Future financial services regulatory regime for cryptoassets: consultation and government response (2023)

Future financial services regulatory regime for cryptoassets: Consultation and call for evidence (February 2023)

February 2023

Future financial services

regulatory regime for cryptoassets

Consultation and call for

evidence

regulatory regime for cryptoassets

evidence

© Crown copyright 2023 This publication is licensed under the terms of the Open Government Licence v3.0 except where otherwise stated. To view this licence, visit nationalarchives.gov.uk/doc/open-government-licence/version/3. Where we have identified any third party copyright information you will need to obtain permission from the copyright holders concerned. This publication is available at: www.gov.uk/official-documents. Any enquiries regarding this publication should be sent to us at public.enquiries@hmtreasury.gov.uk ISBN: 978-1-915596-55-0, PU 3273

Contents

Foreword 5

Chapter 1 Cryptoassets and the current regulatory landscape 7

Chapter 2 Definition of cryptoassets and legislative approach 13

Chapter 3 Overview of the current regulatory landscape for

cryptoassets 18

Chapter 4 Cryptoasset Activities 24

Chapter 5 Regulatory Outcomes for Cryptoasset Issuance and

Disclosures 34

Chapter 6 Regulatory Outcomes for Operating a Cryptoasset

Trading Venue 41

Chapter 7 Regulatory Outcomes for Cryptoasset Intermediation

Activities 45

Chapter 8 Regulatory outcomes for cryptoasset custody 49

Chapter 9 General Market Abuse Requirements 54

Chapter 10 Regulatory outcomes for operating a cryptoasset

lending platform 61

Chapter 11 Call for Evidence: Decentralised Finance (DeFi) 66

Chapter 12 Call for Evidence: Other Cryptoasset Activities 70

Chapter 13 Call for evidence: Sustainability 73

Chapter 14 Responding to this Consultation 75

Annex A : Glossary of Terms 78

Annex B : Market abuse offences under UK MAR 80

Foreword

The government’s firm ambition is for the UK to be home to the most open, well-regulated, and technologically advanced capital markets in the world. Delivering on this ambition means taking proactive steps to harness the opportunities of new financial technologies. We believe that crypto technologies can have a profound impact across financial services. By capitalising on the potential benefits offered by crypto we can strengthen our position as a world-leader in fintech, unlock growth and boost innovation. Cryptoasset markets continue to develop with increasing pace and complexity. But this is a nascent sector and as with any emerging technology, this brings risk as well as opportunity. Risk taking is a desirable part of the cycle of innovation and we wish to manage, not stifle, this. Ongoing turbulence in cryptoasset markets has highlighted that risk, with the high-profile collapse of firms like FTX having widespread implications for global cryptoasset markets and investors. Our view is that this reinforces the case for clear, effective, timely regulation and proactive engagement with industry. Effective regulation will create the conditions for cryptoasset service providers to thrive in the UK, and give people and businesses the confidence to invest with an understanding of the often high risks involved. We have already begun to deliver on this ambition through the Financial Services and Markets Bill, by laying the legislative foundations to bring stablecoins and cryptoassets into financial services regulation. We are also exploring how Distributed Ledger Technology (DLT) could offer benefits to financial market infrastructures and the UK’s sovereign debt management. This document marks the next step in the government’s plans and sets out proposals for delivering a broader financial services regulatory regime for cryptoassets. Our objective is to establish a proportionate, clear regulatory framework which enables firms to innovate at pace, while maintaining financial stability and clear regulatory standards. This includes a proposal to bring centralised cryptoasset exchanges into financial services regulation for the first time, as well as other core activities like custody and lending. Through regular engagement I have already heard first-hand some of the opportunities and challenges faced by industry in this sector, and I am keen to continue our important dialogue. Your responses will help inform the government’s approach and ensure the UK’s regulatory

framework helps us achieve our ambition for this exciting new technology. I look forward to your input.

Andrew Griffith MP, Economic Secretary to the Treasury

Chapter 1

Cryptoassets and the

current regulatory landscape

Introduction

1.1 Over recent years cryptoassets and the activities underpinning

their use (or ‘crypto’) has evolved into an extensive, complex, and rapidly evolving ecosystem. It features a myriad of different activities and business models, each generating different types of opportunities and risks for the actors involved.

1.2 The government’s view is that the technology underpinning this

innovation could bring a number of benefits, and with appropriate regulation and safeguards, certain cryptoassets and associated activities can offer significant new financial services opportunities for users. However, these benefits can only be realised sustainably if the technology is adopted safely and accompanied by an effective and appropriate regulatory framework for financial services. Against this backdrop, the government and the financial services regulators are already taking a number of steps to bolster the UK regulatory framework in order to harness this innovation and mitigate or clearly communicate the most pressing risks. However, most cryptoasset activities are not currently subject to broader financial services regulation, covering such matters as conduct and prudential requirements.

1.3 The government’s view is that cryptoassets and the activities

underpinning their use should follow the standards expected of other similar financial services activities, commensurate to the risks they pose, while harnessing potential benefits of the technology behind them. Having such a framework in place should stimulate growth and innovation in the sector by giving responsible actors the regulatory certainty and confidence to participate in cryptoasset markets, and investors the confidence to invest in the UK for the long-term. This consultation marks the next – but not the final – phase of the government’s approach to regulating cryptoassets and delivers on the government’s commitment to set out proposals for the financial services regulation of cryptoasset investment and trading activities. In doing so, the government is seeking views from a wide range of market participants and users.

1.4 This consultation builds on a series of HM Treasury publications

on cryptoassets, including the “UK regulatory approach to cryptoassets, stablecoins, and distributed ledger technology in financial markets” published in April 2022, “Cryptoasset promotions” published in April 2022 and the related policy statement on cryptoasset financial promotions to be published alongside this consultation. In addition, the Financial Conduct Authority (FCA) and Bank of England have issued a number of discussion papers, consultation papers, policy statements and regulatory guidance notes on cryptoassets, including the FCA’s consultation paper on financial promotions for cryptoassets (published in January 2022). In parallel, international organisations such as the Financial Stability Board (FSB), the Bank for International Settlements (BIS), the International Organization of Securities Commissions (IOSCO), the Organisation for Economic Co-operation and Development (OECD) and the Financial Action Task Force (FATF) have been developing global standards for many aspects of cryptoasset regulation.

1.5 This consultation focuses specifically on the future UK regulatory

framework for cryptoassets used within financial services, rather than the wider application of distributed ledger technology (DLT) in financial services or the use of cryptoassets outside financial services. There are a number of UK government and regulator initiatives in the broader DLT space, such as the UK’s Financial Market Infrastructure (FMI) Sandbox and DLT-supported debt issuance initiative. Figure 1.A provides a high- level summary of the main initiatives relating to cryptoassets, digital assets and DLT more broadly which the UK is leading or participating in, as well as some of the main organisations involved.

Figure 1.A Overview of consultation work on crypto and broader digital assets and DLT topics

Overview of cryptoasset markets

1.6 As well as emerging as a new asset class for investment, cryptoassets and their underlying technology have the potential to

disrupt various parts of traditional finance. Further, this continues to be a very volatile sector, with cryptoasset price volatility significantly exceeding that of many traditional asset classes such as equities or commodities. However, both retail and institutional participation in the sector continues to grow. On the retail side, most recent surveys show that 5-10% of UK adults now own cryptoassets, an increase of more than 100% over the past 1-2 years1. Institutional participation has been limited but is growing.2 A number of large banks and other traditional financial services institutions with a material presence in the UK are undertaking crypto-related activities including execution, brokerage, market making, custody and tokenisation of traditional assets.

1.7 Cryptoasset markets have undergone a turbulent year. Total

global market capitalisation of cryptoassets is currently around $0.8 trillion, down around 75% from a peak of roughly $3 trillion in November 2021. The second quarter of 2022 saw the failure of several cryptoasset lending and trading platforms, such as Celsius Network and Voyager Digital. The recent FSB report – published in October 2022 – noted that this episode exposed a number of vulnerabilities in those markets, arising from unsuitable business models, liquidity and maturity mismatches, the extensive use of leverage, and a high degree of interconnectedness within the cryptoasset ecosystem. These vulnerabilities were exacerbated by limited transparency and disclosures, suboptimal governance models, inadequate consumer and investor protections, and weaknesses in risk management.

1.8 These issues have been further emphasised by more recent

events surrounding the failure of a major crypto exchange, FTX, which has had widespread and ongoing implications for global crypto markets and prices and has contributed to the failure of another crypto trading and lending platform – BlockFi. FTX’s failure has underscored important questions around conflicts of interest, market conduct and operational resilience. It has also demonstrated that integrated business models – currently prevalent across the ecosystem – can result in complex and sometimes reinforcing risk profiles. Mitigating these risks will require a combination of robust prudential safeguards, operational risk controls, transparency and data reporting arrangements, measures to manage conflicts of interest, good governance and adequate record keeping. Should cryptoasset markets or entities become or be likely to become systemic, there may be a case to develop additional regulatory requirements or wider oversight commensurate with the risk these markets or entities could pose.

1.9 There have also been recent investigations and enforcement

cases in various jurisdictions: wire fraud and insider trading cases relating to admissions of cryptoassets to trading venues in North

1 https://www.gov.uk/government/publications/individuals -holding-cryptoassets-uptake-and-understanding ; https://yougov.co.uk/topics/finance/trackers/how -many-brits-have-bought-cryptocurrency 2 https://www.bankofengland.co.uk/-/media/boe/files/financial-policy-summary-and-record/2022/fpc-summary-and-record-october-2022.pdf

America; money laundering cases connected with the use of crypto mixing services in Europe; and fraud charges brought against certain actors involved in the operation and collapse of the Terra Luna token in Asia. UK authorities have also taken action – for example, warnings given to illegal crypto ATMs to shut down or face enforcement action,3 and actions against scams perpetrated by crypto firms that are unregistered with the FCA.4

1.10 The technology underpinning cryptoassets could bring a number

of benefits and innovations in the financial system. However, as highlighted by recent episodes, and as set out by the Financial Policy Committee of the Bank of England (FPC),5 these benefits can only be realised if the activity is undertaken with appropriate knowledge of the risks. This underlines and motivates the need for authorities to develop an enhanced regulatory framework for cryptoassets.

Overarching policy objectives and principles

1.11 By seeking to establish a regulatory framework for cryptoassets

in the UK, HM Treasury is pursuing four overarching policy objectives:

1. encourage growth, innovation, and competition in the UK

2. enable consumers to make well-informed decisions, with a

clear understanding of the risks involved

3. protect UK financial stability

4. protect UK market integrity

1.12 In addition, and as set out in prior consultation papers, HM

Treasury will continue to be guided by a set of core design principles: • “Same risk, same regulatory outcome”. The government will remain technology agnostic while also considering whether the technology, or its use, gives rise to additional risks. Equally, it will be considered where the use of a technology may mitigate risks. This does not mean exactly the same form of regulation, as the features and use of cryptoassets may require a different regulatory method, but the aim is to achieve the same or a very similar regulatory outcome where possible. Subject to consultation, HM Treasury intends to take an activities-based approach to regulation, although there may be cases where specific entities pose or are likely to pose systemic risk and may warrant further regulation. • “Proportionate and focused”. Efforts will be focused on where the risks and opportunities are most urgent or acute. HM

Treasury and the financial services regulators should avoid

applying disproportionate or overly burdensome regulation to entities, particularly where end users are aware of risks, and

3 https://www.fca.org.uk/news/news-stories/warning-illegal-crypto-atms-operating-uk

4 https://www.fca.org.uk/data/consumer-investments-data-review-april-sept-2021

5 Financial Stability in Focus: Cryptoassets and decentralised finance | Bank of England

where the activities do not give rise to market integrity or financial stability risks. • “Agile and flexible”. The regulatory framework should accommodate evolving markets and products. Future legislation will provide a clear framework in the UK, providing clarity as to the scope of activities to which the regime applies, with detailed rules set by the regulators. This approach is consistent with the

Future Regulatory Framework (FRF), which is intended to be

established by the Financial Services and Markets Bill 2022 (FS&M Bill). The government judges that this agile approach will enable regulators to adapt to changes in the market and developments in international standards. In addition, and in line with the objective of promoting UK financial stability, the proposed regime will need to evolve if cryptoasset markets pose or are likely to pose financial stability risks. Given the cross-border nature of cryptoassets, the UK encourages cooperation with other jurisdictions and will continue to interact through bilateral engagement and participation in international standard-setting bodies to support harmonisation of treatment as far as is feasible.

1.13 Subsequent chapters highlight some of the challenges posed by

the global and decentralised nature of cryptoasset markets to delivering these objectives, including where their delivery may be more aspirational due to the absence of international standards and cooperation. For example, Chapter 9 describes how the underlying structure of cryptoasset markets limits the ability of UK authorities to achieve the outcome of offering market integrity or protecting consumers to the same degree as in traditional securities markets.

1.14 In line with these design principles, HM Treasury intends to

continue to pursue a phased approach to regulating cryptoassets, which is prioritised according to the areas of greatest risk and opportunity. These phases are summarised in Figure 1.B. The proposals covered in this consultation represent an important next step in a longer process, with further work anticipated as the sector continues to evolve and authorities gather further information on the industry.

1.15 The government and financial services regulators are already

taking a number of steps to equip the UK regulatory framework to harness this innovation and mitigate the most pressing risks. Since January 2020, an Anti-Money Laundering and Counter Terrorist Finance (AML/CTF) registration regime has been in place for businesses undertaking cryptoasset exchange or custody wallet services in the UK, in order to regulate compliance with the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (“MLR”). The government will shortly introduce legislation to require the regulation of promotions of cryptoassets by the FCA to ensure promotions are clear, fair and not misleading. The government is also currently legislating in the Financial Services and Markets Bill 2022 (FS&M Bill) to introduce a regime that will allow for the regulation of fiat-backed stablecoins which are used for payments, similar to that

for other payment methods (Phase 1) given that these stablecoins have the potential to become widely used as a form of payment. The regime will address issuance and custody activities relating to fiat-backed stablecoins as well as payment-related activities for those fiat-backed stablecoins which are used in payments.6 The scope of this is expected to cover, at a minimum, GBP and other fiat-backed stablecoins which are issued in the UK. The Bank of England and the Payment Systems Regulator (PSR) will also have a regulatory remit for Digital Settlement Assets (DSAs). These various regimes are covered in more detail in Chapter 3 but are not the focus of this consultation. Figure 1.B Phased approach for regulating cryptoassets in the UK Source: HM Treasury

1.16 In Phase 2, the government’s intention is to introduce a regime

to regulate broader cryptoasset activities, such as the trading of and investment in cryptoassets. Phase 2 will be focused on targeting the activity areas associated with (i) a higher degree of risk from a consumer and overall market perspective and (ii) greater opportunities to support the UK’s growth agenda. As a consequence, not all cryptoasset activities are proposed to form part of Phase 2. Chapter 4 sets this out in more detail. In addition, in more nascent areas of the market, the government is actively seeking views to inform future policy development. The government will continue to strategically assess developments in the market to determine future phases of work, taking into consideration the views of industry, consumers, and regulators. As these markets develop and international standards are further implemented, HM Treasury will continue to work to adapt and complete these proposals. This will particularly be the case where current proposals do not achieve the same regulatory outcome as in traditional finance.

6 Some activities – e.g. custody – will be addressed through Phase 1 for fiat-backed stablecoins and then later (Phase 2) for other types of cryptoassets that come into the perimeter; the same framework is expected to be adopted for all types of cryptoassets as they come into regulation, rather than separate, overlapping regimes

Chapter 2

Definition of

cryptoassets and legislative approach

Definition of cryptoassets

2.1 There is no universal definition of a “cryptoasset” or related terms

such as a “digital asset” or “virtual asset”, but there is increasing consensus on the basic elements of the definition in UK and overseas legislation, and in global standards. The FS&M Bill includes the following definition of “cryptoasset” for the UK’s financial services regulatory framework, to be introduced into FSMA: ““cryptoasset” means any cryptographically secured digital representation of value or contractual rights that— (a) can be transferred, stored or traded electronically, and (b) that uses technology supporting the recording or storage of data (which may include distributed ledger technology).”

This definition in the FS&M Bill is drawn broadly so as to capture all current types of cryptoasset. The definition underpins the powers HM Treasury has to specify activities within the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 ("RAO”), or to designate activities as part of the Designated Activities Regime (“DAR”) being legislated for in the FS&M Bill. It is similar to the definition of “cryptoasset” used in regulation 14A(3)(a) of the MLR, with the principal difference being that the FS&M Bill definition references a wider range of underlying technology. Though the overwhelming majority of cryptoassets currently rely upon DLT, for financial services regulation it is important to encompass potential future changes in the technology underlying cryptoassets in order to mitigate against regulatory arbitrage. The definition is also very similar to the definition of “cryptoasset” in the EU’s Markets in Cryptoassets legislation (“MiCA”), and also shares some features with the definition of “virtual asset” in the FATF’s recommendations.7 To react to future changes, the definition of “cryptoasset” is accompanied by a power to update it by way of

7 FATF (2012-2022), International Standards on Combating Money Laundering and the Financing of Terrorism & Proliferation, FATF, Paris, France, www.fatf-gafi.org/recommendations.html

secondary legislation. Note that the term “token” is used interchangeably with “cryptoasset” hereafter.

2.2 The government anticipates that the future financial services

regulation of cryptoassets created using HM Treasury’s powers will typically apply to a particular subset of cryptoassets depending on the matter being regulated, and will accordingly use a narrower definition to capture these. For example, Schedule 6 to the FS&M Bill extends the application of the existing scope of Part 5 of the Banking Act 2009 to include payment systems using digital settlement assets. A “digital settlement asset” comprises only those digital assets that can be used for the settlement of payments (it therefore covers other digital assets that can be used for the settlement of payments, as well as cryptoassets used in payments). In addition, the government has confirmed that non-fungible tokens (NFTs) will not be in scope of the cryptoassets financial promotions regime, since NFTs can represent a wide array of different assets which might constitute non-financial services products.8

2.3 Box 2.A below sets out a glossary of commonly used terms for

different types of cryptoasset. Importantly though, the government’s intention is that activities will be regulated, rather than the asset itself. Readers should also note that these terms – commonly used in industry, media and public discourse – will not necessarily be aligned to regulatory definitions.

2.4 Under the proposals being consulted on, any of the

cryptoassets listed in Box 2.A could in the future be subject to financial services regulation where being used for the financial services activities referenced in Chapter 4 (as well as those already in the UK’s regulatory perimeter). The proposed regulatory framework for cryptoassets is not intended to impose regulation on any underlying non-financial services activity which a cryptoasset might be used for. If the activity is non-financial in nature this may be covered by other laws or regulations (e.g. fraud cases relating to digital art assets or NFTs).

2.5 Regarding investor protections, whilst it is not the government’s

intention for FSCS protections to apply to investor losses arising from cryptoasset exposures, it is the responsibility of the PRA and FCA as the UK’s independent financial regulators to set the limits of FSCS protection in respect of regulated activities carried out by authorised firms.

