Regulation of Cryptocurrency and Initial Coin Offerings (ICOs) in United Kingdom (UK)
The UK is a jurisdiction which has generally adopted a “wait-and-see” approach to the regulation of cryptocurrencies.
The UK Financial Conduct Authority’s (FCA) Consultation Paper: Guidance on Cryptoassets was released in January 2019 and final guidance on cryptoassets was published in its policy statement later that year (in July 2019) on the extent of FCA regulation of activities relating to virtual assets and providing much needed guidance to market participants. According to the UK Cryptoassets Taskforce report of October 2018 however, the number of UK firms carrying out virtual asset activities was (at the time) small relative to other jurisdictions.
Categorisation of Virtual Assets
A key aspect of the FCA guidance is its categorisation of virtual assets. The FCA identified three principal types of virtual assets, while stressing that these categorisations are neither mutually exclusive nor exhaustive.
E-money tokens – cryptocurrencies meeting the Electronic Money Regulations’ (EMRs) definition of e-money, that is:
- an electronically stored monetary value that represents a claim on the issuer;
- issued on receipt of funds for the purpose of making payment transactions;
- accepted by a person other than the issuer; and
- not excluded by regulation 3 of the EMRs.
These tokens are subject to the Electronic Money Regulations and firms must ensure they have the correct permissions and follow the relevant rules and regulations.
Security tokens – tokens that provide rights and obligations similar to instruments (regulated under the UK’s securities laws) (such as shares, debentures and collective investment schemes).
Unregulated tokens – encompassing any token that does not meet the definition of e-money tokens or security tokens. This includes utility tokens, and exchange tokens, which fall outside the scope of UK regulation. However, where an FCA authorised firm carried on activities in an unregulated cryptoasset, it is possible that some FCA rules (such as the Principles for Business and the individual conduct rules under the Senior Managers and Certification Regime (SMCR)) may apply to those unregulated activities in certain circumstances.
Cryptocurrencies are most likely to be regulated as shares, debt instruments, warrants, certificates representing securities, and units in collective investment schemes.
The FCA notes that virtual assets vary widely in terms of the rights they grant to holders and use, recognising that they can be used as a means of exchange. However, the UK does not regard virtual assets as a currency or money, as has been previously stated by the Bank of England and the G20 Finance Ministers and Central Bank Governors. In his 2018 speech “The future of money”, Bank of England Governor, Mark Carney noted that cryptoassets are “too volatile to be a good store of value, they are not widely accepted as a means of exchange, and they are not used as a unit of account”. In Hong Kong, virtual assets are also not considered to be currency, but are virtual commodities.
Regulated tokens, in particular security tokens, are tokens which provide rights and obligations similar to specified investments under the Regulated Activities Order (excluding e-money), such as shares, debentures or units in a collective investment scheme.
Whether or not a virtual asset is a Specified Investment depends on its particular characteristics, although the FCA has recognised that most cryptoassets are not specified investments.
Factors indicative of a virtual asset being a Specified Investment (and thus regulated by the FCA), include, but are not limited to:
- the contractual rights and obligations the holder has by virtue of holding or owning the virtual asset;
- any contractual right to profit-share (e.g. dividends), revenues, or other payment or benefit of any kind;
- any contractual right to ownership in, or control of, the issuer or other relevant person (e.g. by way of voting rights);
- the language used in relevant documentation (e.g. the term ‘whitepaper’) that suggests the virtual assets are intended to function as an investment;
- whether the virtual assets are transferable and tradeable on virtual asset exchanges or any other type of exchange or market;
- a direct flow of payment from the issuer or other relevant party to holders of virtual assets may be an indicator that the virtual asset is a security, although an indirect flow of payment (such as profits or payments derived exclusively from the secondary market) would not necessarily indicate the contrary. If the flow of payment were a contractual entitlement, the FCA would consider this to be a strong indication that the token is a security).
The substance of a virtual asset, and not the label ascribed to it, will determine whether a virtual asset is a Specified Investment. Thus a virtual asset which is described as a ‘utility token’ will still be a Specified Investment if it confers rights typical of a Specified Investment. The FCA guidance describes ‘utility tokens’ as tokens that provide consumers with access to a current or prospective product or service and often grant rights similar to pre-payment vouchers. The FCA generally considers utility tokens to be unregulated, except where they meet the definition of e-money tokens or security tokens. The FCA notes in its guidance that utility tokens can usually be traded on the secondary markets and be used for speculative purposes, but that does not in itself mean that they are specified investments if they do not otherwise have the characteristics of specified investments. Virtual assets are most likely to fall within the following categories of Specified Investments: shares, debt instruments, warrants, certificates representing securities, units in collective investment schemes and rights and interests in investments. So let’s take a look at the most relevant categories of specified investments for tokens.
