The House of Commons Treasury Committee has published a report following an inquiry into crypto-assets launched last February, whose remit was to examine the role of digital currencies in the UK; consider the potential impact of distributed ledger technology on financial institutions and infrastructure; evaluate the regulatory response to digital currencies from the Government, the Financial Conduct Authority (FCA) and the Bank of England (BoE), and how regulation could be balanced to provide adequate protection for consumers and businesses without stifling innovation.
Crypto-assets’ advantages and limitations
Blockchain, as a technology, allows the validation, storage, and synchronisation of information across multiple parties more securely and more efficiently than before. It can increase the efficiency of managing data, by reducing reconciliation processes, costs and time as the intermediaries required for processing a transaction are removed. Resilience and security are two other advantages that blockchain can offer. On the other hand, performance standards of blockchain need to meet those of conventional technologies. The scalability and reliability of blockchain are also a significant challenge. A decentralised blockchain poses risks that no one is accountable for and in control of it. While blockchain technology represents an alternative way of transacting and living, providing a potential payment service solution for people without bank accounts, users would still have to acquire crypto-assets with conventional currency, which generally requires access to banking services. It is noted in the report that blockchain is not being widely used as a payments system, and crypto-assets are not being used as a medium of exchange, because they are currently failing to perform the three key functions of money: as a store of value, a means of payment and a unit of account. Cash and contactless card payments can be confirmed instantly whilst transactions on crypto-asset platforms are only confirmed when they have been included in a block of transactions that is written to the ledger (e.g. for Bitcoin, the most widely-used crypto-asset, it takes an average of 10 minutes to receive the first confirmation and it is not usually accepted by most merchants).
The risks of crypto-assets and the regulatory response
After considering the opportunities and limitations, the report lists risks that investors in crypto-assets face, such as:
- High price volatility compared to other asset classes;
- Hacking of crypto-asset exchanges and theft of their investment, with no deposit insurance scheme to compensate investors;
- Poor market liquidity and greater potential for price manipulation, considering that crypto-assets fall outside the scope of market abuse rules;
- Money laundering and implications for the financial stability.
Regulatory initiatives to bring crypto-asset exchanges into the anti-money laundering (AML) regulations are under scrutiny in the EU. The Fifth AML Directive will extend AML and Counter-Terrorist Financing rules to virtual currencies, so that crypto-assets entities will have to identify their customers and report any suspicious activity to relevant regulators and authorities. At the moment, these entities are not subject to the Money Laundering Regulations 2017 requirements. Considering their anonymity and the absence of regulation, crypto-assets can facilitate the sale and purchase of illicit goods and services, and can be used to launder the proceeds of serious crime and terrorism.
The report mentions the crypto-asset market capitalisation, which was $17 billion in January 2017, reached a peak in January 2018 at $830 billion and was $191 billion as of end August 2018. This is small relative to the global financial system, as noted by the BoE, which thinks the risk to financial stability arising from crypto-assets is low.
Both Initial Coin Offering (ICO) issuers and crypto-exchanges use advertisements, including on social media, that highlight the potential for quick returns on investments in crypto-assets. Because neither of them are regulated, these advertisements are not subject to the FCA’s rules, nor does the FCA have any powers to withdraw a misleading advert. This creates particular risks for inexperienced retail investors.
The Treasury Committee proposes that the UK government and financial regulators urgently introduce regulation for crypto-assets, which now look like the “Wild West”. In this way, the FCA would be empowered to improve consumer protection and anti-money laundering standards.
The Committee argues that the introduction of regulation could lead to positive outcomes for the crypto-asset market, enabling a more mature business model that improves consumer outcomes and grows sustainably. The likely entry of institutional investors into the market would increase liquidity, reducing some of the inherent risks that exist at present. Should the UK develop an appropriate and proportionate regulatory environment for crypto-assets, it could become a global centre for this activity, ensuring that the crypto-asset market adheres to high standards and that it is no longer associated with criminality.
There are two ways in which regulation of crypto-assets can be introduced in the UK, the report says: incorporating crypto-assets activity into the existing regulation or designing a new framework of regulation specifically for crypto-assets. The first option means amending the FSMA (Regulated Activities) Order (RAO) to include crypto-assets related activities as regulated ones, as was done for peer-to-peer (P2P) lending activity. Whilst designing a new framework of regulation would inevitably take much longer, the Committee considers that introducing the regulation of crypto-assets and associated activities by extending the RAO would be the quickest method of providing the FCA with the necessary legal powers to protect consumers and maintain market integrity. Furthermore, the experience of those countries that have already implemented relevant regulations would help in this process.
The Committee urges the Government to treat the transposition of the Directive as a priority, and to expedite the consultation process, which is currently not planned to finish until the end of 2019.
Whereas overall this report is very useful as it has raised issues around the crypto-assets industry and suggests possible solutions, it is still not easy to predict how the FCA will respond to this report. Will there be a generic or bespoke regime? How would certain conduct rules, such as best execution or product governance, apply? How would the principle of accountability be valid?
An FCA consultation paper is expected to be published Q4 2018 which should shed some light as to whether the crypto-assets sector will be subject to heavy regulation or a light-touch regime with open growth opportunities. Alternatively, a combination of both approaches could be required.