Legislative Approach

2.6 The government intends to include the financial services

regulation of cryptoassets within the regulatory framework established by the UK’s Financial Services and Markets Act 2000 (FSMA), taking advantage of the confidence, credibility and regulatory clarity that this existing system affords, and as it is intended to be updated by the FS&M

8 https://www.fca.org.uk/publications/policy-statements/ps19-22-guidance-cryptoassets

Bill. FSMA is a well-established feature of the UK’s legal framework for financial services. The alternative approach of developing a fully bespoke regime outside of the FSMA framework was also considered but discounted on the basis that this would not deliver a level playing field between crypto and traditional financial services firms conducting the same activity (contrary to the “same risk, same regulatory outcome” principle, as set out above). A bespoke regime – built outside of the FSMA framework – is also more likely to create overlapping regulatory regimes and confusion for market participants.

2.7 Under FSMA, HMT has secondary legislation powers to bring

activities into the regulatory perimeter by specifying them in the RAO. The government’s intention is to expand the list of “specified investments” in Part III of the RAO to include cryptoassets. An amendment to the RAO power, Section 22(4) of FSMA, made through the FS&M Bill affirms the use of the RAO power for the financial services regulation of cryptoassets. This clarifies that persons (natural or legal) who are carrying out certain activities involving cryptoassets “by way of business” would be performing regulated activities and therefore require authorisation under Part 4A of FSMA. It would also mean that the FCA’s general rule making powers would be available, allowing the FCA to design regulatory regimes for newly added activities. In practice this means that the FCA will be given powers to write tailored rules, as opposed to the existing rules automatically applying to cryptoassets. The FCA will need to consider what is appropriate and consult accordingly.

2.8 HM Treasury has other powers and legislative options available to

regulate activities which might not be suitable for regulation under the RAO (e.g. if they are carried out by actors which HM Treasury does not wish to subject to the requirements of the authorisation regime in Part 4A FSMA). In particular, the DAR, a new regime set out in the FS&M Bill, is designed to enable HM Treasury to designate certain activities in order to make regulations relating to the performance of that activity, including prohibiting the activity in its entirety or setting direct requirements.

2.9 HM Treasury does not currently intend to expand the definition

of “financial instrument” in Part 1 of Schedule 2 to the RAO to include presently unregulated cryptoassets. This is due to the limitations of retrofitting an existing regime to a new asset class with unique features and risks. However, in line with the principle of “same risk, same regulatory outcome”, HM Treasury will seek to use other legislative and regulatory mechanisms to put in place equivalent or similar safeguards where cryptoassets present similar risks to financial instruments (e.g. market manipulation practices which arise from the fact that cryptoassets are traded in a way which resembles financial instruments).

Box 2.A: Glossary of commonly used terms for cryptoassets (not exhaustive) Exchange tokens are cryptoassets which use a technology such as DLT to support the recording or storage of data and are not issued or backed by a central bank or other central body. They are used as a means of exchange or for investment purposes but do not provide the types of rights or access provided by security tokens or utility tokens. Bitcoin and Ether are prominent examples. These are often referred to as “cryptocurrencies”, though we deliberately avoid this terminology since it draws a potentially unwarranted equivalence with fiat currencies. Utility tokens are cryptoassets which provide digital access to a specific service or application (e.g. digital advertising or digital file storage) and use a technology such as DLT to support the recording or storage of data. They do not provide the rights or features associated with a security token (e.g. share or ownership rights), and do not function as a means of payment – though they can be traded on cryptoasset trading venues for investment purposes. Security tokens are cryptoassets which use a technology such as DLT to support the recording or storage of data and already meet the definition of a specified investment under the RAO and are therefore already subject to regulation. Non-Fungible Tokens (NFTs) are cryptoassets which confer digital ownership rights of a unique asset (e.g. a piece of digital art), using a technology such as DLT to support the recording or storage of data. NFTs do not provide the rights or features associated with a security token and do not function as a means of payment. Stablecoins are exchange tokens which attempt to stabilise their value by referencing one or more assets, such as fiat currency. The UK’s proposed legislation for stablecoins used in payments will initially apply specifically to fiat-backed stablecoins which are expected to include stablecoins that seek to maintain a stabilised value of the cryptoasset by reference to, and which may include the holding of, one or more specified fiat currencies. Further details on the government’s approach to fiat-backed stablecoins will be set out in due course. Various types of tokens which are currently marketed or labelled as “stablecoins” might not meet the requirements under these regimes.

Asset-referenced tokens are a subset of exchange tokens which

include commodity-linked tokens and crypto-backed tokens.

Commodity-linked tokens are a subset of asset-referenced tokens which aim to maintain a stable value relative to the underlying commodity price by being collateralised with one or more commodities or real-world assets, or act as a digital representation of an underlying real-world asset such as gold, property, or oil.

Crypto-backed tokens are a subset of asset-referenced tokens

which reference their value in relation to other cryptoassets. Algorithmic tokens are exchange tokens that aim to maintain a stable price largely, or in some part, through an algorithm that facilitates a change in supply and demand between the coin and one or more cryptoassets that support it. Governance tokens are a subset of utility tokens which are used solely by holders to vote on a blockchain or network's decisions, but do not provide any kind of exclusive perks or discounts. Fan tokens are a subset of utility tokens which give holders access to a variety of fan-related membership perks like voting on club decisions, rewards, merchandise designs and unique experiences.

Box 2.B: Questions for respondents

1. Do you agree with HM Treasury's proposal to expand the list of

“specified investments” to include cryptoassets? If not, then please specify why.

2. Do you agree with HM Treasury's proposal to leave cryptoassets

outside of the definition of a "financial instrument"? If not, then please specify why.

3. Do you see any potential challenges or issues with HM Treasury’s

intention to use the DAR to legislate for certain cryptoasset activities?

Chapter 3

Overview of the current

regulatory landscape for cryptoassets

3.1 This chapter provides a summary of the current financial services

regulatory landscape relevant to cryptoasset activities in the UK. Each section also covers how interactions between these regimes and the broader regulatory framework for cryptoassets are expected to be addressed.

Activities relating to security tokens and other specified

investments

3.2 Certain types of cryptoasset may already fall within the existing

FSMA regulatory perimeter set by the RAO, as they qualify as “specified investments”. For instance, security tokens provide rights and obligations akin to shares, debt instruments or other securities, which are specified investments as set out in the RAO. This means that they are already within the regulatory perimeter and that firms carrying on specified activities involving security tokens need to ensure that they have the correct permissions and are following the relevant rules and requirements.

3.3 For the most part, HM Treasury expects continuation of the

current treatment of those cryptoassets that already qualify as “specified investments”, though there may be some amendments over time (e.g. updating custody obligations in the Client Assets Sourcebook for security tokens).

3.4 Certain types of cryptoasset may also fall within other elements

of existing financial services regulation, notably where forming part of (or being the subject matter of) a financial instrument within Part 1 of

Schedule 2 to the RAO, e-money under the E-Money Regulations 2011

(EMR 2011) or, where facilitating regulated payment services, the Payment Services Regulations 2017 (PSR 2017). The FCA’s Perimeter Guidance for Cryptoassets (PS 19/22) sets out more detail on the different types of cryptoassets and their interactions with the existing regulatory perimeter.

AML/CTF Regime

3.5 In January 2020, following an amendment to the MLR, the FCA

became the supervisory authority for cryptoasset exchange providers

and custodian wallet providers (‘cryptoasset businesses’) in respect of the AML and CTF obligations contained in the MLR.9 These cryptoasset businesses encompass firms or sole practitioners undertaking activities in the UK in relation to: the exchange, arranging or making arrangements with a view to the exchange of money for cryptoassets, cryptoassets for money, or one cryptoasset for another; the operation of a machine which utilises automated processes to exchange cryptoassets for money or money for cryptoassets; and the safeguarding or safeguarding and administering of cryptoassets or private cryptographic keys in order to hold store and transfer cryptoassets. Consequently, existing cryptoasset businesses have had to be registered and comply with the MLR, requiring them to demonstrate that their controls, policies and procedures are adequate to deal with the money laundering and terrorist financing risks of the cryptoasset market, and requiring any officers, managers and beneficial owners of the business to be fit and proper. 3.6 To prevent undue disruption to existing cryptoasset businesses, the FCA announced the establishment of a temporary registration regime (TRR). This allowed existing cryptoasset businesses who had applied to be registered with the FCA to continue trading whilst applications were assessed. Since the closure of the TRR on 31 March 2022, cryptoasset businesses are required to be registered by the FCA before they start operating in the UK. This year, HM Treasury further amended the MLR to extend the FATF’s “travel rule” to capture cryptoasset activities.10 This extends information sharing and record keeping requirements that apply to bank transfers to transfers of cryptoassets, to assist in the prevention and detection of money laundering.

3.7 When the broader cryptoasset regulatory regime being

consulted on becomes effective, HM Treasury expects firms undertaking regulated cryptoasset activities to adhere to the same financial crime standards and rules under FSMA that apply to equivalent or similar traditional financial services activities. This is necessary since the financial crime rules in FSMA are broader than those contained in the MLR, covering anti-bribery and corruption, sanctions, fraud and other aspects of financial crime. It is important for the UK to have a robust gateway to mitigate these risks and maintain high standards and reputational integrity. Under the proposal to introduce certain cryptoasset activities into FSMA, and as with other areas, the FCA would have the powers to write and amend their Handbook rules in relation to financial crime.11 The FCA will consider whether to update the Senior Management Arrangements, Systems and Controls sourcebook and other financial crime rules to apply to new cryptoasset activities. HMT and FCA will work with industry to

9 Regulation 7, Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer)

Regulations 2017/692

10 Regulation 5, The Money Laundering and Terrorist Financing (Amendment) (No. 2) Regulations 2022. 11 Relevant FCA Handbook references include - but are not limited to - SYSC 3.2.6, SYSC 6.1.1 SYSC 6.3

ensure crypto firms are made fully aware of the standards required for approval at the FSMA gateway. Further communications will be provided in due course to ensure standards for approval are clearly available to crypto firms operating in the UK.

3.8 The list of proposed cryptoasset activities (see Chapter 4) seeks to

incorporate the full scope of activities that currently require registration under the MLR into the regulatory perimeter of FSMA. Bringing crypto firms within the regulatory perimeter of FSMA and amending the geographical scope to business conducted in or to the UK would, in time, enable authorities to operate a single register and would align the business test for determining activities undertaken in the UK to better protect consumers and support a single authorisation process for firms undertaking cryptoasset activities. HM Treasury and the FCA both have a strong preference for having a single authorisation process in the long term, in order to give businesses and consumers a streamlined process and regulatory clarity. This would also support supervisory and enforcement processes as there may be complexities arising from an enforcement case involving multiple parties, some of whom are MLR- registered and some of whom are FSMA-authorised. This single process may take time to achieve as we bring new legislation into force using a phased approach, in order to navigate any differences in scope in the short term.

3.9 The introduction of an authorisation regime under FSMA for

persons who are carrying out certain activities involving cryptoassets means that crypto firms already registered under the MLR regime and carrying out those activities would be required to also seek authorisation under the new FSMA-based regime. This is because businesses will need to be assessed against a wider range of measures than they have been as part of the MLR registration process. However, in order to smooth this transition, the FCA will adopt a timely and proportionate authorisation process for complete and accurate applications, and will endeavour to avoid duplicative information requests of businesses, taking into account the supervisory history of businesses during the authorisation process. New crypto firms not yet registered under the MLR regime would not need to separately apply for registration under the MLR. All crypto firms in scope of the MLR will still be expected to comply with them, as with current FSMA-authorised businesses that are subject to the MLR.

Financial Promotions Regime

3.10 Consumer information ensuring transparent disclosure of the

nature of the investment and risks involved is a key plank of the government’s proposed framework. In summer 2020, HM Treasury published a consultation on bringing qualifying cryptoassets into the

scope of the financial promotions regime.12 The consultation response – published in January 2022 – confirmed the government’s plan to introduce legislation to address the significant risk of misleading cryptoasset promotions.13 HM Treasury is seeking to lay the secondary legislation to extend the financial promotions perimeter in 2023. The FCA consulted on proposed rules for cryptoasset promotions, such as risk warnings and consumer frictions, in January 2022.14

Fiat-backed stablecoins which are used for payment

(Phase 1)

3.11 For the purposes of this consultation, “fiat-backed stablecoins”

are expected to include stablecoins that seek to maintain a stabilised value of the cryptoasset by reference to, and which may include the holding of, one or more specified fiat currencies.15

3.12 As part of the FS&M Bill, the government is taking forward

legislation to: • bring Digital Settlement Assets (DSAs) into the regulatory perimeter for systemic payment systems and service providers (to fall under the remit of the Bank of England where they are systemically important)16 • enable HM Treasury to bring activities such as the issuance and custody of fiat-backed stablecoins into the regulatory perimeter via statutory instrument (to fall under the remit of the FCA) • enable HM Treasury to establish via statutory instrument a mechanism for facilitating dual regulation (to fall under the remit of the FCA, the Bank of England and the PSR)

12 Cryptoasset promotions: Consultation (July 2020)

https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/902 891/Cry ptoasset_promotions_consultation.pdf

13 Cryptoasset promotions: Consultation response (January 2022)

https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1047232/Cryptoasset_Financial_Promotions_Response.pdf 14 Strengthening our financial promotion rules for high risk investments, including cryp toassets (January 2022) https://www.fca.org.uk/publication/consultation/cp22 -2.pdf 15 This does not consider the interaction of the new regulated activity with accepting deposits , which will also need to be considered in Phase 1. It is not the government’s intention to include tokenised deposits (which operate on blockchains and may represent unsecured debt claims) within the scope of regulated activity for Phase 1. This is in addition to cryptoassets that seek to maintain a stable value by way of a purely algorithmic mechanism (see 4.25-4.26). The final phraseology for fiat-backed stablecoins will be developed further in later legal drafting. 16 The definition of a digital settlement asset is “a digital representation of value or rights, whether or not cryptographically secured that a) can be used for the settlement of payment obligations, b) can be transferred, stored or traded electronically, and c) uses technology supporting the recording or storage of data (including DLT)”. A “digital settlement asset” comprises only those cryptoassets that can be used for the settlement of payments (and in fact covers assets other than cryptoassets that can b e used for the settlement of payments too). See clause 22(2), Financial Services and Markets Bill, Bill 181 2022-23 (as amended in Public Bill Committee)

3.13 The FCA’s regime will apply to fiat-backed stablecoins, which is to

be defined in the statutory instrument expected to be laid in H1 2023. HM Treasury is intending to regulate activities such as the issuance and custody of fiat-backed stablecoins in Phase 1. At a minimum, GBP and other fiat-backed stablecoins which are issued in the UK are expected to be in scope.

3.14 In addition, a range of specific amendments will be made to the

Electronic Money Regulations (EMRs) and Payment Services

Regulations 2017 (PSRs). This is to ensure that the regime can be applied effectively, including when fiat-backed stablecoins are used in retail payments activities. Further details on the government’s approach to fiat-backed stablecoins will be set out in due course.

3.15 Under provisions currently in the FS&M Bill, including provisions

which amend the Banking Act 2009 and the Financial Services (Banking Reform) Act 2013, the Bank of England and the PSR will also have a regulatory remit for DSAs, covering systemic payment systems and service providers. There are currently no systemic DSA systems, and this would only be triggered were the system or service provider to meet the relevant criteria and thresholds, and where recognised and/or designated by HM Treasury. In practice, the concept of a DSA could extend to cryptoassets other than fiat-backed stablecoins (e.g. if an unbacked cryptoasset was used for payments and became systemic in nature). This is intended to provide future flexibility and act as a backstop function should any DSA system or service provider scale to pose systemic risks.

3.16 The intention of this legislation is to focus on the regulation of

issuers, custodians and payment service providers for fiat-backed stablecoins, reflecting their specific risks, benefits and potential use cases. It does not capture exchange or trading activities of stablecoins (which are covered in this consultation). Figure 3.A sets this out for clarity. While the stablecoin and broader cryptoasset regimes are being developed according to different timelines, HM Treasury and the regulators are designing both in a consistent and compatible way in order to streamline common processes wherever possible – for example, the admission for trading processes, lending platforms and cryptoasset exchange.

Figure 3.A Scope of regime for fiat-backed stablecoins vs broader cryptoasset regime

Security tokens

and other specified investments

Fiat-backed

stablecoins2 All other cryptoassets

Issuance

Already regulated1

(e.g. prospectus rules apply to security tokens)

Stablecoin

legislation (phase 1)

Cryptoasset legislation

(phase 2) (specifically addressing admission of cryptoassets to a cryptoasset trading venue or a public offer of cryptoassets)

Payment

(e.g. Payment

Services

Regulations apply

to E-Money)

Stablecoin

legislation (phase 1) (+ regulated as systemic DSA if meets criteria)2

Not applicable

(could theoretically be regulated as systemic

DSA if meets criteria)2

Exchange

/ trading

Already regulated1

(e.g. MTF / OTF rules apply to security tokens)

Cryptoasset legislation (phase 2)

Custody

(e.g. CASS rules currently apply to security tokens)

Stablecoin

legislation (phase 1)

Cryptoasset legislation

(phase 2)

1. unless specific exceptions / exemptions apply

2. Any systemic Digital Settlement Asset payment system or service provider would be subject to

regulation by the Bank of England and Payment Services Regulator (PSR) Source: HM Treasury

Box 3.A: Questions for Respondents

4. How can the administrative burdens of FSMA authorisation be

mitigated for firms which are already MLR-registered and seeking to undertake regulated activities? Where is further clarity required, and what support should be available from UK authorities?

5. Is the delineation and interaction between the regime for fiat-

backed stablecoins (phase 1) and the broader cryptoassets regime (phase 2) clear? If not, then please explain why.

6. Does the phased approach that the UK is proposing create any

potential challenges for market participants? If so, then please explain why.

Chapter 4

Cryptoasset Activities

4.1 The cryptoasset ecosystem features a complex array of activities

and business models, each generating different types of opportunities and risks. Some of these activities resemble “specified activities” (listed under Part II of the RAO) – such as safeguarding and administering investments or operating a Multilateral Trading Facility (MTF). Others have more in common with electronic money-like activities (mostly regulated under the PSR 2017 and EMR 2011), and for the final category of cryptoasset activities – including mining and validation – there is no close analogue to traditional financial services activities.

4.2 The complexity of cryptoasset activities and the proliferation of

new business models creates challenges for policy makers and regulators. It is highly unlikely that a “one size fits all” approach to regulation would work for all types of cryptoasset firms, since different activities present different forms of risk. For this reason, and in line with the principle of “same risk, same regulatory outcome” set out above, HM Treasury intends to create a number of new regulated or designated activities tailored to the cryptoasset market where these activities seek to mirror, or closely resemble, regulated activities performed in traditional financial services. There are also some novel cryptoasset activities for which existing regulatory frameworks would not provide a suitable basis. These various activities are laid out in the following section.