Virtual assets conferring rights similar to shareholders’ rights, such as voting rights, access to a dividend or rights to capital distribution on liquidation, are likely to be security tokens. Virtual assets representing ownership (through dividends and capital distribution) or control (through voting) are also likely to be security tokens. However, voting rights on direction which do not amount to control will not make a virtual asset a security tokens. The FCA gives the example of a virtual asset which gives the holder the right to vote on future ICOs the firm will invest in, and no other rights, as being unlikely to be considered a share, since the voting rights do not confer control-like decisions on the future of the firm.
2019 FCA guidance on cryptoassets sets out the position as to when tokens may be considered “transferable securities” under the EU’s MiFID (the Markets in Financial Instruments Directive). The UK has onshored provisions of the MiFID, including the regulation of “investment services and activities” in relation to “financial instruments”. The categories of financial instruments under MiFID, including transferable securities, have been onshored to the UK’s Regulated Activities Order. For a token to be considered a transferable security, it must be negotiable on the capital markets (that is it must be capable of being traded on the capital market). As such, tokens that confer rights like ownership and control and are capable of being tradeable on the capital markets are likely to be considered transferable securities. Importantly, a token which acts like a share but is not a transferable security, may still be capable of being a specified investment. An example may be where a token has the characteristics of a share but has a restriction on its transferability.
A virtual asset which creates or acknowledges a debt owed by the issuer to the virtual asset holder is likely to be considered a debenture and will thus constitute a security token. If it is negotiable on the capital markets, it may also be a transferable security (other than in the case of government and public securities).
As set out in PERG 2.6.13 of the Perimeter Guidance Manual in the FCA’s Handbook, warrants are one of several categories of specified investment that are expressed in terms of the rights they confer in relation to other categories of specified investments. In particular, the rights conferred must be rights to ‘subscribe’ for the relevant investments – i.e. they must be rights to acquire the investments directly from the issuer and by way of issue of new investments (not by purchase of investments that have already been issued). If virtual assets are issued that give holders the right to subscribe for specified investments (e.g. shares or debentures), the virtual assets will likely constitute warrants and will therefore be security tokens.
Certificates representing certain securities
A certificate or other instrument that confers contractual or property rights over other investments (e.g. shares or debentures) will be a specified investment if the other investment is owned by someone who is not the person on whom the certificate confers rights; and that other person’s consent is not required for the transfer of the investments. Depositary receipts are specified investments within this category.
A virtual asset which confers rights in relation to tokenised shares or debentures, including depositary receipts, is likely to be a security token.
Units in a collective investment scheme
A collective investment scheme is an arrangement, the purpose or effect of which is to enable persons taking part in the arrangement to participate in, or receive profits or income arising from the investment, or sums paid out of such profits or income. The participants do not have day-to-day control over the management of the investment and the participants’ contributions, and the profits from which payments are made, are pooled and/or the investment is managed as a whole by or on behalf of the scheme’s operator (subject to certain arrangements which are excluded).
This category includes units in a unit trust scheme or authorised contractual scheme, shares in open-ended investment companies and rights in respect of most limited partnerships and all limited partnership schemes.
A virtual asset that acts as a vehicle through which profits or income are shared or pooled, or where the investment is managed as a whole by a market participant (e.g. the issuer of the virtual assets) is likely to be a collective investment scheme.
Rights and interests in investments
Rights to or interests in certain investments, including shares to units in a collective investment scheme, also constitute specified investments under the RAO.
Virtual assets that represent rights to or interests in other specified investments are therefore also likely to be securities. Hence a virtual asset that represents a right in a share will be a security token even though the virtual asset itself does not have the characteristics of a share.
- Financial Services and Markets Act 2000. Section 235.
Products referencing virtual assets
Products that reference virtual assets, like derivative instruments, are also likely to be specified investments as options, futures or contracts for difference under the RAO. According to FCA guidance on cryptocurrency, they may also be financial instruments under MiFID II. The MiFID categories of “financial instruments” have been onshored to the RAO.
