Last month (September 2018), the House of Commons Treasury Committee issued a report on its inquiry into the regulation of crypto-assets. The inquiry examined, amongst other subjects, the role of digital currencies in the UK; the impact of distributed ledger (blockchain) technology; and how these should be regulated. The report recommends improvements to consumer and anti-money laundering protections (AML) when dealing in crypto-assets. The improvement will be achieved in part by extending the Financial Services and Markets Act (Regulated Activities) Order 2000 (RAO) to crypto-assets and associated activities.
‘Crypto-assets’, not ‘cryptocurrencies’
As a point of protocol, the report employs the term ‘crypto-assets’ instead of the more commonly used ‘cryptocurrencies’ on the basis that they do not demonstrate the functions of a conventional currency, such as a medium of exchange or store of value.
The report also identifies a number of inherent problems with crypto-assets. It identifies the inherent risks to investments due to volatile crypto-asset markets, when compared to conventional fiat currencies. Related to this is the vulnerability of crypto-assets to market manipulation given that the exchanges currently sit outside of market abuse regulations.
There is also increased scope for hacking, which would inevitably lead to the theft of the crypto-assets. The Committee suggests that such risks were exacerbated by the lack of a deposit insurance scheme (such as the UK Financial Services Compensation Scheme) to compensate investors in the event of a hack. Investors themselves have also caused losses, particularly where they have lost their passwords and have, therefore, been barred from accessing the exchange.
The Committee believes that investors and consumers are further let down by the irresponsible nature of promoters, whose advertisements are often misleading (and in some cases initial coin offerings have used celebrities to advertise the offering). The Financial Conduct Authority (FCA) is powerless in mitigating this, as crypto-assets, conveniently (!) fall outside of its remit.
Crypto-asset platforms were widely considered to provide opportunities for money laundering and other criminal enterprises because exchanges allow anonymous access and are not governed by the AML regulation.
Each of the above concerns is underpinned by the absence of a secure regulatory environment that affords investors and consumers sufficient safeguards.
Limitations of blockchain
The Committee discussed the use and benefits of blockchain technology as a means of storing data that crypto-assets use to record and verify transactions. The Bank of England and the FCA, together with industry experts, identified the efficiencies and features that blockchain will bring to transaction processing. The Chief Operating Officer of Everledger, Chris Taylor, in particular, spoke of the advantages that blockchain’s immutable record-keeping bring to records of transfers, whether they concern the transfer of assets or of money.
That said, the Committee also heard about the limitations of crypto-assets and blockchain, including from the Bank of England which argued that neither function well as a means of payment because of capacity constraints, citing the 30 million electronic payments per day that are made via its Bacs and Faster Payments systems compared to Bitcoin’s global peak of around 0.6 million transactions per day. Capacity constraints lead to higher costs as users must pay Uber-style surge fees in order to put their transactions at the front of a payments queue. These fees peaked in December 2017 at US$ 60 per Bitcoin transaction.
From an environmental perspective, blockchain transactions also require a large amount of computer power and therefore energy, which itself will lead to higher transaction costs.
The report explains that during the inquiry the Committee heard evidence that blockchain technology is currently ill-suited to processing the transactions required for mass-market payment systems. Although it did recognise the utility of blockchain technology, especially in Financial Services and supply chain management, the Committee concluded that it had not been presented with any evidence that suggested blockchain was currently operationally reliable, and so would not promote it for blockchain’s own sake.
The beginning of crypto-asset regulation?
The Committee has clearly recognised the need to regulate crypto-assets. Extending the RAO to cover crypto-assets and associated activities was considered to be the quickest method to achieve this, which would enable the FCA to protect consumers in respect of their dealings in crypto-assets. The EU’s fifth Anti-Money Laundering Directive will bring crypto-assets under the umbrella of AML requirements when it is eventually implemented.
The rapidly developing tech industry will want to pay close attention to this space. However, with Brexit negotiations consuming the majority of the government’s time, there is no clear timeline as to when it will consider the Committee’s proposal to implement new legislation specifically regulating crypto-assets. However, the UK government’s consultation period is expected to run to the end of 2019, delaying any concrete progress. It is therefore unlikely that we can expect the much-needed measures outlined in the report to come into effect anytime soon.
The inquiry has overlapped with the European Securities and Markets Association (ESMA) review into the risks that initial coin offerings (ICOs) and crypto-assets present to investors and to financial stability, while recognising that ICOs and crypto-assets also provide innovation to the Financial Services sector. The review has culminated in a report issued at the end of last week, which recommends that ESMA writes to the EU Commission asking it to consider adding crypto-asset tokens to the Markets in Financial Instruments Directive (MIFID) II list of financial instruments and transferable securities.
If crypto-asset tokens are added to this list, secondary markets in tokens will qualify as MIFID, MTFs or OTFs; any investment offering in tokens would be subject to the EU Prospectus Regulation and MIFID II; and those advising on them would also be subject to MIFID II.