Proposed scope of regulated cryptoasset activities

4.3 Table 4.A below lists a set of illustrative cryptoasset activities

that HM Treasury proposes to bring into the regulatory perimeter, and the proposed sequencing. Where a person (natural or legal) is engaged in these activities by way of business, they are expected to be subject to regulatory obligations which will be legislated for via the RAO, DAR or other legislative means. Further details on HM Treasury’s desired regulatory outcomes for these activities are set out in later chapters.

4.4 For newly defined RAO activities, firms which are already FSMA-

authorised and intend to undertake the activity will generally need to apply for a variation of their permission from the FCA (and the PRA for dual-regulated firms). Regulatory permissions would not be automatically granted for firms which are already authorised.

4.5 The requirement for a person to be FSMA-authorised only applies

to activities that are carried out “in the United Kingdom”. However, determining the location in which an activity is carried out varies according to the nature of that activity. In the case of cryptoasset

activities – which are provided and consumed digitally and are very often not confined to a specific jurisdiction – this is not always straightforward to determine. For the purpose of activities in Phase 2 and subsequent phases, HM Treasury proposes to capture cryptoasset activities provided in or to the United Kingdom. This would capture activities provided by UK firms to persons based in the UK or overseas (natural and legal), as well as those provided by overseas firms to UK persons (natural or legal). Whilst this is intended to be the standard approach, HM Treasury recognises that there may be nuances in the application of this for specific activities.

4.6 Such an approach is in line with a number of other areas of the

UK’s regulatory perimeter and would likely be necessary since UK consumers can (and frequently do) easily access cryptoasset products and services which are provided by overseas companies. Furthermore, a definition which only captures firms operating in the UK would result in a situation where firms could move offshore to easily evade UK regulations but still serve UK customers. This would create an unlevel playing field for firms based in the UK.

Figure 4.A Geographic scope of cryptoasset activities carried on “in the United Kingdom”

Location of the customer

UK Overseas

Location of the

provider UK In scope In scope

Overseas In scope Out of scope

Subject to exceptions and nuances for specific activities

Source: HM Treasury

4.7 There may be certain exceptions that the UK government wishes

to consider to this approach – for example, to accommodate “reverse solicitation” of cryptoasset activities that are provided from overseas companies. Under this exception, if a UK customer accessed a particular cryptoasset service entirely at their own initiative from an overseas firm and the firm does not otherwise solicit from such customers, then this may not trigger an FSMA-authorisation requirement for that overseas firm in relation to that particular service. However, this would likely be defined in a way to prevent misuse and regulatory arbitrage.

4.8 Whether firms carrying out these activities would be required to

have a physical presence in the UK in order to obtain authorisation is under consideration and for the FCA to determine at the point at which firms apply for authorisation. This is expected to be informed by the

FCA’s existing framework for international firms and based on the nature and scale of the firm’s activities and the risks of harms the activities could cause. 17 In particular, risk of retail, client asset and wholesale harm will be taken into account. Firms operating cryptoasset trading venues would be likely to require subsidiarisation in the UK since they play a critical role in the cryptoasset value chain – from admission to trading (see Chapter 5) through to helping to prevent, detect and disrupt market abuse (see Chapter 9). HM Treasury intends to pursue equivalence type arrangements whereby firms authorised in third countries can provide services in the UK without needing a UK presence, provided they are subject to equivalent standards and there are suitable cooperation mechanisms to help make this work. The government is supportive of pursuing this as soon as practicably possible to help reduce the risk of market fragmentation. The table below contains a list of "economic" or "business model activities", phrased in non-legal language. This will allow respondents to better understand the scope of the regime and is meant for illustrative purposes only. It should be read in the context of the following caveats and clarifications: • the wording of the activities should not be interpreted as draft legislation or the wording of regulated activities, but rather as an illustration to provide clarity on what sorts of activities HM

Treasury intends to regulate (and when)

• the list is not exhaustive and activities with a very similar nature, purpose and risk profile could also be captured in the perimeter (to mitigate against risks of regulatory arbitrage) • some future activities (beyond Phase 2) may ultimately be left out of the regulatory perimeter in full or in part, pending further consultation and analysis • some activities – e.g. custody – will be addressed through Phase 1 for fiat-backed stablecoins and then later (under Phase 2) for other types of cryptoassets that come into the perimeter; we expect the same framework will be adopted for all types of cryptoassets as they come into regulation rather than having separate, overlapping regimes • in addition to the activity-specific requirements set out below, HM Treasury is considering how to ensure that regulators have the necessary information to deliver their objectives, and how this can be obtained in the most cost-effective manner • the FCA already has powers to implement regulatory requirements for activities relating to security tokens – which meet the definition of a specified investment – but the

17 https://www.fca.org.uk/publication/corporate/approach -to-international-firms.pdf

cryptoasset regime being consulted on in this document does not replace or negate these existing powers • the regulation pertaining to these activities will be subject to exemptions – for instance, only those firms or individuals undertaking these activities by way of business will be regulated – with this being especially relevant to activities like dealing in cryptoassets as principal, or mining and validation

Table 4.A Proposed scope of cryptoasset activities to be regulated

Activity

category

Sub-activities

(indicative, non-exhaustive) Chapter Phase

Issuance

activities

Issuance and redemption of a

fiat-backed stablecoin

Further

detail to be set out in due course

Phase 1

Admitting a cryptoasset to a

cryptoasset trading venue Chapter 5 Phase 2

Making a public offer of a

cryptoasset Chapter 5 Phase 2

Payment

activities e.g. execution of payment transactions or remittances involving fiat-backed stablecoins

Further

detail to be set out in due course

Phase 1

Exchange

activities

Operating a cryptoasset trading

venue which supports: (i) the exchange of cryptoassets for other cryptoassets (ii) the exchange of cryptoassets for fiat currency (iii) the exchange of cryptoassets for other assets (e.g. commodities)

Chapter 6 Phase 2

Post-trade activities in

cryptoassets (to the extent not already covered)

Chapter 12 Future

phases

Investment

and risk management activities

Dealing in cryptoassets as

principal or agent

Chapter 7

Phase 2

Arranging (bringing about)

deals in cryptoassets Phase 2

Making arrangements with a

view to transactions in cryptoassets

Advising (to the extent not

already covered) on cryptoassets Chapter 12

Future

phases (or exclude from regulatory perimeter)

Managing (to the extent not

already covered) cryptoassets

Activity

category

Sub-activities

(indicative, non-exhaustive) Chapter Phase Lending, borrowing and leverage activities

Operating a cryptoasset

lending platform

Chapter

10 Phase 2

Safeguarding

and /or administration (custody) activities

Safeguarding or safeguarding

and administering (or arranging the same) a fiat- backed stablecoin and/or means of access to the fiat- backed stablecoin18 (custody)

Further

detail to be set out in due course

Phase 1

and administering (or arranging the same) a cryptoasset other than a fiat- backed stablecoin and/or means of access to the cryptoasset19 (custody)

Chapter 8 Phase 2

Validation and

governance activities

Mining or validating

transactions, or operating a node on a blockchain

Chapter 12 Future

phases Using cryptoassets to run a validator node infrastructure on a proof-of-stake (PoS) network (layer 1 staking)

Additional considerations relating to vertically

integrated business models

4.9 In practice many cryptoasset exchanges play a central role in the

cryptoasset ecosystem – conducting many more activities than solely operating a trading venue (e.g. custody, post-trade activities, proprietary trading, lending and admission of cryptoassets to a platform). Some venues may also issue their own native cryptoasset or act as intermediaries for the distribution of stablecoins. This is sometimes referred to as “vertical integration” or “agglomeration”.

Accordingly, the government expects, as a minimum, that these

entities follow rules covering all of these activities – not just those relevant for operating a trading venue. To illustrate, a major cryptoasset exchange would be required to comply with the issuance and disclosure rules for assets that they admit for trading (Chapter 5), the rules relating to the operation of a trading venue (Chapter 6) and certain surveillance and reporting requirements to detect and prevent market abuse (Chapter 9). Additionally, and depending on the sorts of activities they undertake, they would also need to comply with rules for market intermediaries (Chapter 7), cryptoasset custody rules for cryptoassets which they safeguard or safeguard and administer

18 e.g. a wallet or cryptographic private key

19 e.g. a wallet or cryptographic private key

(Chapter 8) and rules for operating a cryptoasset lending platform (Chapter 10).

4.10 Exchanges which combine a number of regulated activities may

present conflicts of interest as well as complex and sometimes reinforcing risk profiles, as demonstrated by the recent failure of FTX. This is especially problematic where there is a lack of transparency around organisational structures and balance sheets. Traditional financial institutions that provide multiple services and business lines are subject to comprehensive prudential and conduct regulation which seeks to address the risks of the combined entity, and in some cases particular functions are segregated. For instance, in traditional finance, when different functions or activities happen within a single group, regulation can require separate, independent governance, to ensure that the risks are properly managed and functions are separated in different entities or managed with tight controls and ring-fences. Further consideration will be given to the risks of such combined activities in the cryptoasset sector, and whether and how existing controls on combinations of activity in traditional finance could be applicable.

4.11 Despite the existence of information on blockchains, there

remains considerable opacity in cryptoasset markets, reflecting their often-pseudonymous nature, related inability to monitor aggregated position holdings, and the existence of off-chain activity. Information gathered by exchanges could therefore be of value to the authorities, for both market abuse and systemic risk monitoring purposes.

4.12 Market participants in traditional finance are required to

regularly report market data. However, given the size and structure of cryptoasset markets, the government considers that it would not be proportionate to require such regular reporting at this time. Instead, under the proposed regime venues would be required to keep, and make available at all times, accurate and comprehensive data related to trading on their exchanges. Authorities would retain the ability to propose more regular and wider reporting over time, for example if the size or interconnectedness of the crypto markets were to increase and as international standards in that area progress further.

Activities relating to asset-referenced tokens

4.13 In line with the existing perimeter guidance, the government

intends to regulate financial services activities, rather than the assets themselves. This is consistent with the existing regulatory approach in traditional financial services, and also reduces risk of regulatory arbitrage through structuring products or instruments in particular ways to circumvent financial services regulation. This section provides further clarity on how this approach will work, since some jurisdictions have taken slightly different approaches and defined separate regimes according to the structure and characteristics of the asset. The government is already taking forward a regime for fiat-backed stablecoins which are used in payments – therefore, tokens used in that way are not considered in this chapter.

4.14 “Commodity-linked tokens” aim to maintain a stable value

relative to the underlying commodity price by being collateralised with one or more commodities or real-world assets, or act as a digital representation of an underlying real-world asset such as gold, property, or oil. Currently, these are a relatively small proportion of the market, representing less than 1% of daily trading volumes and market capitalisation.20 While commodity-linked tokens have a range of use cases, they are often used by the holder to access the market of the underlying commodity in a way that may be cheaper and more flexible than buying the commodity outright. They could be structured or sold as an NFT representing a unique asset, for example real estate, or as a token referencing a commodity or basket of commodities. They can also be structured and marketed as “stablecoins”, by being pegged to a given commodity. In such a case the commodity/commodities would act as the underlying collateral.

4.15 The structure of these assets and the ability to buy and sell them

on cryptoasset trading venues, among other features, means that they may also share characteristics and pose similar operational, market integrity and consumer risks as ‘unbacked’ crypto tokens – for example, susceptibility to cyber-attacks and risk of consumer losses and fraud.

4.16 There are already established regulatory structures to

accommodate products which provide entry into the market for commodities or other assets (e.g. collective investment schemes, derivatives, or other fund structures). Indeed, where a particular arrangement meets the definition of a collective investment scheme in section 235 of FSMA then persons operating those arrangements will need to be authorised (unless exempt), will be subject to existing regulation, and the tokens themselves will constitute units to which relevant regulation will also likely apply.

4.17 For these reasons, HM Treasury does not consider a bespoke

regulatory regime for commodity-linked tokens to be required. If a commodity-linked token meets the definition of a specified investment, or the arrangements relating to the token meet the definition of a collective investment scheme, it should continue to be regulated accordingly, whether or not distributed ledgers are used in the underlying technology.

4.18 If there are other commodity-linked tokens which do not meet

the definition of a specified investment or financial instrument, but do meet the definition of a cryptoasset, then the activities relating to these tokens could be adequately catered for through the broader cryptoasset regime described in this consultation – including financial promotions rules (Chapter 3), disclosure rules for tokens which are admitted to trading or offered to the public (Chapter 5) and market abuse rules (Chapter 9). HM Treasury’s preference is to have a single, consistent framework to govern the trading, exchange, and custody of these tokens. Commodity-linked tokens would not qualify as a

20 CoinMarketCap; HM Treasury Analysis.

stablecoin under the proposed regime for fiat-backed stablecoins which only applies to those which are backed by fiat currency.

4.19 “Crypto-backed tokens” are those which reference their value in

relation to other cryptoassets. Given the volatility of non-backed cryptoassets (such as Bitcoin), crypto-backed tokens may be “over- collateralised”, which means that they are backed with assets which are worth more than their value. For instance, £100 of Bitcoin may be required to collateralise the £50 value of a Bitcoin-backed token to account for fluctuations in the value of the underlying asset. There are several use cases for crypto-backed tokens. For some, they represent a more decentralised version of fiat-backed tokens, since they can be created through the use of smart contracts with no central entity controlling them. Crypto-backed tokens can also be issued to enable a cryptoasset to launch on a different blockchain.

4.20 As with commodity-linked tokens, crypto-backed tokens can

sometimes be marketed as “stablecoins” which are pegged to a currency, with a reserve of cryptoassets forming the collateral. Given that such tokens use unbacked cryptoassets as collateral, they are only as stable as the underlying cryptoasset. Whilst crypto-backed tokens are typically overcollateralised, the value of the unbacked cryptoassets underpinning the token can still vary drastically both inter and intra- day. This volatility could potentially undermine the stability of the crypto-backed token’s price.

4.21 For these reasons, HM Treasury’s starting point is that crypto-

backed tokens should be regulated in the same way as unbacked cryptoassets such as Bitcoin. However, depending on the structure and characteristics associated with the tokens, they could meet the definition of a specified investment and/or the arrangements carried on in relation to them could meet the definition of a collective investment scheme, in which case the tokens and activities carried on will likely be subject to regulation. Crypto-backed tokens would not qualify as a stablecoin under the proposed regime for fiat-backed stablecoins, which only applies to those which are backed by fiat currency.

4.22 Some of the more specific risks relating to asset-referenced

tokens – such as risks around the misrepresentation of the backing assets and/or the ability to redeem the tokens – are intended to be addressed through the proposed approach to activities regulation. In particular, the issuance and disclosures regime covered in Chapter 5 will provide a mechanism to protect against false information or major omissions in admission documents which will be required for cryptoassets made available for trading on a UK cryptoasset trading venue.

4.23 This will be reinforced through the cryptoasset financial

promotions regime which will require (amongst other proposals) in- scope promotions to be clear, fair and not misleading. This should reduce the risk of any token marketing itself as stable where this is

potentially not the case.21 Financial stability risks potentially posed by the widespread adoption of asset-referenced tokens used in payments could be addressed by the regime expected to be put in place through the new concept of a “Digital Settlement Asset” in the Banking Act 2009 being introduced via the FS&M Bill – which could capture such tokens if needed.

Activities relating to so-called algorithmic stablecoins

4.24 So-called algorithmic stablecoins are a type of token that aims to

maintain a stable price largely, or in some part, through an algorithm that facilitates a change in supply and demand between the coin and one or more cryptoassets that support it. For example, the recently collapsed TerraUSD token relied on a linked cryptoasset called “Luna”. Algorithmic stablecoins are typically undercollateralised as they don’t require independent assets in reserve. Instead, the model relies on economic incentives for individual users who are able to use any fluctuation in the stablecoin as an arbitrage opportunity.

4.25 HM Treasury is not proposing to ban algorithmic tokens or to

leave them outside the regulatory perimeter – an approach which has been proposed by some jurisdictions. However, given the undercollateralised nature of these tokens, so-called algorithmic stablecoins share characteristics with unbacked cryptoassets. As such, they would not qualify as a stablecoin under the proposed regime for fiat-backed stablecoins - which only applies to those which are backed by fiat currency. Their promise of ‘stability’ could also lead to different risk behaviours by investors. It is not clear that regulating the algorithm itself would provide adequate stability for this class of tokens given that the stability mechanism relies on constant trading by economic actors. For these reasons, HM Treasury considers that activities relating to so-called algorithmic stablecoins should be subject to the same requirements as for unbacked cryptoassets. As noted above, cryptoasset financial promotions rules should reduce the risk of firms marketing algorithmic stablecoins as “stable”, “payments instruments” or very similar terms where the use of those terms would be misleading.

Activities relating to Non-Fungible Tokens (NFTs) and

utility tokens

4.26 An NFT is a digital asset that represents a real-world object, such

as a digital only artwork, music, or game. Like other cryptoassets, NFTs use a technology such as DLT to record and verify ownership. Unlike some other cryptoassets, NFTs are not fungible; each NFT is unique and cannot be mutually traded or substituted for another token. There are a

21 Per FCA Guidance in COB 4.2.5 (G): a communication or a financial promotion should not describe a feature of a product or service as guaranteed”, “protected” or “secure”, or use a similar term unless that term is capable of being a fair, clear and not misleading description of it

number of risks associated with the NFT market including fraud, market manipulation and money laundering.

4.27 Utility tokens are cryptoassets which provide digital access to a

specific service or application (e.g. digital advertising or digital file storage) and use a technology such as DLT to support the recording or storage of data. They do not provide the rights or features associated with a security token (e.g. share or ownership rights), and do not function as a means of payment, though they can be traded on cryptoasset trading venues for investment purposes.

4.28 As noted in Chapter 2, financial services activities will be

regulated, rather than the asset itself. All cryptoassets featured in Box 2.A – including NFTs and utility tokens – would have the potential to be in included in the future regulatory perimeter if they were used in one of the activities in Table 4A. If an NFT or utility token is not used in such a way, it would not fall into scope of financial services regulation unless – as a result of the particular structure and characteristics of the NFT or utility token – it constitutes a specified investment and the activities carried on in relation to the token constitute regulated activities that fall within the existing perimeter.

Box 4.A: Questions for Respondents

7. Do you agree with the proposed territorial scope of the regime? If

not, then please explain why and what alternative you would suggest.

8. Do you agree with the list of economic activities the government

is proposing to bring within the regulatory perimeter?

9. Do you agree with the prioritisation of cryptoasset activities for

regulation in phase 2 and future phases?

10. Do you agree with the assessment of the challenges and risks

associated with vertically integrated business models? Should any additional challenges be considered?

11. Are there any commodity-linked tokens which you consider

would not be in scope of existing regulatory frameworks?

12. Do you agree that so-called algorithmic stablecoins and crypto-

backed tokens should be regulated in the same way as unbacked cryptoassets?

13. Is the proposed treatment of NFTs and utility tokens clear? If not

please explain where further guidance would be helpful.

