The UK Treasury Select Committee recently published a much anticipated report on “crypto-assets”. The bottom line? Regulation is recommended and may be part of the Chancellor’s Autumn statement.
That’s it really. The long and the short. You can stop reading now. Recommending regulation was not unexpected and the report simply amplifies that established position. What was perhaps more interesting was the breadth of analysis the Committee undertook. The report goes into considerable detail analysing the strengths and weaknesses of cryptocurrencies. The overall tone and treatment by the Committee was supportive of crypto-assets and the associated technologies, provided they were solving “real-world” problems. Their concerns centred on what regulation could achieve to improve investor confidence and experience.
The report starts by clarifying the Committee’s definition as to why they describe cryptocurrencies as “crypto-assets”. The Committee explains that there are no cryptocurrencies that function as currency, i.e., they do not act as a medium of exchange, due to their volatility are not a particularly good store of value and are not used as a unit of account. A subtle distinction, but critical to the understanding and treatment of such investments for the purposes of, e.g., taxation. The distinction provided by the Committee follows a similar assessment under the SEC rules in America.
The Committee’s Considerations
1. Volatility and stability:
Although argument was heard that price volatility has decreased over time, it was noted that volatility rates were much higher than FIAT currencies. The causes for this were attributed to market sentiment and speculative use cases, as crypto-assets are not tied to consumption, future demand, assets or commodities in the same way as FIAT currencies. A situation further exacerbated by long blockchain settlement times during which exchanges can fluctuate significantly. Furthermore, crypto-asset markets, due to their relatively low trading volumes and small market capitalisation, are vulnerable to manipulation, but such markets currently fall outside market abuse rules. In and of themselves such crypto-assets are not stable, but when viewed from the perspective of the whole payments market there is negligible impact on financial stability.
The report focused on storage, insurance and hacking. There is no collective deposit scheme to compensate investors and individual exchanges do not maintain such arrangements. Loss, due to hacking, loss of access to accounts and the impossibility of recovery, due to the cryptographic elements of the technology, are also causes for concern. As such the investment risks are higher and not suitable for retail investors.
3. Initial Coin Offerings (ICOs):
The FCA warns that ICOs present significant risks to investors. The FCA’s remit does not include crypto-asset regulation, as such there is little it can do to protect individuals from fraud or loss. The position arises as ICOs generally do not promise financial returns but offer access to services. However, investors clearly expected some form of financial return as they likely wanted to sell the tokens for a profit in the future. The development of ICOs has exposed a regulatory loophole that is being used, by some, to the detriment of ordinary investors. On this point the Committee recommended that ICOs be brought within the scope of the Regulated Activities Order (RAO) as a matter of urgency.
The relative anonymity and absence of regulation can facilitate the sale and purchase of illicit goods and services, as well as launder the proceeds of crime. However, the National Crime Agency reported that the scale of use of crypto-assets for money laundering is low. There are initiatives underway in the EU that will mean crypto-assets fall within the Fifth Anti-Money Laundering Directive (AML) and, therefore, require Know Your Client (KY) processes to be undertaken.
At present crypto-assets are generally not within the scope of FCA regulation as they do not meet the relevant criteria under the Regulated Activities Order nor qualify as funds or e-money under the Payment Services Directive 2 or E-Money Regulation 2009. However, whether FCA Regulation would apply to an ICO depends on how it is structured and what the token represents, e.g., if a token were to represent a transferable security then it would be within the FCAs regulatory ambit.
The report states that “[T]he current ambiguity surrounding the Government’s and the regulators’ positions is clearly not sustainable.” Inaction must turn to action. The direction of evolution of digital currencies will come under increasing regulation: (1) in the immediate term KYC and AML and (2) in the medium term, most likely, within the RAO.
Some may be concerned that regulation would have an adverse impact on entrepreneurialism and innovation. But consider if ICOs were regulated, as IPOs are. They become mainstream, risk managed, acceptable investments. The playing field is levelled, those with genuine and robust business plans will have access to the widest possible range of investors who are able to invest with confidence, earlier investment stages from seed, angels and venture caps will accelerate development, ancillary services will develop to support such enterprises. Solutions will be stronger, commercially robust and more likely to be widely adopted.
Farewell the wild ICO west, hello brave new world?