Many of the categories of specified investments broadly overlap with the different categories of securities under the SFO (shares, debentures, structured products, regulated investment products and Collective Investment Schemes). So, in many senses, the UK’s approach to regulated tokens (in this case security tokens) is quite similar to Hong Kong’s regulatory approach. In Hong Kong, the SFC has however gone further so as to classify security tokens as “complex products”, which are investment products whose terms, features and risks are not reasonably likely to be understood by retail investors because of its complex structure, meaning that if an intermediary intends to distribute a complex product, additional investor protection measures must be adopted.
Comparably, in October 2020, the FCA voiced a similar sentiment with a ban on the sale of crypto derivatives to retail consumers. This decision followed a consultation in July 2019 on rules to address harm to retail consumers from the sale of derivatives and exchange traded notes referencing certain types of cryptoassets. The FCA stated that they considered these products to be “ill-suited” to retail consumers due to the underlying assets having no reliable basis for valuation, the prevalence of market abuse and financial crime in the secondary market for cryptoassets, the extreme volatility and inadequate understanding by retail consumers. PS20/10 (an FCA Policy Statement) was then issued in October and the ban came into effect on 6 January 2021, with the FCA estimating that it would save retail investors around £53 million a year in losses and fees.
Notably, 97% of respondents to the consultation opposed the ban, arguing that the underlying assets do have intrinsic value and retail investors have the ability to asses them. Others, particularly retail investment advocates, did not agree and welcomed the ban citing that crypto trading advertisements targeting unsophisticated investors had “gone too far”.
As for Hong Kong, there has been no ban on crypto derivatives but the SFC has recognised and cautioned against the risks relating to crypto derivatives (in its December 2017 circular). Licensed exchanges are however prohibited from offering or trading crypto futures and crypto derivatives despite already being restricted to providing trading services only to professional investors. Similar restrictions are likely to apply to exchanges licensed under the proposed new regime for exchanges trading cryptocurrencies that are not securities.
The FCA’s July 2019 guidance on the UK regulation of cryptocurrencies is set out in its Policy Statement 19/22. That guidance looks at regulation in relation to three types of cryptocurrencies (e-money tokens, security tokens and unregulated tokens).
The FCA generally considers “exchange tokens” to be ‘unregulated tokens’. Examples of “exchange tokens” are Bitcoin, Litecoin and equivalents. In Hong Kong, the term “exchange tokens” is not used. Bitcoin and other similar cryptocurrencies are commonly referred to as “payment tokens” (by the IRD).
Exchange tokens are used in a similar way to traditional fiat currency and can be used as a means of exchange, but are not currently viewed as legal tender in the UK and they are not considered to be a ‘currency’ or ‘money’. Hong Kong also does not consider the likes of Bitcoin and other similar cryptocurrencies to be legal tender, instead they are classified as “virtual commodities”.
Exchange tokens are said to be more volatile than currencies and commodities (bearing in mind the UK does not consider cryptocurrencies to be commodities). The Guidance explains that because of this volatility, exchange tokens are not widely used as a means of exchange in the UK outside of the crypto and digital communities and are typically used as a unit of account or a store of value.
Generally, exchange tokens do not grant the holder any rights associated with Specified Investments. This is because exchange tokens tend to be decentralised with no central issuer obliged to honour those contractual rights, if any such contractual rights were to exist.
The fact that an exchange token can be acquired and held for speculative purposes rather than exchange, with holders expecting the tokens to increase in value, is not sufficient to bring the exchange token within the definition of a Specified Investment. The FCA gives the analogy of a person holding a different fiat currency or a commodity in anticipation of an increase in value. It notes that this approach aligns with its approach to other products which are not FCA-regulated, such as art or fine wine which may also be considered to have speculative value.
Exchange tokens fall under the category of unregulated tokens, therefore the FCA does not currently regulate activities in exchange tokens. So, the operation of a virtual asset exchange which only trades exchange tokens and the transfer or trading of exchange tokens on exchanges are currently outside the scope of FCA regulation. This is also the case in Hong Kong, where exchanges are required to be licensed and regulated where they trade at least one security token (which Bitcoin is not). However, there is an FSTB proposal which would bring all virtual asset exchanges within the SFC’s regulatory reach.
AML/CFT Regulation of Crypto Activity in the UK
While the operation of a virtual asset exchange falls outside the FCA’s regulatory ambit, amendments to the UK’s Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (the “MLRs”) extended AML and CTF regulation to “cryptoasset exchange providers” (CEPs) and “custodian wallet providers” (CWPs) from 10 January 2020. The revised MLRs apply to cryptoasset exchange providers and custodian wallet providers which carry on business in the UK. Both types of entity are now included in the definition of ‘relevant persons’ and are now under the same AML and CTF obligations to carry out customer due-diligence and report suspicious transactions as the other entities categorised as obliged entities, such as financial institutions and money service businesses.