Chapter 5

Regulatory Outcomes

for Cryptoasset Issuance and Disclosures

5.1 Within traditional financial services the closest parallel to the

creation, issuance and distribution of cryptoassets probably exists in the securities markets. In the UK, company shares are governed in the first place by company law (primarily the Companies Act 2006) and financial services securities regulation is applied to transferable securities at the point at which they are offered to the public or admitted to trading on a regulated market. It is a criminal offence to make an offer or request admission to trading of transferable securities without an approved prospectus, although a number of exemptions are available – for example for offers addressed only to wholesale investors or offers which fall below a certain value threshold.

5.2 For cryptoasset issuance and disclosures, the government

proposes to follow a similar approach to that for securities and apply regulation when the asset is admitted to trading on a regulated cryptoasset trading venue and therefore becomes exchangeable for fiat currency, or subject to a public offer. In line with the approach applied to securities, HM Treasury does not intend to directly regulate the “creation” of unbacked cryptoassets under financial services regulation.

5.3 The actors involved in the “issuance” process for cryptoassets –

and the ways in which they subsequently behave once the cryptoassets have been issued – differ significantly from transferable securities such as bonds and equity instruments. Cryptoassets such as Bitcoin do not provide a claim on an identifiable issuer since coins can be created or “minted” according to a protocol which has been coded by computer developers often based in overseas or unknown locations. Even where the creator of the cryptoasset is identifiable, they do not have the same level of control over it as a company does over the securities it issues.

5.4 The FSB is consulting on the recommendation that “authorities

should have the appropriate powers and tools, and adequate resources to regulate, supervise, and oversee crypto-asset activities and markets, including crypto-asset issuers”. However, the paragraph above highlights some of the challenges and limitations of applying existing issuance and disclosure regulations which were developed for traditional financial markets. Other jurisdictions are taking a range of approaches to tackle this. In terms of public offers of cryptoassets

(roughly equivalent to an Initial Public Offering (IPO)) some countries have developed bespoke frameworks to govern Initial Coin Offerings (ICOs), whilst others deliberately do not on the basis that most ICOs would meet the criteria for being a security offering, and therefore are within existing laws. In terms of cryptoassets which are admitted to trading on an exchange or trading venue, some jurisdictions require approval by the relevant regulator to designate the cryptoasset as an “accepted asset”, or to confirm that it does not represent a security. There is also precedent for Self-Regulatory Organisations (SROs) in this space, for example the Japan Security Token Offering Association (JSTOA) is an SRO with a mandate to ensure security token offerings (STOs) comply with local securities laws.

High level regulatory outcomes

5.5 The government proposes to establish an issuance and

disclosures regime for cryptoassets grounded in the intended reform of the UK prospectus regime – the Public Offer and Admissions to Trading Regime – and tailored to the specific attributes of cryptoassets. The following list sets out the regulatory outcomes the government is seeking: • a minimum standard of information regarding a cryptoasset should be available so investors are able to make informed investment decisions; this should be subject to a ‘necessary information test’, striking a balance between the interests of the investor and avoiding a disproportionate burden on the issuer or trading venue • appropriate liability and compensation should be available for untrue or misleading statements made in disclosure / admission documents • an appropriate level of due diligence should be performed over the content of disclosure / admission documents • an appropriate level of investor protection should be offered around marketing materials and advertisements, and trading venues should have in place rules governing marketing materials / product appropriateness • there should be controls or procedures to prevent a harmful offer from being made (e.g. to detect fraud)

Proposed regulatory approach

5.6 The proposed approach would generally follow the principles of

the intended reform of the UK prospectus regime – the Public Offer and Admissions to Trading Regime. 22

22https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/1123008/Policy_Note_Admissions_to_Trading_and_Public_Offer_Regime_Illustrative_Statutory_Instrument.pdf

5.7 Under the intended reforms there will be a general prohibition

on public offerings of securities, subject to certain exemptions. These include (i) where the securities are admitted to trading on a UK Regulated Market (ii) where the securities are admitted to trading on MTFs operating primary markets and (iii) securities offered via a “public offer platform” (a new bespoke permission for platforms facilitating public offers of unlisted securities, such as crowdfunding platforms). In addition, certain exemptions are intended to be available according to the type or scope of public offer, including offers below a de minimis monetary threshold, offers made only to “qualified investors” and offers made to fewer than 150 persons.

5.8 For securities admitted to trading on a Regulated Market, the

FCA will set detailed rules, including on whether a prospectus is required and what it should contain. For securities admitted to trading on an MTF, the FCA would be given rulemaking powers to ensure that, in appropriate circumstances, the rulebooks of MTFs operating as primary markets require an admission document to be published and treated as a prospectus. Those admission documents will therefore also be subject to the statutory compensation remedy for prospectuses. 5.9 Outside of admissions to trading on a regulated market or MTF, the government intends to continue to allow companies to offer securities to the public where certain conditions apply regarding the size of the offer. An alternative route will also be available, through which offers can be made to the public via a new regulated activity covering the operation of an electronic platform for the public offering of securities (such as a crowdfunding platform). In this case, a prospectus will not be required, but the FCA will determine the detailed requirements for such platforms including the levels of due diligence and disclosure required on offers made through them.

5.10 For cryptoassets, two regulatory trigger points have been

considered:

1. Admitting (or seeking the admission of) a cryptoasset to a

cryptoasset trading venue

2. Making a public offer of cryptoassets (including ICOs)

5.11 For admission of cryptoassets to a UK cryptoasset trading

venue, the government is proposing to adapt the MTF model from the intended reform of the UK prospectus regime. The FCA would include principles in their rule book for admission and disclosure requirements that cryptoasset trading venues would then be responsible for administering. Cryptoasset trading venues would be responsible for writing more detailed content requirements for admission and disclosure documents as well as performing due diligence on the entity admitting the cryptoasset. Where there is no issuer (e.g. Bitcoin), the trading venue would be required to take on the responsibilities of the issuer if they wish to admit the asset to trading. The venue would be given a choice as to whether the admission and disclosure document itself has to comply with financial promotions

rules, or whether it has to be accompanied by a separate document for this purpose. All admission and disclosure documents would then be stored on the National Storage Mechanism (NSM), maintained by the FCA.23

5.12 The government considers public offers of cryptoassets –

including ICOs where a fund raiser creates new tokens and sells them to investors – may meet the definition of a security offering. The presence of a token per se does not fundamentally change the nature of a capital raising event from a regulatory perspective. For public offers of cryptoassets which meet the definition of a security offering and are considered an STO, the intended Public Offers and

Admissions to Trading Regime could be an adequate regulatory

framework to capture this activity. Accordingly, public offers of cryptoassets which are deemed to be security token offerings which were less than the de minimis monetary threshold in the reformed regime would be exempt. Those that were larger, would need to go through a public offer platform (or a Regulated Market or a primary MTF) and would not require a prospectus; instead, due diligence would be done via the platform according to the platform’s rules.

5.13 For public offers of cryptoassets which do not meet the definition

of a security token offering, the government is considering an alternative route to regulate the activity. The DAR – or similar legislative mechanism – could be used to prohibit these offers unless they were conducted via a regulated platform. Again, due diligence would need to be performed by the platform according to its rules.

5.14 The FCA will also consider whether ongoing disclosures should

be required subsequent to cryptoassets being admitted to a trading venue in order to ensure a minimum standard of information is available to investors.

5.15 The proposed features of the regime are summarised in Table 5.A

below:

Table 5.A. Proposed design features for cryptoasset issuance and disclosures regime

Basis for the

regime • A mix of provisions from existing MTF and public offer platform disclosure regimes • Specific characteristics and risks of cryptoasset issuance will need to be accommodated (e.g. disclosing details of the underlying technology)

23 https://www.fca.org.uk/markets/primary-markets/regulatory-disclosures/national-storage-mechanism

Definition /

regulatory trigger point • Admitting (or seeking admission of) a cryptoasset to a cryptoasset trading venue,24 which will be in accordance with the venue’s admission requirements and subject to overarching FCA-defined principles set out in their rulebook • Making a public offer of a cryptoasset (including ICOs), which would need to be done via a regulated platform

Responsibility

for defining content requirements and vetting disclosure / admission document content • The venue will write detailed requirements for disclosure documents required for admission, in accordance with principles established in the FCA’s rulebook • The government does not expect these admission disclosure documents to take the same shape and form as a traditional prospectus given specific characteristics and investor profiles of cryptoassets • Venues should be required to reject the admission of cryptoassets should they consider that it may result in investor detriment

for preparing the disclosure / admission document content • The issuer or the trading venue would prepare the admission documents, should they be willing to take on all the associated responsibilities, including consideration within their prudential requirements • The FCA will also consider whether ongoing disclosures should be required subsequent to a cryptoasset being admitted to a venue, in order to ensure a minimum standard of information is available to investors; this could cover information such as code audits, or planned changes to the way a cryptoasset functions (e.g. the recent Ethereum “merge”)

Liability for

disclosure / admission document content • Liability would be applied to the preparer of the document, which could be the issuer or the trading venue • Clear liability should be attached to the preparer of the document • A necessary information test (see below) would be used to determine liability outcomes - for example where an investor had suffered loss as a result of the preparer of the disclosure / admission document omitting necessary information.

24 See Chapter 6 for description of a cryptoasset trading venue

• Liability standards are likely to be based on the “negligence standard” currently applicable to the contents of a prospectus under the existing prospectus regime (Section 90, Schedule 10 FSMA) or the “recklessness standard” currently applicable to information published via a recognised information service under the existing prospectus regime (Section 90A, Schedule 10A FSMA), or some hybrid of the two according to the type of disclosure (e.g. distinguishing between certain types of forward- looking information) • Some prudential requirements are likely to be necessary for issuers to ensure they are able to absorb losses arising from liability (either through adequate financial resources or professional indemnity arrangements)

Proposed

necessary information test for cryptoasset disclosure / admission documents • We provisionally consider that disclosure documents (which could be required for either an offer to the public, where not already required by existing law, or for admission onto a trading venue) could require the following as necessary information material for an investor making an informed assessment of the cryptoasset: ‒ the features, prospects and risks of the cryptoassets ‒ the rights and obligations attached to the cryptoassets (if any) ‒ an outline of the underlying technology (including protocol and consensus mechanism) ‒ if applicable, the person seeking admission to trading on a cryptoasset trading venue • Information may vary depending on the following: i) the type and design of the cryptoasset; or ii) if, or as applicable, the nature and circumstances of the person making the public offer or seeking admission to trading on a cryptoasset trading venue

Admission

document storage and re- use • All admission and disclosure documents should be stored on the NSM, maintained by the FCA • Venues would be required to search the NSM before new admissions and ensure information is consistent with other documents lodged • Venues would be able to accept other regulated trading venues’ disclosure / admission documents if they chose

Marketing, disclosures, and promotions • Venues should have in place rules governing the accuracy and fairness of marketing materials / advertisements. • Where marketing materials / advertisements are available to retail investors, they will need to comply with the financial promotion regime. Exceptions likely to apply (e.g. for disclosures relating to cryptoassets which are only offered to qualified investors)

Box 5.A: Questions for Respondents

14. Do you agree with the proposed regulatory trigger points –

admission (or seeking admission) of a cryptoasset to a UK cryptoasset trading venue or making a public offer of cryptoassets?

15. Do you agree with the proposal for trading venues to be

responsible for defining the detailed content requirements for admission and disclosure documents, as well as performing due diligence on the entity admitting the cryptoasset? If not, then what alternative would you suggest?

16. Do you agree with the options HM Treasury is considering for

liability of admission disclosure documents?

17. Do you agree with the proposed necessary information test for

cryptoasset admission disclosure documents?

18. Do you consider that the intended reform of the prospectus regime

in the Public Offers and Admission to Trading Regime would be sufficient and capable of accommodating public offers of cryptoassets?

Chapter 6

Regulatory Outcomes

for Operating a

Cryptoasset Trading

Venue

6.1 Cryptoasset trading venues (often referred to as “exchanges”) are

still at a relatively early stage of development when compared to traditional financial market infrastructures. Many of the risks associated with cryptoasset trading are comparable to those of traditional exchanges, including operational disruptions and fraudulent or market abusive trading. However, the proliferation of cryptoasset trading venues across the globe has heightened challenges around monitoring trading venue activity (e.g. for AML purposes) and protecting consumers. Lack of regulation to support market integrity and increased fragmentation of liquidity across venues and jurisdictions is also creating more opportunities for market manipulation. The FSB have identified a range of other risks associated with cryptoasset trading venue activities, including counterparty credit, market, exchange rate and operational risks.

6.2 Most jurisdictions with existing regulatory frameworks for

cryptoassets have sought to address these challenges by defining persons who are operating a cryptoasset trading venue or offering exchange-like services as cryptoasset service providers (CASPs), or a similarly termed designation.25 CASPs are then subject to a range of obligations including authorisation or licensing rules, prudential requirements, operational resilience rules and conduct and consumer protection rules. This provides regulators with the appropriate powers and tools to regulate, supervise, and oversee cryptoasset activities and markets, including cryptoasset trading venues and other CASPs.

25 Also known by various other terms depending on the jurisdiction – e.g. Virtual Asset Service Providers (VASPs), Digital Payment Token (DPT) service providers, Crypto Asset Exchange Service Providers (CAESPs), Crypto

Asset Secondary Service Providers (CASSPrs)

High Regulatory Outcomes

6.3 The following list sets out the regulatory outcomes the

government is seeking to achieve through a cryptoasset trading venues regime: • there should be orderly, open and resilient conditions for trading on cryptoasset trading venues • venues should have transparent and fair access and operating rules • persons operating cryptoasset trading venues should have the people, processes, systems and controls to facilitate fair, orderly and efficient trading, and address conflicts of interest • persons operating cryptoasset trading venues should have the systems and processes for ensuring accurate market data (both on- and off-chain) is available in real time where appropriate

Proposed Regulatory Approach

6.4 HM Treasury is proposing to establish a regulatory framework

which is based on existing RAO activities of regulated trading venues – including the operation of an MTF. Accordingly, persons carrying out these activities would be subject to prudential rules and various other requirements including consumer protection, operational resilience, and data reporting. This is set out in further detail below.

Table 6.A. Proposed design features for cryptoasset trading regime

Definition /

regulatory trigger point • Operating a cryptoasset trading venue

Basis for the

regime • To be based on existing RAO activities of regulated trading venues, including the operation of an MTF • Specific characteristics and risks of cryptoasset trading activities will need to be accommodated (e.g. cyber security risks or risks arising from conflicts of interests which are specific to the cryptoasset industry)

Authorisation

rules • Authorisation will be required since operating a cryptoasset trading venue will become a regulated activity under the RAO • Applications should include details of operations, services and business plans, description of organisational and governance arrangements, description of controls and risk management

processes, cybersecurity, outsourcing arrangements and financial resources

Location

requirement • Scope will be set by whether: i) firms are incorporated in the UK; and ii) services are being provided to UK persons (natural or legal) • Requirements on physical location to be determined by the FCA. It is expected that this will be informed by the FCA’s existing framework for international firms (see Chapter 4 for further detail)26. • Firms operating cryptoasset trading venues would likely require subsidiarisation in the UK given their critical role in the cryptoasset value chain

Prudential

requirements • Persons operating trading venues should have sufficient financial resources to conduct business in a prudent manner • Thresholds to be set by the FCA – e.g. minimum capital, liquidity and other relevant prudential requirements addressing both the potential for harm from on-going operations and the ability to wind-down in an orderly manner

Consumer

protection and governance requirements • Venues should have fair, open and transparent access rules and fee schedules • Conflicts of interest should be appropriately identified and managed. Separate entities may be required should conflicts prove unmanageable • Persons operating trading venues should have robust governance arrangements • There should be adequate procedures for handling customer complaints

Operational

resilience requirements • Persons operating trading venues should have the people, processes, systems, controls and arrangements to ensure that their trading systems are resilient, including under conditions of market stress • Outsourcing arrangements should require appropriate due diligence, ongoing oversight and formal documentation

26 https://www.fca.org.uk/publication/corporate/approach -to-international-firms.pdf

• Trading systems should be subject to effective business continuity, disaster recovery arrangements and cyber security protections Data reporting • Cryptoasset trading venues should have the capability to make accurate and complete information readily accessible for both the on- and off-chain transactions which they facilitate • This should include the need to have systems in place for sharing information, such as order book data, with other trading venues that admit the same cryptoasset to trading for market abuse monitoring purposes (see Chapter 9) • Specific requirements to be set by the FCA, which are likely to require order book data and transaction information (e.g. type of cryptoasset, price, time stamp, wallet information) and information concerning management of large positions (e.g. size of holdings and holder information for large positions) – as well as market abuse reporting (see

Chapter 9)

• This could potentially be done through arrangements with specialist blockchain surveillance providers as an alternative to using or developing in-house capabilities • Authorities would retain the ability to propose more regular and wider reporting over time

Resolution and

Insolvency

• Insolvency powers under Part 24 of FSMA should apply, enabling the FCA to participate in insolvency proceedings governed by the Insolvency Act • The government will consider whether a bespoke resolution regime should be developed in time (e.g. new special administration regime)

Box 6.A: Questions for respondents

19. Do you agree with the proposal to use existing RAO activities

covering the operation of trading venues (including the operation of an MTF) as a basis for the cryptoasset trading venue regime?

20. Do you have views on the key elements of the proposed

cryptoassets trading regime including prudential, conduct, operational resilience and reporting requirements?

Chapter 7

Regulatory Outcomes

for Cryptoasset

Intermediation Activities

7.1 As with traditional financial markets, cryptoasset intermediaries

play an important role in the ecosystem. Dealers and liquidity providers make markets in cryptoassets, helping to increase order book depth and narrow spreads. Some firms facilitate cryptoasset trading by arranging transactions which take place “off-exchange” (i.e. not on a centralised order book). Agency brokers help execute trades on behalf of investors and other market participants. Specialist cryptoasset firms and some large traditional financial services firms operate in this space.

7.2 The FSB have highlighted a number of risks that can arise from

these activities, including those arising from conflicts of interest and, in the case of some business models, credit and liquidity risks.27 Most jurisdictions with established regulatory frameworks for cryptoassets have sought to bring these types of activities into the regulatory perimeter in some way, often through adapting securities legislation.

7.3 The activities of these market intermediaries have much in

common with regulated activities such as “arranging deals in investments” and “making arrangements with a view to transactions in investments” set out in Article 25 of the RAO. For these already regulated activities, the FCA’s Senior Management Arrangements, Systems and Controls (SYSC) sourcebook contains requirements on management bodies, systems and controls and conflicts of interest, while MIFIDPRU is the FCA handbook which sets out relevant prudential rules. Conduct of business requirements regulating the way firms interact with their clients, including rules on acting in clients’ best interests, communicating with clients, and the execution of client orders are contained in various articles of MiFID II (including Articles 24 to 30) and in the FCA’s Conduct of Business Sourcebook (COBS).

