Digital assets – Q3 2023

Statistics like this are emblematic of the ongoing struggle to mitigate risks inherent to the digital asset space. As industry specialists theorise on possible explanations for an ongoing retail ‘crypto winter’, UK regulators have continued to move forward with initiatives that aim to protect stakeholders, limit the use of cryptoassets in financial crime, and incentivise the adoption of decentralised finance (DeFi) solutions within the business.

In this edition of our quarterly regulatory insights into crypto, we focus on updates from contributors across the UK’s digital asset industry. Domestic regulators continue to adapt existing regulatory frameworks and hone crypto-specific provisions, while further legitimising the use of digital assets by addressing concerns relating to financial crime. Meanwhile, industry bodies have highlighted that stakeholders still harbour concerns around regulatory implementation and limited incentivisation for adopting decentralised finance (DeFi) solutions. Looking ahead, Q4 will be characterised by the implementation deadline for cryptoasset promotion regulations, and several pending updates from regulatory consultations discussed in this and previous crypto insight editions.

The Financial Conduct Authority (FCA)

The FCA’s self-described “tough” new rules on Cryptoasset Promotions come into effect on October 8^th, 2023. This initiative is intended to protect consumers by aligning restrictions on cryptoasset promotions with those placed upon other emerging asset classes, counteracting the risks associated with the mass-marketing of speculative, technical, and highly volatile DeFi products to the public.

Within an assertive September press release, the regulator outlined its expectations for firms to comply with the regulation’s core rules by October but acknowledged a lack of industry readiness when discussing implementation. To address this, the FCA is allowing firms to apply for back-office flexibility when adopting specific features of the regulations that will require greater operational change. If approved, these firms would only be expected to implement the more technical aspects of the rules surrounding promotions by January 8^th, 2024.

One example provided is a 24-hour cooling-off window during which new customers must not be sent promotional material by cryptoasset service providers (CASPs). In addition, firms granted the extension can delay the implementation of rules on client appropriateness testing and client categorisation. The FCA has committed to publishing final guidance for firms shortly.

As a reminder, some of the core rules detailed in Policy Statement 23/6 ‘Financial promotion rules for cryptoassets’ include:

• The involvement of an authorised person in either the communication or approval of any cryptoasset promotion (firms registered with the FCA under the AML/CTF regulations 2017 are exempt).
• A ban on firms offering monetary or non-monetary benefits to incentivise greater investment (i.e., refer-a-friend schemes).
• Qualifying cryptoassets will now be categorised as Restricted Mass Market Investments (RMMIs).

Further analysis of PS23/6 can be found in the Q1 2023 edition of our newsletter.

Although not directly addressed towards digital assets, the FCA’s Discussion Paper 22/5 ‘The potential competition impacts of Big Tech entry and expansion in retail financial services’, which was published in October 2022, contained findings relevant to CASPs and had implications for digital asset stakeholders more broadly. In July, the regulator published Feedback Statement 23/4, providing a timely reminder that the impact of technological innovations on competition is a regulatory priority.

The next steps described by the FCA include a suggestion that work being undertaken by the Bank of England, the Payment System’s Regulator and HM Treasury could result in new payment methods or systems being introduced. Thus, firms should stay tuned for further developments emanating from DP22/5; similarly, relevant themes were explored in a July speech by the FCA’s CEO, Nikhil Rathi.

The Joint Money Laundering Steering Group (JMLSG)

Following a period of consultation, on 31 August 2023, the JMLSG published new guidance for cryptoasset service providers (CASPs) and custodian wallet providers relating to cryptoasset transfers.

The thrust of this amendment is the application of a travel rule to CASPs. Typically, rules of this nature require financial institutions (FI) that partake in the transfer of funds between more than one FI to pass specified information on to the next FI in the process. With regards to crypto activity, starting 1 September 2023, platforms will be required by law to collate and share certain identifiable information on the originator (person who owns and allows the transfer of the cryptoasset) and the beneficiary (intended recipient of the cryptoasset); this is intended to prevent cryptoassets from being employed in money laundering and terrorist financing operations.

UK Finance

In August, UK Finance published an article responding to HMRC’s consultation on ‘The taxation of decentralised finance involving the lending and staking of cryptoassets’. The piece centred on a critique of the proposed tax exemption for DeFi lending firms.

The proposed exemption would require exempted amounts to be held in the same token and be of the same quantity during lending and repayment. However, the way that many forms of DeFi lending currently function means that token and quantity mismatches are common. As such, the exemption is too narrow to apply to a plurality of firms providing DeFi lending.

Further, questions are raised about the proposals’ lack of consideration around the usage of automated market maker algorithms and smart contract optimisation strategies. Despite criticisms, the article acknowledges that provisions of this nature are a welcome step towards greater integration of digital assets in the UK economy and signify a wider strategy for solidifying the UK’s position as a global leader in operating an innovative but adequately regulated crypto industry.