Cryptoasset exchange providers and custodian wallet providers are required to register for AML supervision with the FCA, as the responsible authority for supervision and enforcement of the AML/CTF aspects of cryptoasset businesses. In Hong Kong, similar developments are underway with the FSTB proposal, which will extend the application of the provisions of Schedule 2 to the Anti-Money Laundering and Counter-Terrorist Financing Ordinance (AMLO) to a wider scope of crypto businesses, with the SFC being the responsible authority for licensing and supervision. The Hong Kong consultation closed on 31 January 2021, however it may be some time before the regime is put in place.
Key definitions under the UK’s Money Laundering Regulations
“Cryptpoasset exchange provider” – means a firm or sole practitioner who by way of business provides one or more of the following services, including where the firm or sole practitioner does so as creator or issuer of any of the cryptoassets involved, when providing such services
exchanging, or arranging or making arrangements with a view to the exchange of, cryptoassets for money or money for cryptoassets;
exchanging, or arranging or making arrangements with a view to the exchange of, one cryptoasset for another; or
operating a machine which utilises automated processes to exchange cryptoassets for money or money for cryptoassets.
Cryptoasset exchange providers thus include crypto exchanges which exchange cryptoassets for money or other cryptoassets, the operators of crypto ATMs and the issuers of cryptoassets in initial coin offerings or initial exchange offerings. The definition would also capture the operators of peer-to-peer exchanges which facilitate the exchange of cryptoassets for money or other cryptoassets between buyers and sellers
“Custodian wallet providers” – an entity that provides services to safeguard or safeguard and administer cryptoassets on behalf of its customers or private cryptographic keys on behalf of its customers in order to hold, store and transfer crypto assets.
Under the MLRs, a cryptoasset is defined as a cryptographically secured digital representation of value or contractual rights that uses a form of distributed ledger technology and can be transferred, stored or traded electronically. The definition includes a right to, or interest in, the cryptoasset. The definition of cryptoasset brings into scope (i) exchange tokens; (ii) security tokens; and (iii) utility tokens.
This definition goes further than the definition of virtual assets used in the FATF Recommendations. The result is that in the UK, the scope of cryptoassets that are subject to the new AML/CFT regime is broader than if the FATF definition of virtual assets had been adopted.
In short, these new regulatory measures mean that all businesses carrying on cryptoasset activity in the UK are required to register with the FCA and comply with the MLRs. Thus, previously unregulated cryptoasset businesses are now subject to the same AML/CFT obligations as financial institutions in the UK.
The AML/CTF regime for businesses engaging in activities related to virtual assets is broader than is currently proposed for Hong Kong. Even with the implementation of the proposed new licensing regime under Hong Kong’s Anti-Money Laundering and Counter-Terrorist Financing Ordinance, Hong Kong will only impose AML and CTF obligations on crypto exchanges. Unlike the UK, Hong Kong is not planning at this stage to bring crypto ATMs or providers of crypto custody services as a standalone business within the ambit of its regulation.
Utility tokens also fall within the category of unregulated tokens. The FCA describes utility tokens as virtual assets that provide consumers with access to a current or prospective service and often grant rights similar to pre-payment vouchers. In some instances, utility tokens may have similarities with or be the same as, rewards-based crowdfunding. In these cases, the participants will contribute funds to a project, in exchange usually for a reward, for example access to products or services at a discount. Reward-based crowdfunding models are not regulated by Hong Kong’s securities legislation and a number of reward-based models have been set up in Hong Kong, including FringeBacker, SparkRaise and Dreamna.
Like exchange tokens, utility tokens can normally be traded on the secondary markets and be used for speculative investment purposes. However, the FCA notes in its guidance that this does not of itself mean that they are Specified Investments if they do not have features that would render them Specified Investments. The FCA guidance does however note that exchange tokens may in certain circumstances meet the definition of e-money, in which case their issue will be regulated under the Electronic Money Regulations.
Hong Kong’s regulatory approach to utility tokens is broadly similar, and the SFC has suggested that utility tokens are not securities within the definition in the SFO (in its statement of February 2018). Given the absence of case law, particularly on the definition of interests in a collective investment scheme, it is however difficult to predict how a Hong Kong court would view an offer of utility tokens.
Use of Virtual Assets to Facilitate Regulated Payment Systems
The provision of payment services in the UK are regulated under the Payment Services Regulations (the PSRs), which cover certain activities when carried out as a regular occupation or business activity (including for example, execution of payment transactions, card issuing, merchant acquiring and money remittance). Activities which do not constitute payment services include cash payments made directly between payers and payees.