High level regulatory outcomes

7.4 The regulatory outcomes the government is seeking to achieve

through a cryptoasset market intermediaries regime include the following:

27 https://www.fsb.org/wp-content/uploads/P111022-3.pdf

• there should be fair and transparent conditions for any trades executed for, or on behalf of, a third party • trades should be executed in a way that serves the best interest of the client • persons offering cryptoasset market intermediation should have effective controls and arrangements to manage conflicts of interest • persons offering cryptoasset market intermediation should have sufficient financial resources to conduct business in a prudent manner • persons operating cryptoasset trading venues should have systems and processes to be able to detect market abuse and submit suspicious transaction and order reports (STORs)

Proposed regulatory approach

7.5 The government proposes that requirements applying to

analogous regulated activities – such as “arranging deals in investments” and “making arrangements with a view to transactions in investments” set out in article 25 of the RAO – would be used and adapted for cryptoasset market intermediation activities. The government does not consider that there are many major differences required to existing requirements for investment firms but there may need to be additional rules or guidance to address specific risks and characteristics of cryptoasset market intermediation activities (e.g. to address conflicts of interest that arise from more vertically integrated cryptoasset business models, or specific controls or resilience requirements). The proposed design features of the regime are set out in further detail in Table 7.A below.

Table 7.A Proposed Design Features for Cryptoasset

Market Intermediation Regime

Definition /

regulatory trigger point28 • Dealing in cryptoassets as principal or agent • Arranging (bringing about) deals in cryptoassets • Making arrangements with a view to transactions in cryptoassets

28 For analogous activities in the existing regulatory perimeter, readers should refer to i) Article 14 of the RAO (“Buying, selling, subscribing for or underwriting….as principal); ii) Article 21 of the R AO (“Buying, selling, subscribing for or underwriting….as agent); iii) Article 25(1) of the RAO (“Making arrangements for another person (whether as principal or agent) to buy, sell, subscribe for or underwrite…”) ; and iv) Article 25 (2) of the RAO (“Making arrangements with a view to a person who participate s in the arrangements buying, selling, subscribing for or underwriting…(whether as principal or agent)… ”)

Basis for the

regime • MiFID derived rules applying to similar “investment services and activities” – e.g. dealing on own account, (Annex I, Section A (3) of MiFID), execution of orders on behalf of clients (Annex I, Section A (2) of MiFID) and reception and transmission of orders in relation to one or more financial instruments (Annex I, Section A (1) of

MiFID)

Authorisation

rules • Authorisation will be required since the above listed activities will become regulated activities under the RAO • Applications should include details of operations, services and business plans, description of organisational and governance arrangements, description of controls and risk management processes, cybersecurity, outsourcing arrangements, and financial resources

Location

requirements • Scope will be set by whether: i) firms are incorporated in the UK; ii) services are being provided to UK persons (natural or legal) • Requirements on physical location to be determined by the FCA. It is expected that this will be informed by the

FCA’s existing framework for international firms (see

Chapter 4 for more details)29

Consumer

protection and governance requirements • Persons offering cryptoasset intermediation services should act honestly and fairly, and in the best interests of their clients • Conflicts of interest should be appropriately identified and managed • All reasonable steps should be made to obtain the best possible result for the client when executing a client order • Firms should assess cryptoassets as appropriate for the consumer before an application or order to purchase can be made • Trading arrangements should be transparent to clients - e.g. liquidity sourcing and execution methods, related parties, fees and price methodology

Data

reporting • Persons professionally intermediating orders should have the systems and controls to be able to detect market abuse and submit STORs to the relevant trading venue (see Chapter 9)

29 https://www.fca.org.uk/publication/corporate/approa ch-to-international-firms.pdf

• Authorities would retain the ability to put in place further reporting requirements in future, including regular and wider reporting over time

Prudential

requirements • Persons offering cryptoasset intermediation services should have sufficient financial resources to conduct business in a prudent manner • Thresholds to be set by the FCA – e.g. minimum capital, liquidity and other relevant prudential requirements addressing both the potential for harm from on-going operations and the ability to wind-down in an orderly manner

Operational

resilience requirements • Persons offering cryptoasset intermediation services should have adequate people, processes, systems, and controls to mitigate operational resilience risks • Outsourcing arrangements should require appropriate due diligence, ongoing oversight, and formal documentation

Resolution

and insolvency • Insolvency powers under Part 24 of FSMA should apply, enabling the FCA to participate in insolvency proceedings governed by the Insolvency Act • The government will consider whether a bespoke resolution regime should be developed in time (e.g. new special administration regime)

Box 7.A: Questions for respondents

21. Do you agree with HM Treasury's proposed approach to use the

MiFID derived rules applying to existing regulated activities as the basis of a regime for cryptoasset intermediation activities?

22. Do you have views on the key elements of the proposed

cryptoassets market intermediation regime, including prudential, conduct, operational resilience and reporting requirements?

Chapter 8

Regulatory outcomes for

cryptoasset custody

8.1 In financial services, the term custody broadly refers to a firm

holding an asset on behalf of another. In traditional financial models, investors rely on a custodian to access global markets and secure their assets to reduce risk of theft or loss. In the UK, there is an established custody regulatory framework for traditional finance which is primarily set through Article 40 of the RAO and the FCA’s Client Assets Sourcebook (CASS). These requirements aim to protect investors’ custody assets while a firm is a going concern such that, if and when the custodian becomes insolvent, those assets are returned to investors promptly and as whole as possible.

8.2 Custody represents one of the key aspects of the cryptoasset

lifecycle in terms of providing investors access to, and safe storage of, their assets. Custody of cryptoassets is conceptually similar to traditional finance as the custodian holds itself out as being responsible for safekeeping a cryptoasset on behalf of another. However, in contrast to traditional finance custody, information is recorded on DLT (often pseudonymously) and the custodian generally holds a ‘private key’30 that allows access and usage of the cryptoasset. Custody providers can use a range of technology solutions to secure the assets and private keys – for example, cold (offline) storage or multi-signature hot (online) wallets, as well as techniques such as multi-party computation.31 They can also undertake off-chain transactions outside of the blockchain network. Therefore, the digital nature of the asset means that cryptoasset custody operates differently from traditional finance custody arrangements in some important ways. The irreversible, immutable nature of cryptoasset transactions also means that protecting against unauthorised access to these private keys is especially important.

8.3 Currently there is no regime for cryptoasset custody in the UK

and industry feedback has highlighted that there is a wide variance of cryptoasset custody business models and practices. If a cryptoasset custodian were to fail today, the lack of a clear regulatory framework results in uncertainty that would likely cause harm by delay and cost to

30 A private key is a string of alphanumeric characters – similar to a password – which is used to perform functions like signing and authorising a cryptoasset transaction 31 Multi-party computation enables multiple parties – each with their own private data – to evaluate a computation without ever revealing any of the private data held by each party

investors in obtaining their assets back. More significantly, without clear and tailored regulatory standards to which firms are required to adhere, cryptoassets may not be safeguarded adequately, leading to risk of losses should the firm enter insolvency (either as a consequence of the assets being treated as assets of the firm or due to loss, fraud or operational errors). In addition to the harm to investors, an outcome that results in uncertainty in insolvency could also impact confidence in the market.

8.4 Related work underway by the Law Commission, exploring

whether English and Welsh law needs to be adapted to accommodate digital assets, has considered different custody arrangements and the legal obligations that they may give rise to. Future recommendations from this work will be considered in developing the regime.

8.5 Liability standards for custodians are also under consideration by

the authorities. The government is exploring taking a proportionate approach which may not impose full, uncapped liability on the custodian in the event of a malfunction or hack that was not within the custodian’s control.

8.6 As noted in Chapter 4, custody requirements will be addressed

through phase 1 for fiat-backed stablecoins and under Phase 2 for other types of cryptoassets that come into the regulatory perimeter. The government expects the same custody requirements will be adopted for all types of cryptoassets as they come into regulation. For cryptoassets that already meet the definition of a specified investment (security tokens), the existing regulatory framework that currently applies will be replaced by the new custody regime. The FCA expect to run a separate consultation on this.

High level regulatory outcomes

8.7 The following list sets out the regulatory outcomes the

government is seeking to achieve through a cryptoasset custody regime:

1. custodians should ensure adequate arrangements to safeguard

investors’ rights to their cryptoassets when it is responsible for them such that, if and when the custodian becomes insolvent, those assets are returned to investors promptly and as whole as possible

2. custodians should have sufficient financial resources to conduct

business, wind down and, where applicable, fail without causing significant harm to consumers and market participants

3. custodians should establish clear processes for redress in the event

that cryptoassets held in custody are lost

4. custodians should maintain adequate systems, controls and

governance arrangements to help minimise risk of misuse or loss to investors’ cryptoassets

5. authorities would retain the ability to put in place more

comprehensive reporting requirements in future, including regular and wider reporting over time

Proposed regulatory approach

8.8 The government is proposing to apply and adapt existing

frameworks for traditional finance custodians under Article 40 of the RAO for cryptoasset custody activities, making suitable modifications to accommodate unique cryptoasset features, or putting in place new provisions where appropriate. Key design features are set out in further detail in the table below.

Table 8.A. Proposed Design Features for Cryptoasset

Custody Regime

Definition /

regulatory trigger point • Safeguarding, or safeguarding and administering (or arranging the safeguarding or safeguarding and administering) of a cryptoasset other than a fiat- backed stablecoin and / or means of access to a cryptoasset (e.g. a wallet or cryptographic private key) • This activity would be broader than the closest equivalent regulated activity (Article 40 of the RAO) as it would capture firms that only safeguard (but not administer) assets (e.g. firms that solely safeguard cryptographic private keys which provide access to cryptoassets). The government considers those arrangements in the cryptoassets market to pose the same risks of harm as firms that safeguard and administer assets. This broader definition is also consistent with the definition of cryptoasset custodians in the Money Laundering and Terrorist

Financing (Amendment) Regulations 2019

Basis for the

regime • Existing frameworks for traditional finance custodians under Article 40 of the RAO, making suitable modifications to accommodate unique cryptoasset features, or putting in place new provisions where appropriate (e.g. specific controls and safeguards for the safekeeping of private keys)

Authorisation /

licensing rules • Authorisation will be required since the activities described above are expected to become regulated activities • Applications should include details of operations, services and business plan, description of organisational and governance arrangements, description of controls and risk management

processes, cybersecurity, outsourcing arrangements, and financial resources

Location

requirements • Scope will be set by whether: i) firms are incorporated in the UK; or ii) services are being provided to UK persons (natural or legal) • Requirements on physical location to be determined by the FCA. It is expected that this will be informed by the FCA’s existing framework for international firms (see Chapter 4 for more details)32

Custody /

safeguarding / client assets rules (CASS) • Existing custody provisions in the Client Assets Sourcebook (CASS) to be used as a basis to design bespoke custody requirements for cryptoassets.

These provisions aim to protect investors’ rights to

their assets while a firm is a going concern such that, if and when a custodian becomes insolvent, assets are returned to investors promptly and as whole as possible. Core components of the custody provisions are expected to be the following: ‒ adequate arrangements to safeguard investors’ rights to their cryptoassets (e.g. restrict commingling of investors’ assets and the firm’s own assets) ‒ adequate organisational arrangements to minimise risk of loss or diminution of investors’ custody assets ‒ accurate books and records of investors’ custody assets holdings ‒ adequate controls and governance over safeguarding arrangements of investors’ custody assets holdings

Prudential

requirements • Persons offering cryptoasset custody should have sufficient financial resources to conduct business in a prudent manner • Thresholds to be set by the FCA – e.g. minimum capital, liquidity and other relevant prudential requirements addressing both the potential for harm from on-going operations and the ability to wind- down in an orderly manner • Analogous regimes will be considered as a starting point for policy development)

32 https://www.fca.org.uk/publication/corporate/approach-to-international-firms.pdf

Consumer

protection and governance requirements • Availability of FSCS protection for claims against failed authorised cryptoasset custodians under consideration and to be determined by FCA • Persons offering cryptoasset custody should have robust governance arrangements • Conduct of business requirements (e.g. client disclosures, clear contractual terms) should be met by persons offering cryptoasset custody

Operational

resilience requirements • Persons offering cryptoasset custody should have adequate people, processes, systems, and controls to mitigate operational resilience risks related to custody, such as inaccurate record-keeping, loss or malfunction of means of access to cryptoassets, and / or mismanagement or misuse of cryptoassets • Outsourcing (including sub-custodian) arrangements should require appropriate due diligence, ongoing oversight and formal documentation

Resolution and

insolvency • Insolvency powers under Part 24 of FSMA should apply, enabling the FCA to participate in insolvency proceedings governed by the Insolvency Act • The government will consider whether a bespoke resolution regime should be developed (e.g., new special administration regime)

Box 8.A: Questions for Respondents

23. Do you agree with HM Treasury’s proposal to apply and adapt

existing frameworks for traditional finance custodians under Article 40 of the RAO for cryptoasset custody activities?

24. Do you have views on the key elements of the proposed

cryptoassets custody regime, including prudential, conduct and operational resilience requirements?

Chapter 9

General Market Abuse

Requirements

9.1 In traditional financial services, the UK has a market abuse

regime (MAR) which applies to i) financial instruments that are admitted (or requested to be admitted) to trading on a regulated UK, Gibraltar or EU trading venue and ii) other financial instruments (e.g. derivatives) whose price depends on those instruments. MAR defines and prohibits insider dealing, unlawful disclosure of inside information and market manipulation. All persons, regardless of where they are based, are subject to the prohibitions on market abuse.

9.2 MAR places various obligations on market participants to prevent

and detect market abuse. For example, issuers must maintain lists of persons who have access to inside information (insider lists) and must disclose inside information which concerns the issuer as soon as possible, although delayed disclosure is permissible if certain conditions are met. Trading venues must maintain effective arrangements, systems, and procedures to prevent and detect market abuse. Persons professionally arranging or executing transactions must also have in place arrangements, systems, and procedures to detect and report Suspicious Transaction and Order Report (STORs) and notify these to the FCA without delay. A suspicious transaction or order is one where there are ‘reasonable grounds’ to suspect it might be market abuse. In addition to requirements under UK MAR, authorised firms must also have policies and procedures for countering the risk that the firm might be used to further financial crime, including market abuse (see FCA Financial Crime Guide).33

9.3 The table in Annex B sets out core elements of the behaviours

that constitute the three offences under the retained EU law version of the Market Abuse Regulation (596/2014) (UK MAR).34

9.4 While the technology and the channels used to conduct market

abuse may be different in cryptoasset markets compared to traditional markets, the types of activities and behaviours are similar. There is

33 https://www.handbook.fca.org.uk/handbook/FCG.pdf

34 Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on market abuse (market abuse regulation) and repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission Directives 2003/124/EC, 2003/125/EC and 2004/72/EC (Text with EEA relevance) (Retained EU

Legislation)

significant evidence in cryptoasset markets of “pump and dump”35 and “trash and cash”36 schemes which resemble price manipulation strategies carried out on equity instruments. Other market manipulation behaviours which have been reported include “wash trading” and “spoofing”, among other trading techniques which seek to give false market signals or distort pricing to the advantage of the orchestrator. In addition to market manipulation, there are parallels to the activities of insider dealing or acting on non-public information, which are prohibited in securities markets. For example, there is evidence of “front-running” ahead of coin listings on cryptoasset exchanges, whereby a number of market participants have traded at favourable prices immediately before a coin listing (where the timing information of that coin listing was not available to the general public). Novel abusive behaviours may also be possible in cryptoasset markets.

9.5 One of the key challenges which policy makers and regulators

face is that some of the existing market abuse regulations are based around concepts and market structures which manifest themselves differently in cryptoasset markets versus traditional securities markets. For example, some of the requirements under the existing market abuse regulations are orientated around the concept of a traditional issuer. In traditional securities markets the issuer is often the main holder and creator of inside information which is reflected in the structure and design of the market abuse regulations. However, this concept does not translate easily to cryptoassets, since there may not be a clearly identifiable issuer, or the issuer may be an individual rather than a corporate entity. In these circumstances it may be challenging to place obligations on the “issuer” to control inside information. Further, as price movements in cryptoasset markets are often linked to supply and demand rather than the fundamental nature of the cryptoasset, inside information may be more likely to be held or created by entities other than the issuer – e.g. miners, validators and oracles.37 Manipulation from the “true” value of the cryptoasset may therefore be harder to detect.

9.6 Another difference versus traditional markets is that the

cryptoasset market currently has a higher proportion of direct retail participation. This creates a gap in the surveillance of market abuse as there may not be intermediaries who have obligations to detect and prevent market abuse. It is likely to be challenging to impose similar obligations on direct retail market participants.

35 “Pump and dump” schemes take place when the operator(s) of the scheme artificially inflate the price of an asset using false and misleading information in order to sell assets at a higher price ( “pumping”). The operators of the scheme then sell the overvalued assets (“dumping”) before the price collapses 36 “Trash and cash” schemes are the inverse of “pump and dump” schemes; the operator of the scheme disseminates false, misleading or damaging information about the asset (“trashing”) causing the market price to fall artificially. The scheme operators then buy the assets at undervalued prices (“cashing”) 37 Oracles connect blockchains to external systems, allowing smart contracts to be executed according to instructions and data held in legacy systems; they are a way of connecting traditional systems to decentralised infrastructures

9.7 The highly globalised, fragmented, and borderless nature of

cryptoasset markets makes the cross-border challenges of identifying and controlling market abuse behaviours materially more difficult than, for example, in more localised equity and fixed income markets where there are clear ‘main’ markets where the majority of trading is concentrated. Cryptoasset trading venues are globally accessible by retail and institutional market participants, and there is little geographic nexus between the trading venue, the entity who issued the cryptoasset and those trading the cryptoasset. At present there are thousands of tokens being traded within and across hundreds of cryptoasset trading venues domiciled in dozens of different countries. There is trading across the globe that contributes to price formation, with limited ability currently to exchange information globally. This global market makes it difficult for any single jurisdiction to effectively address the risks of market abuse. There is, at present, no agreement between international regulators on how to divide up the oversight or how to enable this in practical terms, although work is being undertaken in international forums to enable cooperation as regimes are developed.

9.8 Despite these challenges, HM Treasury believes there is a strong

case for including a market abuse regime in the proposed crypto regulatory framework. A well-functioning and efficient financial market requires market integrity. Market abuse regulation seeks to foster confidence in markets, balancing the benefits of market integrity against the cost of obligations on market participants, as well as their efficacy.

9.9 The underlying technology used in cryptoasset market structures

also offers some potential advantages. For example, the transparency of the blockchain may make it easier to identify instances of market abuse. There may be scope for collaboration between firms, regulators, and enforcement agencies to develop Regulatory Technology (RegTech) solutions to help detect, prevent and disrupt market abuse38.

However, there are currently notable limitations to this since

transactions on centralised exchanges happen off-chain, and much of the on-chain data can be difficult to cleanse and interpret, though capabilities may improve over time.

