals to bring additional cryptoassets into a regulatory regime being considered for the second phase of regulatory updates. Meanwhile, existing regulations continue to apply to other digital assets inclusive of the financial promotion regime, AML and CTF regulations, which are not discussed in this client alert.
Other key differences in the UK’s approach as compared to MiCA include that there is no proposal to impose a reserve requirement on asset-referenced tokens; NFTs, which typically are out of scope of MiCA, are intended to be in scope of additional regulatory updates; authorized firms such as banks will not receive automatic authority to conduct cryptoasset activities; and UK regulations will require authorization for lending activities including collateralized and uncollateralized crypto lending and the borrowing of fiat backed by cryptoassets.
[1] Future Financial Services Regulatory Regime for Cryptoassets: Consultation and call for evidence, HM Treasury (February 2023), chapter 4.