The Payment Services Regulations apply to “funds” which are defined as “banknotes and coins, scriptural money and electronic money”. They therefore do not generally apply to virtual assets. However virtual assets can constitute e-money in certain circumstances and the provision of payment services in virtual assets which qualify as e-money would then be regulated under the PSRs. The use of cryptocurrency as an intermediary currency in money remittance may also involve providing a payment service regulated under the Payment Service Regulations. For example, where fiat currency is converted first into virtual assets and then back into another fiat currency before transmission to the recipient, the service will be regarded as a regulated payment service, although the cryptocurrency is not itself regarded as a regulated financial product.
Exchange tokens can also be used to facilitate regulated payment services such as international money remittance (to enable remittances to occur quicker and cheaper), however this would fall outside the scope of the PSRs.
E-money issuance is regulated under the Electronic Money Regulations 2011 (EMRs) and is a regulated activity under article 9B of the Regulated Activities Order when carried on by credit institutions, credit unions and municipal banks. As such, firms that issue e-money must ensure that they are appropriately authorised or registered. Similarly, in Hong Kong, institutions engaging in e-money related payment services must be licensed by the HKMA.
The UK defines e-money as 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 payment transactions;
accepted by a person other than the electronic money issuer; and
not excluded by regulation 3 of the Electronic Money Regulations.
In order to be considered as e-money, a virtual asset must enable the user to make payment transactions with third parties, meaning the e-money must be accepted by more parties than only the issuer.
Fiat balances in online wallets or prepaid cards constitute e-money. However, exchange tokens such as Bitcoin, Ether and similar virtual assets are unlikely to constitute e-money because, among other things, they are not normally centrally issued on the receipt of funds, nor do they represent a claim against the issuer.
Distributed ledger technology (DLT) and cryptographically secured tokens can be used to represent fiat funds. The FCA guidance notes that virtual assets that establish a new type of unit of account (rather than representing fiat funds) are unlikely to constitute e-money unless the value of the unit is pegged to a fiat currency, but even then, it will still depend on the facts of the case. Firms have used DLT-based e-money to provide more efficient and automated services (including for international payments) within the FCA’s sandbox.
Hong Kong’s Monetary Authority (the HKMA) has said that it does not regard Bitcoin as e-money.
Stablecoins are virtual assets where attempts have been made to stabilise their value using various mechanisms. Many stablecoins are pegged to a fiat currency (typically the US dollar and usually with a 1:1 backing), with the aim of reducing volatility. Stablecoins can also be stabilised in other ways, for example by being backed by particular assets which could include Specified Investments or commodities such as gold or a basket of cryptoassets. Other stablecoins are stabilised using algorithms that increase or decrease the supply of the stablecoin to maintain a stable price.
In the UK, stablecoins can fall into any of the three categories of tokens (e-money tokens, security tokens or unregulated tokens), although the HM Treasury most recently stated in its January 2021 consultation paper that they are currently more likely to be unregulated exchange tokens or e-money tokens. However, in this consultation paper, the UK outlines its proposal to introduce a new category of regulated tokens to capture stablecoins – to be known as “stable tokens”, with the proposed regulatory regime covering stable tokens used as a means of payment. This would cover entities issuing stable tokens, and firms providing services relating to them, to consumers (either directly or indirectly). The UK Government outlined that they are seeking to regulate stablecoins due to their potential application to retail and wholesale transactions and the risks they present for consumers.
It is proposed that the scope of the definition will extend to stablecoins that are linked to a single fiat currency and stablecoins whose value is linked to an asset other than a single fiat currency (for example, gold or multi-currency). Algorithmic stablecoins will be excluded from the scope of the proposals for the time being, as will security tokens, which are already regulated. As for e-money tokens, they are regulated under the e-money regulations and it is proposed that those requirements will continue to apply. However, where e-money tokens are also stable tokens, they may be subject to enhanced requirements under the new regime if they have “significant potential” to become systemic.
In Hong Kong, as is the position in the UK currently, there is no distinct regulatory regime or framework for stablecoins. Their classification and regulation of related activities ultimately depends on a number of considerations (i.e., do they have a central issuer, the underlying asset or assets and so on).
- HKMA. “The HKMA reminds the public to be aware of the risks associated with Bitcoin”. (Feb 2015). https://www.hkma.gov.hk/eng/news-and-media/press-releases/2015/02/20150211-3/