High level regulatory outcomes

9.10 Given the challenges and limitations identified above, the

government considers that the following are a sensible and realistic set of initial outcomes: • market participants should have a shared understanding of what constitutes unfair and abusive practices

38 For example, real time surveillance systems for trading venues, systems to share information across trading venues where the same cryptoasset is admitted to trading on multiple venu es, and blockchain analytics technologies

• market participants should understand their obligations to prevent, detect and take action against these practices • abusive practices can be sanctioned • markets should be structured to prevent market abuse, and to make it easier to detect and take action against abuse when it does occur • there should be a proportionate regime, with an appropriate balance between the benefits to consumers arising from market integrity versus the cost of obligations on market participants

9.11 In pursuit of several of the objectives above, a key consideration is

the appropriate balance of responsibilities between the FCA and cryptoasset trading venues. HM Treasury is very interested to hear views from industry on this. The proposed model would place the primary responsibility on the trading venues for preventing, detecting and disrupting market abuse. Trading venues would be expected to establish “who” the offenders are, to establish information sharing arrangements with other venues that admit the same cryptoassets, and to have an effective regime for disrupting market abuse such as the ability to publicly blacklist offenders.

9.12 This model could create greater scope for firms to develop

innovative technological approaches to detecting market abuse behaviours enabled by crypto innovation. The FCA would then be responsible for supervising trading venues and other regulated entities (i.e. intermediaries) to ensure they have the appropriate systems and controls to prevent, detect and disrupt market abuse.

9.13 The above represents a pragmatic approach which recognises

the practical challenges and limits of regulating a highly cross-border industry. This regime would not achieve the outcome of offering market integrity or protecting consumers to the same degree as in traditional markets for financial instruments, and therefore represents an area where the objective of “same risk, same regulatory outcome” is not considered to be achievable – at least in the foreseeable future. Longer term, with international standards and cooperation in place on surveillance, reporting and market abuse safeguards more broadly, HM Treasury is seeking to additionally achieve the following outcomes: • aspirationally, market prices should reflect genuine forces of supply and demand and should not be manipulated • market participants should be able to trade in a fair and orderly environment • market participants should have the same opportunities to access information

9.14 Until the point at which international standards and coordination

are in place between the majority of jurisdictions where the major

exchanges are domiciled, these objectives will be difficult to achieve and enforce. For example, price manipulation on an overseas exchange could impact the price of a cryptoasset on a UK exchange. Even in the long run, it is unclear whether the same outcomes for market integrity and consumer protection that exist in traditional securities markets could realistically be achieved. Cryptoasset markets are more globalised with no clear UK nexus, and some crypto exchanges may choose to continue operating in offshore jurisdictions which do not impose equivalent market abuse rules and safeguards – e.g. market surveillance and enforcement mechanisms. These exchanges would be breaking the law if they were offering services to UK customers without authorisation in the UK – but customers could still continue to access them. Consumers and market participants will need to be made aware of these limitations to ensure well-informed trading decisions and to avoid the perception that the same levels of market integrity exist in cryptoasset markets vs securities markets (“halo effect”).

9.15 Despite these challenges, HM Treasury considers there is

significant value in taking steps to enable authorities and venues to deter, prevent and sanction much of the most egregious market abuse behaviour. This would be preferable to the alternative of not having a market abuse regime. Over time market abuse prevention and enforcement capabilities could be enhanced through the adoption of new technologies and international coordination and by introducing criminal offences.

Proposed regulatory approach

9.16 The government is proposing a cryptoassets market abuse

regime based on elements of the MAR for financial instruments. The offences against market abuse would apply to all persons committing market abuse on a cryptoasset that is requested to be admitted to trading on a UK trading venue. This will apply regardless of where the person is based or where the trading takes place. It would entail obligations for certain market participations, in particular cryptoasset trading venues who would be expected to detect, deter, and disrupt market abusive behaviours. The main design features are detailed in the table below.

Table 9.A. Proposed design features for cryptoasset market abuse regime

Regulatory

trigger point • Requesting the admission of a cryptoasset to a UK cryptoasset trading venue. This applies regardless of the location of the market abuse activity (which could take place within the UK or overseas)

Basis for the

regime • Based on UK MAR, though it is important to note that the government does not expect to be able to achieve the same outcomes as MAR (at least in the foreseeable future)

Scope of

offences • Civil offences of market abuse would be similar as for traditional markets, covering insider dealing, market manipulation and unlawful disclosure of inside information.

All persons would be subject to these prohibitions

regardless of where they are based

Enforcement

mechanism • The primary means of taking action against breaches of these offences would be trading venues disrupting occurrences of this activity • This assumes a definition of a “market” to encompass a “marketplace” rather than the entire market in a particular asset • This would place the onus upon trading venues to establish “who” offenders are and information sharing arrangements with other venues that admit the same cryptoassets, to have an effective regime for disrupting the activity of offenders

Obligations

for trading venues • Cryptoasset trading venues should establish systems and controls to prevent, detect and disrupt market abuse • Venues will be responsible for determining the appropriate systems, controls and methods of disruption subject to FCA supervision. Indicatively, this could include Know Your

Customer (KYC) requirements, public blacklists, order book

surveillance, STORs, information sharing between trading venues, use of blockchain analytics and providing the means for ongoing disclosures of information to the market • Trading venues would be required to investigate suspected abuse on their markets and to sanction individuals, for example through the use of public blacklists

for other market participants • Persons professionally arranging or executing transactions should establish systems and controls to prevent and detect market abuse, subject to FCA supervision. This could include preventing misuse of information relating to client orders and obligations to submit STORs to the relevant trading venue • The government is proposing that all regulated firms undertaking cryptoasset activities would be required to disclose inside information and maintain insider lists. HM Treasury welcomes views on this since this may be difficult to apply to cryptoasset markets, and would be a departure from MAR, under which only issuers are required to do so.

Box 9.A: Questions for Respondents

25. Do you agree with the assessment of the challenges of applying

a market abuse regime to cryptoassets? Should any additional challenges be considered?

26. Do you agree that the scope of the market abuse regime should

be cryptoassets that are requested to be admitted to trading on a cryptoasset trading venue (regardless of where the trading activity takes place)?

27. Do you agree that the prohibitions against market abuse should

be broadly similar to those in MAR? Are there any abusive practices unique to cryptoassets that would not be captured by the offences in MAR?

28. Does the proposed approach place an appropriate and

proportionate level of responsibility on trading venues in addressing abusive behaviour?

29. What steps can be taken to encourage the development of

RegTech to prevent, detect and disrupt market abuse?

30. Do you agree with the proposal to require all regulated firms

undertaking cryptoasset activities to have obligations to manage inside information?

Chapter 10

Regulatory outcomes for

operating a cryptoasset lending platform

10.1 Lending and borrowing makes up a significant amount of activity

in the cryptoasset and DeFi market (see Chapter 11). Dedicated lending platforms offer a variety of business models, some of which have similarities to traditional activities such as: collateralised lending; peer- to-peer lending; securities lending (e.g. exchanges providing margin loans); investment management; and unsecured credit products. There are also novel business models, including those where customers contribute to a platform’s liquidity pool in return for variable yield, usually retaining legal title of their assets. Cryptoasset lending and borrowing can look like a mix of these, though in most cases there is a platform – either centralised or decentralised – sitting between those lending and borrowing.

10.2 The lending model exemplified in the case of the failed platform

Celsius highlights several of the regulatory challenges and prudential risks associated with cryptoasset lending. Celsius took the transfer of legal title to cryptoassets from predominantly retail customers to then lend and invest in predominantly wholesale businesses. This particular model of cryptoasset borrowing and lending combines features of risky wholesale investment with guarantees on interest repayments to retail customers, where poor risk management can generate high losses for platforms and consumers. In the case of Celsius, retail investors were treated as unsecured creditors in insolvency.

10.3 Lending to institutional borrowers can involve significant

amounts of credit risk. In traditional finance this risk is mitigated through prudential assessments of counterparty credit quality, prudent collateral risk-management practices, and regulatory capital requirements. Credit risk is heightened when a lender is exposed to the debt of multiple institutional borrowers who have highly correlated risk profiles, which is often the case in cryptoasset markets. Furthermore, current practices around collateralisation, rehypothecation, leverage and maturity transformation are opaque, increasing the risks associated with counterparty defaults.

10.4 There are also significant liquidity risks associated with operating

a lending platform, which are similar to those witnessed in the case of FTX. Cryptoasset platforms engaged in lending activities have often

held high proportions of illiquid or ‘less liquid’ assets on their balance sheets, which has made it difficult to meet liabilities in periods of stress. This risk is exacerbated when lending platforms incur obligations denominated in one cryptoasset while investing or lending in another. Celsius and FTX are both examples of crypto firms which have experienced significant liquidity mismatches.

10.5 Cryptoasset lending and borrowing activities conducted by

lending platforms typically fall outside the current regulatory perimeter.39 This means that most of the safeguards in place for traditional lending and borrowing activities are unavailable to users of similar cryptoasset products and services. Instead, cryptoasset loans often manage risk through high levels of collateralisation and automated margin calls. Customers should be made aware of risks where traditional safeguards are not in place for cryptoasset lending and borrowing activities.

10.6 Most jurisdictions which have already established regulatory

frameworks for cryptoassets have not explicitly brought lending and borrowing activities into the regulatory perimeter. However, some have signalled intent to regulate the sector given growing risks while others have proposed business model restrictions, such as prohibiting cryptoasset service providers from hypothecating the cryptoassets of retail customers and requiring explicit consent and specific risk disclosures for any lending out of wholesale customer assets.

10.7 HM Treasury believes there is a strong case for developing a

cryptoasset lending and borrowing regime as a priority Phase 2 activity. Given that credit risk has been a significant driver of cryptoasset market turbulence and firm failure, it is important that platforms taking part in lending and borrowing activities have sufficient financial resources to manage counterparty credit risk and ensure they can meet liabilities as they fall due.

10.8 A regime for cryptoasset lending platforms should also consider

the need for firms to have effective risk management of collateral, including appropriate collateral valuation; contingency plans for the failure of participants’ largest market counterparties; and the management of collateral following default.

10.9 The government’s proposal, set out below, requires platforms to

disclose important information to customers, such as the terms of legal ownership, collateral, and margin calls. However, given the wide range of lending business models and unique challenges described in this chapter, the proposed approach does not pursue all of the same outcomes delivered by different traditional lending and borrowing regulations, such as FSCS protection, affordability assessments and forbearance periods. The government will continue to monitor

39 Depending on the specific characteristics of a particular model, some cryptoasset lending and borrowing services may fall within existing regulated activities, for example where the arrangements meet the definiti on of a collective investment scheme, or where captured by other parts of this consultation paper

developments in lending markets and assess the need for any further regulatory action.

High level regulatory outcomes

10.10 Through the creation of a newly defined regulated activity –

‘operating a cryptoasset lending platform’ – the government considers that the following are a sensible and realistic set of initial outcomes: • lending platforms should have adequate risk warnings for consumers lending to said platform (e.g. that the consumer could lose all their money, clarity on lack of FSCS protection) • lending platforms should have adequate financial resources – capital and liquidity – and wind down arrangements to carry out their business • lending platforms should have clear contractual terms on ownership and, if applicable, ringfencing of retail funds in case of insolvency

10.11 Furthermore, it is important that authorities are able to monitor

the build-up of risk present in collateralised lending transactions. HM Treasury is therefore of the view that disclosure requirements derived from those applied to Securities Financing Transactions (e.g. counterparty and transactions details, collateral composition, rehypothecation, substitution of collateral at the end of the day and haircuts applied) could help improve transparency associated with the use of collateral in cryptoassets financing activities. The government is seeking views on whether such a disclosure regime would be necessary, or whether transparency could be enhanced by other means. In any event, it is likely that specifying the requirements and scope of the disclosure requirements for these transactions will happen after Phase 2.

Proposed regulatory approach

10.12 For the regulation of cryptoasset lending and borrowing

activities the government is proposing to apply and adapt existing

RAO activities, while making suitable modifications to

accommodate unique cryptoasset features. Key design features are set out in further detail in the table below.

Table 10.A. proposed design features for cryptoasset lending and borrowing regime

Regulatory

trigger point • Operating a cryptoasset lending platform (this would include facilitating collateralised and uncollateralised borrowing of cryptoassets or borrowing of fiat currency with collateral provided in cryptoassets)

Basis for the

regime • Adapt existing RAO activities e.g. arranging deals in investments, dealing as principal and operating an electronic system in relation to lending

Authorisation

rules • Authorisation will be required since “operating a cryptoasset lending platform” will become a regulated activity under the RAO. • Applications should include details of operations, services, business plans, and organisational and governance arrangements. Applications should also set out persons who are lending assets, persons who are borrowing assets, any loans received or provided, legal title of assets including collateral, liquidity, capital and risk management practices and how liabilities are met in both crypto and fiat at any point in time

Location

requirements • Scope will be set by whether: i) firms are incorporated in the UK; ii) services are being provided to UK persons (natural or legal) • Requirements on physical location to be determined by the FCA. It is expected that this will be informed by the

FCA’s existing framework for international firms (see

Chapter 4 for more details)

Prudential

requirements • Persons operating a cryptoasset lending platform should have sufficient financial resources to meet their liabilities as they fall due • Thresholds to be set by the FCA – e.g. minimum capital requirements, liquidity requirements needed to mitigate credit risk, market risk, liquidity risk and non-financial risks – addressing both the potential for harm from ongoing operations and the ability to wind-down in an orderly manner • Entities will need to monitor and manage liquidity and funding risks across different time horizons and stress scenarios

Consumer

protection and governance requirements • Persons operating a cryptoasset lending platform should have robust governance arrangements and risk management processes in place • Conduct of business requirements (e.g. client disclosures, risk warnings, clear contractual terms including ownership of legal and beneficial title) should apply

40 https://www.fca.org.uk/publication/corporate/approach -to-international-firms.pdf

• Clear terms and disclosures should exist in terms of collateral requirements and margin calls, including the circumstances under which these are enacted

Operational

resilience requirements • Systems and controls requirements, such as operational resilience, should apply to cryptoasset lending and borrowing platforms. Persons operating a cryptoasset lending platform should have adequate people, processes, systems and controls to mitigate operational resilience risks • Outsourcing and third-party arrangements should require appropriate due diligence, ongoing oversight, and formal documentation

Resolution

and insolvency • Insolvency powers under Part 24 of FSMA should apply, enabling the FCA to participate in insolvency proceedings governed by the Insolvency Act • The government will consider whether a bespoke resolution regime should be developed in time (e.g. new special administration regime)

Box 10.A: Questions for Respondents

31. Do you agree with the assessment of the regulatory challenges

posed by cryptoasset lending and borrowing activities? Are there any additional challenges HM Treasury should consider?

32. What types of regulatory safeguards would have been most

effective in preventing the collapse of Celsius and other cryptoasset lending platforms earlier this year?

33. Do you agree with the idea of drawing on requirements from

different traditional lending regimes for regulating cryptoasset lending? If so, then which regimes do you think would be most appropriate and, if not, then which alternative approach would you prefer to see?

34. Do you agree with the option we are considering for providing

more transparency on risk present in collateralised lending transactions?

35. Should regulatory treatment differentiate between lending

(where title of the asset is transferred) vs staking or supplying liquidity (where title of the asset is not transferred)?

Chapter 11

Call for Evidence:

Decentralised Finance

(DeFi)

Context and regulatory challenges

11.1 Decentralised Finance (DeFi) is an umbrella term used to cover a

range of financial services – including lending, exchange, asset management and insurance – which are offered without the use of traditional financial intermediaries. Programmers and developers use the coding language of a blockchain to create “smart contracts”. These represent open sourced, codified sets of rules which automatically execute and record transactions on the blockchain when certain parameters are met. Once deployed, smart contracts are immutable, enabling peer-to-peer (or “peer-to-contract”) transactions without centralised decision making from intermediaries. The functionalities of different smart contracts are typically combined and offered to end users through decentralised apps (“dApps”).

11.2 DeFi services currently form a small proportion of the cryptoasset

financial services market, but recent years have seen a marked increase in retail adoption of DeFi, alongside growing institutional involvement. As a novel and rapidly evolving industry, DeFi presents complex and unique challenges for policy makers and regulators. The underlying protocols are influenced and controlled by varying levels of decentralised governance mechanisms. Furthermore, DeFi organisations are especially globalised and borderless in nature, with participants operating across many jurisdictions. This means that the typical systems of financial services regulation – which usually rely on the authorisation and supervision of individuals and firms undertaking specified activities – may be difficult to apply.

11.3 There is a long list of actors involved in DeFi product chains, from

limited companies and coders creating or editing protocols and code, to Decentralised Autonomous Organisations (DAOs) and governance token holders, who in many cases may not be undertaking financial services activities by way of business. 11.4 Various international organisations, including the BIS, FSB, IOSCO and the IMF, have identified a number of risks arising from the growth of DeFi. In particular, where governance of these protocols lacks transparency and accountability, there may be increased risk to consumers, market integrity and financial stability. While not

exhaustive, other risks may arise from: a lack of operational resilience to cyber-attacks and scams; increased dependencies between traditional and decentralised financial systems; and the lack of backstops in periods of market stress. At the same time, the innovative nature of programmable transactions could also increase efficiency and competition in the financial services industry, leading to consumer benefits such as reduced costs of service.

11.5 HM Treasury is of the view that the regulatory outcomes and

objectives described in the preceding chapters should apply to cryptoasset activities regardless of the underlying technology, infrastructure, or governance mechanisms. However, due to the challenges outlined above, including the rapidly evolving nature of the sector, the way this is achieved may well differ and take longer to clarify. The work of international organisations is especially important in this area (again noting the highly borderless nature of DeFi organisations) and we are not intending to front run this by developing a prescriptive framework for the UK that would need to be fundamentally re-shaped once international approaches and standards crystalise. With this in mind, HM Treasury is considering a range of approaches and seeking views.

11.6 One option for regulating DeFi is to define a set of DeFi-specific

activities – e.g. “establishing or operating a protocol” – as regulated activities under the RAO (or DAR). The persons carrying out those activities would then require authorisation, and the FCA could design a bespoke regime around these regulated activities.

11.7 There is a spectrum of decentralisation amongst current DeFi

offerings. In some cases, governance of a protocol is conducted via on- chain voting, whereby an individual’s voting rights are determined by their holdings of the protocol’s governance token. Therefore, individuals who have a significant share of those tokens can dominate the outcome of the votes. Often, a large proportion of governance tokens are retained by the protocol’s founding team and investors. Some DeFi protocol teams also retain emergency powers to unilaterally make changes to the protocol when they deem necessary. Centralised business models which brand and market themselves as DeFi in order to circumvent regulatory obligations should be subject to the same treatment as centralised organisations. Regulators should be able to apply rules to persons who maintain significant control or influence over a DeFi arrangement or protocol providing cryptoasset services and activities. To illustrate this point further, the objective is not to regulate the activity of developing software, but if software developers go on to maintain, run and operate systems used for regulated financial activities (e.g. exchange, lending) then they should be subject to financial services regulation. Parallels can be drawn with algorithmic trading activity in traditional financial markets; software developers write code (algorithms) which may submit, match and execute orders. However, there are ways to regulate this and control the risks – e.g. enforceable rules around algorithmic trading systems and controls.

11.8 Some parts of the value chain may not be practical to regulate, for example the underlying protocol if that has become truly open- sourced and decentralised over time. The approach to regulation was discussed at the FCA’s cryptoasset sprint in May 2022,41 with one suggestion being to focus regulatory responsibility for mitigating risks on centralised on and off ramps like exchanges. Interface providers and other actors facilitating consumer access to DeFi (e.g. aggregators and other consumer “front ends”) could be another viable hook. Even though these interface providers do not necessarily provide the underlying services or protocols they could be required to demonstrate or check whether certain standards or rules have been met, before facilitating access to a decentralised application or service. These standards could include technical standards – such as conducting regular, independent code audits and IT security tests, as well as standards around information disclosures requiring clear, non-technical descriptions of the services provided and associated risks, third party service provider oversight, and governance standards covering best practices around voting and review periods and vesting schedules.

11.9 Longer term, establishing clarity of the legal structure of DAOs

will be important in helping to determine how regulation could be applied to these structures. The Law Commission has already carried out work, concluding that smart contracts may in many circumstances be binding in English law. Following a recent request from HM Treasury, in November the Law Commission published its call for evidence to develop recommendations on the legal status of DAOs. Both these developments are likely to lead to greater legal certainty for consumers and markets, as well as provide potential insights for regulation. There is also cross-governmental work taking place on artificial intelligence and autonomous code which is likely to have a relevant read-across for DeFi. Shorter term, there may be interim measures such as using recommendations and guidelines to encourage best practices of the sort mentioned in the paragraph above.

11.10 Overall, HM Treasury is looking for a proportionate, innovation-

friendly approach, which recognises distinct opportunities offered by new business models and encourages a thriving and well-regulated UK DeFi industry. However, the government also wishes to deliver similar regulatory outcomes across centralised financial services activities and their DeFi equivalents, thereby preventing risks of regulatory arbitrage. We welcome further views from industry and other stakeholders on how to balance these objectives.

41 https://www.fca.org.uk/firms/cryptoassets/cryptosprint

Box 11.A: Questions for Respondents

36. Do you agree with the assessment of the challenges of regulating

DeFi? Are there any additional challenges HM Treasury should consider?

37. How can the size of the “UK market” for DeFi be evaluated? How

many UK-based individuals engage in DeFi protocols? What is the approximate total value locked from UK-based individuals?

38. Do you agree with HM Treasury's overall approach in seeking the

same regulatory outcomes across comparable "DeFi" and "CeFi" activities, but likely through a different set of regulatory tools, and different timelines?

39. What indicators should be used to measure and verify

“decentralisation” (e.g. the degree of decentralisation of the underlying technology or governance of a DeFi protocol)?

40. Which parts of the DeFi value chain are most suitable for

establishing "regulatory hooks" (in addition to those already surfaced through the FCA-hosted cryptoasset sprint in May 2022)?

41. What other approaches could be used to establish a regulatory

framework for DeFi, beyond those referenced in this paper?

42. What other best practices exist today within DeFi organisations

and infrastructures that should be formalised into industry standards or regulatory obligations?

Chapter 12

Call for Evidence: Other

Cryptoasset Activities

Cryptoasset investment advice and portfolio

management

12.1 At present, cryptoasset investment advice and discretionary

portfolio management services are relatively limited and geared towards institutional and High Net Worth client segments, presenting relatively little immediate risk of financial harms to retail consumers. To date there is little evidence of UK firms offering cryptoasset-focused investment advice, and minimal examples of cryptoassets being placed in wealth and asset management propositions. However, as with other types of financial advice and portfolio management, these activities have potential to generate risks from conflicts of interest, fraud and loss of customer assets. And the extent to which these (or similar) services could expand and be provided to retail clients in future is unclear.

12.2 These activities could be considered as analogous to the current

regulated activities of “advising on investments” and “managing investments” (See Article 53 of the RAO and Article 37 of the RAO). The government is therefore considering whether there is a case for bringing these activities into the regulatory perimeter.

12.3 Despite parallels to existing investment advice activities, there

are important differences. The UK’s current investment advice regime requires regulated advisors to be experienced, competent and qualified, and for them to assess that an investment is suitable before making a recommendation. However, the price and value of an unbacked cryptoasset is driven by speculative investment decisions, rather than market fundamentals which can be objectively assessed. This is in contrast to traditional financial assets; even for high-risk investments such as illiquid securities, advisors at least have experience and qualifications to conduct due diligence on the corporate issuer (e.g. through assessing projected growth plans). It would be very difficult to require an investment advisor to meet these criteria for cryptoasset investment advice.

Post-trade activities in cryptoasset transactions

12.4 Some of the functions currently performed by cryptoasset

exchanges in relation to cryptoassets go beyond solely trading venue activities and can include FMI activities such as settlement. This looks very different to traditional securities settlement, as it is typically performed on a blockchain rather than on a central securities

depository. However, the underlying functions of a central securities depository are still being performed – namely maintaining and updating a record of ownership of the security, and processing transfers of ownership of dematerialised securities. Risks therefore remain to market functioning from a loss of those records, or the loss of integrity due to disputed records. The benefits of regulating settlement include mitigating the risk of settlement failures and ensuring clarity of ownership. As with conventional FMIs, where settlement is captured under existing legislation, future regulations of cryptoasset settlement activity undertaken by cryptoasset exchanges may be required where the activity is deemed to be systemic and proportionate to the scale of the risk to financial stability.

12.5 Clearing – the handling of counterparty credit risk of both parties

to a transaction – may also need to be a regulated cryptoasset activity.

Although the types of clearing services provided by central

counterparties (CCPs) in the traditional financial sector are not being provided widely by cryptoasset exchanges today, the government considers it important to future-proof regulations and bring them in line with those for conventional securities if cryptoasset exchanges were to undertake clearing activity in the future. This would likely follow similar requirements to those that exist under European Market Infrastructure Regulation (EMIR). For example, authorities may need to require firms undertaking clearing activities to establish adequate safeguards to mitigate counterparty credit risk during the post-trade settlement process, such as the creation of a default fund.

12.6 Rather than setting out initial proposals in this consultation, our

regulatory outcomes for the settlement of cryptoassets will be shaped from what the government learns from the FMI Sandbox initiative. While cryptoasset are outside of scope, the sandbox will enable firms to experiment with DLT, to provide the services that underpin financial markets. Accepted firms will be able to set up an FMI that utilises new technology within the sandbox, while being subject to modified legislative requirements (where the existing requirements act as a barrier to using new technology). These modified requirements could be made permanent if testing is successful.

Crypto mining and validation

12.7 The UK makes up a very small percentage of global mining

power – 0.23% of global bitcoin mining is conducted in the UK.42 Instead, it is geographically concentrated in certain countries such as the US, China, and Russia. The decentralised nature of certain cryptoassets also means that authorities may have greater difficulties in enforcing how and where cryptoassets are mined. Another challenge is that attempting to enforce regulation at protocol level may simply push mining / validation and certain software development activity abroad

42 https://chainbulletin.com/bitcoin-mining-map/ - Crypto mining hash rate map

by increasing costs and regulatory obligations – particularly in the absence of international agreements.

12.8 Given the reasons outlined above, there may not be justification

to regulate the activity of mining in and of itself. The environmental impacts associated with mining especially of the Proof-of-Work (PoW) consensus mechanism are discussed in the following section.43 However, the government is interested in any views on whether any other regulatory outcomes should be pursued in regulating mining; for example, whether “miner extractable value” – whereby miners choose how to sequence transactions to extract value from other traders – should be considered.

12.9 There may be an argument for capturing staking activities within

the regulatory perimeter, to the extent that they are currently outside the perimeter; some models – depending on their specific characteristics – may already fall within the perimeter, for example where the staking arrangements meet the definition of a collective investment scheme. Staking services have been targeted at UK consumers and may increase following the transition to Proof of Stake (PoS)44 by Ethereum. However, given the lack of data on the amount of staking that takes place in the UK, it may be sensible to initially seek data on staking to enable us to gather a fuller picture (to the extent this is feasible given the often-decentralised nature of staking pools).

43 PoW is a consensus mechanism that features complex problems for miners to solve using high -powered computers through trial and error. When the first miner authenticates the block or “solves the puzzle”, the digital currency is then added to the blockchain. In return, the miner also receives compensation. 44 PoS is consensus mechanism in which, to validate blocks, miners n eed to put up stake with coins of their own. The choice for who validates each transaction is random using a n algorithm which is weighted based on the amount of stake and the validation experience of the miner. After a miner verifies a block, the miner rec eives cryptocurrency for their fee along with their original stake. Box 12.A Questions for Respondents

43. Is there a case for or against making cryptoasset investment

advice and cryptoasset portfolio management regulated activities? Please explain why.

44. Is there merit in regulating mining and validation activities in the

UK? What would be the main regulatory outcomes beyond sustainability objectives?

45. Should staking (excluding “layer 1 staking”) be considered

alongside cryptoasset lending as an activity to be regulated in phase 2?

46. What do you think the most appropriate regulatory hooks for

layer 1 staking activity would be (e.g. the staking pools or the validators themselves)?

Chapter 13

Call for evidence:

Sustainability

Context and regulatory challenges

13.1 As noted in Chapter 12, the Proof of Work (PoW) consensus

mechanisms can have a high environmental impact. This is mainly due to the energy usage of the computing task, which becomes more intensive as time progresses. Mining rig facilities allow computing for PoW at scale, although it is challenging to estimate energy usage with accuracy, given the need to make assumptions around issues like hardware specifications, indirect energy impacts and regional energy mixes. For illustrative purposes, the latest estimates put Bitcoin’s global annual energy consumption at around 118 TWh, which amounts to approximately 39% of the UK’s annual total energy consumption.45, 46 Some estimates have Bitcoin’s energy consumption even higher.

13.2 PoS blockchains may also use computers or servers located in

data centres, which use electricity for cooling and data storage. However, the energy consumption and carbon footprint for PoS still remains much lower than PoW. Following the switch of the Ethereum blockchain from PoW to PoS (in a process known as “the Merge”), estimations of Ethereum’s TWh of electricity used per year fell from

77.77 to 0.01 TWh.47

13.3 The government reiterates its firm commitment to making the

UK a competitive location for sustainable finance. Elsewhere in the financial services sector, there are various sustainability-related reporting requirements that apply to other types of firms. The FCA note that listed issuers and other entities in scope of requirements under MAR and the Prospectus Regulation may need to consider ESG-related risks and opportunities when determining what to disclose under the various disclosure regimes.48 Furthermore, premium listed companies, issuers of standard listed shares and global depositary receipts, asset managers, life insurers, and FCA-regulated pension providers have mandatory climate-related disclosure requirements aligned with the

45 https://cbeci.org/ Cambridge Centre for Alternative Finance Bitcoin Live Bitcoin Network Power

46 https://www.eia.gov/international/data/world/electricity/electricity -consumption

47 https://digiconomist.net/ethereum-energy-consumption

48 https://www.fca.org.uk/publication/primary-market/tn-801-1.pdf

Task Force on Climate-related Financial Disclosures’ (TCFD)

recommendations. 13.4 Given parallels between cryptoassets and securities markets, applying similar ESG-related reporting requirements may be a proportionate way of achieving our “same risk, same regulatory outcome” principle. However, given the nature of cryptoassets, this may be more challenging. The way that consumers interact with the product and intermediaries is different to securities markets, not least because of decentralisation. Additionally, unlike in other parts of the sector, there is currently no agreed upon set of indicators or metrics for measuring the environmental impact of cryptoassets.

13.5 Therefore, the government is seeking further views from

respondents as to what information about environmental impact or energy intensity would be useful for consumers making decisions about investing in cryptoassets, and at what time in the investor journey these would be particularly helpful to consumers. It would also be useful to know if there are particular indicators or metrics that can be used to calculate these environmental impacts and whether these are interoperable with other recognised sustainability disclosure standards such as those developed by the Taskforce on Climate Related Financial Disclosures (TCFD) or IFRS Foundation’s International Sustainability Standards Board (ISSB). Box 13.A: Questions for Respondents

47. When making investment decisions in cryptoassets, what

information regarding environmental impact and / or energy intensity would investors find most useful for their decisions?

48. What reliable indicators are useful and / or available to estimate

the environmental impact of cryptoassets or the consensus mechanism which they rely on (e.g. energy usage and / or associated emission metrics, or other disclosures)?

49. What methodologies could be used to calculate these indicators

(on a unit-by-unit or holdings basis)? Are any reliable proxies available?

50. How interoperable would such indicators be with other

recognised sustainability disclosure standards?

51. At what point in the investor journey and in what form, would

environmental impact and / or energy intensity disclosures be most useful for investors?

52. Will the proposals for a financial services regulatory regime for

cryptoassets have a differential impact on those groups with a protected characteristic under the Equality Act 2010?

Chapter 14

Responding to this

Consultation

Responding to this consultation and call for evidence

14.1 This consultation will close on 30-April 2023. The government is

inviting stakeholders to provide responses to the questions set out above and to share any other views on the proposed approach to regulating cryptoassets.

14.2 Responses are welcome from all stakeholders, including

cryptoasset firms, technology firms, financial institutions, other businesses impacted by cryptoasset regulation, trade associations, representative bodies, academics, legal firms, and consumer groups.

How to submit responses

14.3 Please send responses to

cryptoasset.consultation@hmtreasury.gov.uk or post to: Future regulatory regime for cryptoassets – consultation

Payments and Fintech

HM Treasury

1 Horse Guards Road

SW1A 2HQ

HM Treasury Consultation: Future financial services regulatory regime for cryptoassets - Processing of

Personal Data

14.4 This section sets out how we will use your personal data and

explains your relevant rights under the UK General Data Protection Regulation (UK GDPR). For the purposes of the UK GDPR, HM Treasury is the data controller for any personal data you provide in response to this consultation.

Data subjects

14.5 The personal data we will collect relates to individuals

responding to this consultation. These responses will come from a wide group of stakeholders with knowledge of a particular issue.

The personal data we collect

14.6 The personal data will be collected through email submissions

and are likely to include respondents’ names, email addresses, their job titles, and employers as well as their opinions.

How we will use the personal data

14.7 This personal data will only be processed for the purpose of

obtaining opinions about government policies, proposals, or an issue of public interest.

14.8 Processing of this personal data is necessary to help us

understand who has responded to this consultation and, in some cases, contact respondents to discuss their response.

14.9 HM Treasury will not include any personal data when publishing

its response to this consultation.

Lawful basis for processing the personal data

14.10 The lawful basis we are relying on to process the personal data is

Article 6(1)(e) of the UK GDPR; the processing is necessary for the performance of a task we are carrying out in the public interest. This task is consulting on the development of departmental policies or proposals to help us to develop good effective policies.

Who will have access to the personal data

14.11 The personal data will only be made available to those with a

legitimate need to see it as part of consultation process.

14.12 We sometimes conduct consultations in partnership with other

agencies and government departments and, when we do this, it will be apparent from the consultation itself. For these joint consultations, personal data received in responses will be shared with these partner organisations in order for them to also understand who responded to the consultation.

14.13 As the personal data is stored on our IT infrastructure, it will be

accessible to our IT service providers. They will only process this personal data for our purposes and in fulfilment with the contractual obligations they have with us.

How long we hold the personal data for

14.14 We will retain the personal data until work on the consultation is

complete.

Your data protection rights

14.15 You have the right to: • request information about how we process your personal data and request a copy of it • object to the processing of your personal data • request that any inaccuracies in your personal data are rectified without delay • request that your personal data are erased if there is no longer a justification for them to be processed

• complain to the Information Commissioner’s Office if you are unhappy with the way in which we have processed your personal data

How to submit a data subject access request (DSAR)

14.16 To request access to your personal data that HM Treasury holds, contact:

The Information Rights Unit

HM Treasury

1 Horse Guards Road

London

SW1A 2HQ

dsar@hmtreasury.gov.uk

Complaints

14.17 If you have concerns about our use of your personal data, please

contact the Treasury’s Data Protection Officer (DPO) in the first instance at privacy@hmtreasury.gov.uk 14.18 If we are unable to address your concerns to your satisfaction, you can make a complaint to the Information Commissioner at casework@ico.org.uk or via this website: https://ico.org.uk/make-a-complaint.

Next steps

14.19 This consultation sets out a proposed policy approach to bringing

cryptoasset activities into the UK regulatory perimeter. The government will carefully consider the responses received and use these to inform a response. If taken forward, further technical consultations will be issued by UK authorities on specific firm rules.

14.20 As part of this consultation, the government will also undertake a

programme of stakeholder engagement. This will maximise opportunities for stakeholders to share their views with the government.

14.21 A Crypto Engagement Group, chaired by the Economic Secretary

to the Treasury, will continue to run on a regular basis over the course of 2023. This group will ensure that key industry participants can offer insights and support the government in establishing a clear regulatory framework that supports innovation and protects consumers.

1.: Glossary of Terms

Acronym Definition

AML Anti-Money

Laundering

HMRC His Majesty's Revenue

and Customs

BIS Bank for

International

Settlements

HMT His Majesty's Treasury

CASP Crypto Asset

Service Provider

ICC International Chamber

of Commerce

CASS (the FCA’s) Client

Assets Sourcebook

ICO Initial Coin Offering

CeFi Centralised

Finance

IME Investment Manager

Exemption

CIS Collective

Investment

Scheme

IMF International Monetary

Fund

CLI Climate Ledger

Initiative

IOSCO International

Organization of

Securities Commissions

COBS (the FCA’s)

Conduct of

Business

Sourcebook

IPO Initial Public Offering

COMP FCA's

compensation rules

KYC Know Your Customer

CPMI Committee on

Payments and

Market

Infrastructures

MAR Market Abuse

Regulation

CTF Counter-Terrorist

Financing

MiCA (The EU's) Markets In

Crypto-Assets

DAO Decentralised

Autonomous

Organisation

MiFID II Markets in Financial

Instruments Directive II

dApps Decentralised

Applications

MIFIDPRU FCA handbook on

prudential rules for certain investment firms

DAR Designated

Activities Regime

MLRs Money Laundering,

Terrorist Financing and

Transfer of Funds

(Information on the

Payer) Regulations 2017

DCMS Department for

Digital, Culture,

Media & Sport

MTF Multilateral Trading

Facility

DeFi Decentralised

Finance

NFT Non-Fungible Tokens

DLT Distributed Ledger

Technology

NSM National Storage

Mechanism

DSA Digital Settlement

Asset

PoS Proof of Stake

Acronym Definition

EMR 2011 E-Money

Regulations 2011

PoW Proof of Work

EMIR The European

Market

Infrastructure

Regulation

PRA Prudential Regulation

Authority

ESG Environmental,

Social, and

Governance

PS 19/22 The FCA’s Perimeter

Guidance for

Cryptoassets

FATF Financial Action

Task Force

PSR Payment Systems

Regulator

FCA Financial Conduct

Authority

PSR 2017 Payment Services

Regulations 2017

FMI Financial Market

Infrastructure

RAO Financial Services and

Markets Act 2000

(Regulated Activities)

Order 2001

FMI Sandbox Financial Market

Infrastructure

Sandbox

RegTech Regulatory Technology

FOS Financial

Ombudsman

Service

SRO Self-Regulatory

Organization

FPC Financial Policy

Committee (of the

Bank of England)

STO Security Token Offering

FRF Future Regulatory

Framework

STOR Suspicious Transaction

and Order Report

FS&M Bill Financial Services

and Markets Bill

SYSC Senior Management

Arrangements, Systems

and Controls

FSB Financial Stability

Board

TCFD Task Force on Climate-

Related Financial

Disclosures

FSCS Financial Services

Compensation

Scheme

TRR Temporary Registration

Regime (for cryptoasset

businesses)

FSMA Financial Services

and Markets Act

WTO World Trade

Organisation

2.: Market abuse offences under UK MAR

Insider Dealing

(Article 8)

Insider dealing arises where a person possesses inside

information and uses that information by acquiring or disposing of, for its own account or for the account of a third party, directly or indirectly, financial instruments to which that information relates.

The use of inside information by cancelling or amending

an order concerning a financial instrument to which the information relates, where the order was placed before the person concerned possessed the inside information, shall also be considered to be insider dealing.

Recommending or inducing another person to engage in

insider dealing also amounts to insider dealing where the person using the recommendation or inducements knows or ought to know that it is based upon inside information.

Unlawful

disclosure of inside information (Article 10)

Unlawful disclosure of inside information arises where a

person possesses inside information and discloses that information to any other person, except where the disclosure is made in the normal exercise of an employment, a profession or duties.

The onward disclosure of recommendations or

inducements to engage in insider dealing also amounts to unlawful disclosure of inside information where the person using the recommendation or inducements knows or ought to know that it is based upon inside information.

Market

manipulation (Article 12) Market manipulation comprises the following activities: a) entering into a transaction, placing an order to trade or any other behaviour which: i. gives, or is likely to give, false or misleading signals as to the supply of, demand for, or price of, a financial instrument; or ii. secures, or is likely to secure, the price of one or several financial instruments, at an abnormal or artificial level; unless the person entering into a transaction, placing an order to trade or engaging in any other behaviour establishes that such transaction, order

or behaviour has been carried out for legitimate reasons, and conform with an accepted market practice b) entering into a transaction, placing an order to trade or any other activity or behaviour which affects or is likely to affect the price of one or several financial instruments, which employs a fictitious device or any other form of deception or contrivance c) disseminating information through the media, including the internet, or by any other means, which gives, or is likely to give, false or misleading signals as to the supply of, demand for, or price of, a financial instrument, or secures, or is likely to secure, the price of one or several financial instruments, at an abnormal or artificial level, including the dissemination of rumours, where the person who made the dissemination knew, or ought to have known, that the information was false or misleading d) transmitting false or misleading information or providing false or misleading inputs in relation to a benchmark where the person who made the transmission or provided the input knew or ought to have known that it was false or misleading, or any other behaviour which manipulates the calculation of a benchmark MAR also sets out various behaviours that, inter alia, are considered to be market manipulation.

Inside

information (Article 7) Inside information is information: • of a precise nature • which has not been made public • which relates, directly or indirectly, to one or more issuers or to one or more financial instruments • which, if it were made public, would be likely to have a significant effect on the prices of those financial instruments or on the price of related derivative financial instruments

For persons charged with the execution of orders

concerning financial instruments, it also means information conveyed by a client and relating to the client’s pending orders in financial instruments, which is of a precise nature, relating, directly or indirectly, to one or more issuers or to one or more financial instruments, and which, if it were made public, would be likely to have a significant effect on the prices of those financial instruments.

HM Treasury contacts

This document can be downloaded from www.gov.uk If you require this information in an alternative format or have general enquiries about HM Treasury and its work, contact:

Correspondence Team

HM Treasury

1 Horse Guards Road

London

SW1A 2HQ

Tel: 020 7270 5000 Email: public.enquiries@hmtreasury.gov.uk

Future financial services regulatory regime for cryptoassets: Consultation and call for evidence (February 2023)

October 2023

Future financial services

regulatory regime for cryptoassets

Response to the consultation

and call for evidence

regulatory regime for cryptoassets

and call for evidence

© Crown copyright 2023 This publication is licensed under the terms of the Open Government Licence v3.0 except where otherwise stated. To view this licence, visit nationalarchives.gov.uk/doc/open-government-licence/version/3. Where we have identified any third party copyright information you will need to obtain permission from the copyright holders concerned. This publication is available at: www.gov.uk/official-documents. Any enquiries regarding this publication should be sent to us at public.enquiries@hmtreasury.gov.uk ISBN: 978-1-916693-49-4 PU: 3363

Contents

Table of Contents

Chapter 1 - Summary of feedback received 7

Chapter 2 - Definition of cryptoassets and legislative approach 15

Chapter 3 - Overview of the current regulatory landscape for

cryptoassets 22

Chapter 4 - Scope and sequencing of cryptoasset activities 27

Chapter 5 - Regulatory outcomes for cryptoasset Issuance and

Disclosures 38

Chapter 6 - Regulatory outcomes for operating a cryptoasset

trading venue 47

Chapter 7 - Regulatory outcomes for cryptoasset intermediation

activities 52

Chapter 8 - Regulatory outcomes for cryptoasset custody 56

Chapter 9 - Regulatory outcomes for market abuse 61

Chapter 10 - Regulatory outcomes for operating a cryptoasset

lending platform 71

Chapter 11 - Call for evidence: Decentralised Finance (DeFi) 76

Chapter 12 - Call for evidence: other cryptoasset activities 83

Chapter 13 - Call for evidence: sustainability 89

Foreword

The government’s ambition to make the UK a global hub for cryptoasset technologies remains steadfast. To realise this ambition we must make the UK a place where cryptoasset firms have the clarity needed to invest and innovate, and where customers have the protections necessary for confidently using these technologies.

In February this year, the government published its consultation on the future financial services regulatory framework for cryptoassets. We set out extensive proposals for a UK regime, including plans to regulate core activities such as custody and lending, and to bring centralised cryptoasset exchanges into financial services regulation for the first time.

I am grateful to all of the firms and other interested parties that engaged so constructively with our consultation. The learnings gathered from our engagement have been invaluable for further informing our approach. While most aspects of our proposals were well- received by the large majority of respondents, we have modified certain features of our future framework to take onboard the evidence presented.

With the future regulatory framework now taking clear shape and the Financial Services and Markets Act now passed, the UK is the obvious choice for starting and scaling a cryptoasset business. The UK is the largest financial centre globally outside of the United States, and our tech industry is worth over $1tn; we are only the 3rd country to hit this valuation after China and the US. This combined with world-leading systems of law and financial regulation makes for a potent combination. Unsurprisingly the UK consistently ranks at or near the top of research reports on ‘crypto-readiness’ and ‘crypto-friendliness’.

I am very pleased to present these final proposals for cryptoasset regulation in the UK on behalf of the Government. I look forward to our continued work with the sector in making our vision a reality for the UK as a global hub for cryptoasset technology.

Andrew Griffith MP, Economic Secretary to the Treasury

Chapter 1

Summary of feedback

received

Background

1.1 This document is the government's response to the consultation

and call for evidence on the future financial services regulatory regime for cryptoassets (Consultation), which was published on 1 February 2023 and closed on 30 April 2023. It outlines a summary of the Consultation questions and the responses received by HM Treasury, as well as the government’s response, including how the consultation process influenced the further development of the policies and proposals consulted upon and next steps.

Profiling of respondents

Source: HM Treasury analysis of responses received

Crypto native firms

and FinTechs, 40%

Traditional FS

firms, 10%

Industry

associations, 27%

Members of public

or academia, 12%

Consumer groups

/ not-for-profits, 3%

Legal and consulting

firms, 4% Other, 4%

TOTAL NUMBER

OF RESPONSES

RECEIVED

1.2 HM Treasury received a total of 131 responses from a wide range

of stakeholders. Around 50% of these were from firms and around 25% from trade associations. 12% of responses were from members of the public or universities, 4% from law and consulting firms, 3% from not- for-profits / consumer associations and 4% came from other categories of respondent (e.g. media organisations). Amongst the firms that responded, there was a broad array of business models including blockchain network providers, crypto exchanges, crypto compliance firms, companies specialising in web3 gaming / collectibles, crypto fund managers and specialist crypto custody providers. A number of traditional financial services firms also responded to the Consultation, including traditional banks and custodians, asset managers and payments providers.

1.3 In addition, since publishing the proposals, HM Treasury has

engaged with more than 80 organisations, mostly through a series of multilateral workshops and roundtables. The Financial Conduct Authority (FCA) also ran an engagement programme in parallel in anticipation of the rule making powers that will be granted to them.

1.4 Since the publication of the original proposals there have been

several important policy developments in the cryptoasset space: • The Financial Services and Markets Act 2000 (Financial Promotion) (Amendment) Order 2023 (Financial Promotions SI) – which brings financial promotions relating to qualifying cryptoassets within the existing financial promotions regime - was made on 7 June 2023.1 The FCA published its Policy Statement on financial promotion rules for cryptoassets and the Guidance Consultation on cryptoasset promotions in June. 2, 3 The regime will come into force in October 2023. • A Treasury Select Committee inquiry (“Fifteenth Report - Regulating Crypto”) was published in May 2023.4 The government’s response was issued by HM Treasury and published on 20 July 2023.5 • The Financial Services and Markets Act 2023 (FSMA 2023) received royal assent on 29 June 2023. 6 FSMA 2023 contains important powers confirming the government’s ability to specify cryptoasset activities within the Financial Services and Markets

Act 2000 (Regulated Activities) Order 2001 (RAO), and to

designate activities as part of the Designated Activities Regime (DAR) as well as providing the regulatory powers necessary to

1 The Financial Services and Markets Act 2000 (Financial Promotion) (Am endment) Order 2023

(legislation.gov.uk) 2 https://www.fca.org.uk/publications/policy-statements/ps23-6-financial-promotion-rules-cryptoassets

3 GC23/1: Guidance on cryptoasset financial promotions (fca.org.uk)

4 https://committees.parliament.uk/publications/39945/documents/194832/default/

5 https://committees.parliament.uk/publications/40999/documents/199652/default/

6 Financial Services and Markets Act 2023 (legislation.gov.uk)

deliver a regulatory regime for the use of ‘digital settlement assets’ (DSA) in payments. • The Law Commission published its Final Report on Digital Assets on 28 June 2023,7 recommending selective reform and development of the private law on digital assets to secure the UK’s position as a global financial hub. • HM Treasury published a consultation on the Digital Securities Sandbox (DSS) in July 2023.8 The DSS will be the first financial market infrastructure sandbox delivered under the powers granted as part of FSMA 2023 and will facilitate the testing and adoption of digital securities across financial markets. • HM Treasury is also separately publishing an update on plans for the regulation of fiat-backed stablecoins (Stablecoins Update) which provides further clarity on activities relating to fiat-backed stablecoins and the delineation of phase 1 and phase 2 legislation.

High-level sentiment analysis

Source: HM Treasury analysis of responses received

1.5 In terms of general sentiment, around 80% of responses were

broadly supportive of the government’s overall approach. Approximately 10% had mixed or neutral feedback and the remaining 10% were critical of the proposals.

7 https://www.lawcom.gov.uk/project/digital -assets/

8 Consultation on the Digital Securities Sandbox - GOV.UK (www.gov.uk)

Mostly supportive, 79% Neutral or mixed, 12% Mostly critical, 9%

TOTAL NUMBER

OF RESPONSES

RECEIVED

1.6 The most critical responses included those from respondents

who fundamentally disagreed with the proposal to bring cryptoassets into the financial services regulatory perimeter (on the basis that they should be banned or, for example, treated in line with gambling regulation) or otherwise disagreed with fundamental aspects of the proposal (e.g. to focus regulation on the activities rather than the assets).

1.7 Figure 1.D. below contains a summary of the most prominent

themes from the consultation feedback.

Figure 1.D Most prominent themes from the Consultation feedback

# Theme Summary of external feedback on theme

Chapter

ref.

Number of

respondents

Non-Fungible

Tokens (NFT) &

utility tokens

Clarify proposed treatment of

NFTs and utility tokens – especially on what constitutes a financial services use case CH 4 25+

2 Geographic

scope

Give further consideration to

the treatment of overseas firms, including making clear the applicability (or not) of the

Overseas Persons Exclusion

(OPE), reverse solicitation, and intra-group exemptions CH 4 25+

3 Phase 1 versus

phase 2

Delineate phase 1 and phase 2

activities in more detail, and give further consideration to potential challenges for firms and consumers CH 3, stablecoin policy note 25+

4 Wholesale

versus retail

Make stronger distinctions

between services provided to professional / sophisticated investors versus retail consumers (e.g. lending, venue disclosures) Various – e.g. CH 5, 6, 7 and 10 25+

5 Timelines Provide more clarity on

timelines for phase 1 and phase 2, and seek to accelerate the CH 3 20+

# Theme Summary of external feedback on theme

Chapter

ref.

Number of

respondents overall implementation programme

6 Security

tokens

Make clear the proposed

treatment of security tokens, and ensure overlapping regimes are avoided (e.g. through an explicit carve-out)

CH 2 and

8 20+

7 Token scope

Ensure cryptoasset definition

used in secondary legislation is not too broad (e.g. make sure it excludes e-money, loyalty schemes, in-game money) CH 2 20+

8 Staking

Provide clarity on the definition

and future treatment of staking and consider accelerating legislation process. Consider carve-out from the scope of the collective investment scheme (CIS) regime CH 12 20+

9 Disclosures

liability

Ensure liability framework for

disclosures is proportionate – especially for tokens without an identifiable issuer CH 5 20+

10 Market abuse

(cross-venue)

Consider a phased

implementation approach towards market abuse surveillance obligations, recognising issues associated with cross-venue information sharing CH 9 15+

FSMA

authorisation process

Streamline authorisation

process – in particular, consider appropriate transition pathways for firms registered with the FCA under its anti- money-laundering regime and/or already authorised under Part 4A of the Financial CH 3 15+

# Theme Summary of external feedback on theme

Chapter

ref.

Number of

respondents

Services and Markets Act 2000

(FSMA)

12 Custody –

scope

Clarify definition and scope for

future regulated cryptoasset custody activities, especially with regards to self-hosted wallets and third-party arrangements CH 8 15+

13 Investment

advice

Reconsider sequencing of

cryptoasset investment advice and portfolio management activities, and ensure these are included in the perimeter CH 12 15+

14 SMEs

Take steps to minimise barriers

to entry for smaller firms – e.g. through careful design of prudential requirements and issuance requirements CH 5 15+

15 Cross-border

enforcement

Clarify how cross-border

enforcement can work in practice to ensure fair and level playing field for UK-regulated firms CH 4, 9 10+

16 Permissionless

blockchains

Ensure the regulatory

framework appropriately reflects the risks associated with permissionless (public) versus permissioned (private) blockchains CH 2 10+

Trading

platform – scope

Clarify definition and scope for

future regulated trading platform activities, e.g. with regards to airdrops and decentralised exchanges

Various -

e.g. CH 5,

6 and 11

10+

18 Banning

crypto

Ban certain cryptoassets from

retail consumer use - or treat them akin to gambling rather than bringing them into the CH 2 5+

# Theme Summary of external feedback on theme

Chapter

ref.

Number of

respondents financial services regulatory perimeter

Transitional

disclosure arrangements

Consider transitional disclosure

arrangements for well- established tokens (e.g.

Bitcoin) to differentiate them

from recently issued tokens CH 5 5+

International

coordination on DeFi

Avoid front-running

international work on DeFi by imposing a prescriptive domestic framework. CH 11 5+

1.8 HM Treasury has considered this feedback carefully and is setting

out some modifications to the original proposals set out in the

Consultation, as well as some actions to be taken forward to provide

further clarity on key areas of interest: • HM Treasury is publishing separately the Stablecoins Update which gives detail on the regulated activities and tokens which will be in scope for phase 1 and how these will be demarcated from phase 2 activities and tokens. • Chapter 2 provides further guidance and reassurance regarding the intended outcomes for NFTs, utility tokens, security tokens and other data objects or ‘things’ which respondents were concerned could unintentionally be captured. It confirms that the proposed regime does not intend to capture activities relating to cryptoassets which are specified investments that are already regulated – e.g. security tokens. It also clarifies that activities relating to truly unique or non-fungible NFTs that are more akin to digital collectibles or artwork than a financial services (in the general sense) or product should not be subject to financial services regulation.9 • Chapter 3 includes updates on timelines for phase 2 legislation and further information on the future FCA authorisation process for cryptoasset activities. • Chapter 4 acknowledges the need to mitigate the fragmentation of cryptoasset liquidity that could arise from a restrictive location and market access policy. The government will proceed with an

9 See chapters 2 and 4 for full details and qualifications

approach that facilitates access to international liquidity pools under specific circumstances. • Chapter 5 restates the government’s position on issuance and disclosures, noting that the recklessness and negligence liability standards will enable market participants to manage their liability so long as they make reasonable enquiries. The government is also supportive of the use of publicly available information to compile appropriate parts of the disclosure / admission documents. 10 • Chapter 9 sets out a modified approach towards market abuse obligations on cryptoasset exchanges, acknowledging the potential need for a staggered implementation for cross-venue data sharing obligations. • Chapter 12 features a clear direction of travel and plan of action on staking to inform the government’s view on a set of critical questions and provide regulatory clarity to industry in an accelerated way versus the previous plan. An engagement programme with external stakeholders has already been launched to inform this work. • Other topics in Figure 1.D. are discussed in various chapters as indicated in the table. Where a significant number of respondents set out a proposed way forward that is different to the government’s proposed approach, the rationale underpinning the government’s decision is set out in this Response.

10 Though persons preparing disclosure/ admission documents would need to be clear on where this

information originated and the level of due diligence they had done over it

Chapter 2

Definition of

cryptoassets and legislative approach

Recap on original proposals from the Consultation

2.1 The Consultation set out government’s intention to include the

financial services regulation of cryptoassets within the regulatory framework established by FSMA, rather than develop a standalone bespoke regime, and to include cryptoassets in the list of ‘specified investments’ in Part III of the RAO. This would require firms undertaking activities involving cryptoassets by way of business to be authorised by the FCA under Part 4A of FSMA and make available the FCA’s general rule-making powers. The Consultation also referred to the government’s ability to use the DAR to designate certain activities in order to make regulations relating to the performance of that activity. The Consultation noted that it is not government’s intention to expand the definition of ‘financial instrument’ in Part 1 of Schedule 2 to the RAO to include currently unregulated cryptoassets (though those cryptoassets that already qualify as financial instruments, such as security tokens, will continue to do so).

2.2 HM Treasury received 80 responses to this question. 94% of

responses agreed or generally agreed with the proposal, and 6% disagreed. Of those who supported the proposal, the main arguments in favour revolved around the fact that this would be a relatively pragmatic and flexible way of bringing cryptoasset activities into the regulatory perimeter, thereby addressing the most critical risks and creating a more level playing field for market participants. Respondents also noted that this approach would be broadly consistent with most other major jurisdictions.

Question 1

Do you agree with HM Treasury's proposal to expand the list of “specified investments” to include cryptoassets? If not, then please specify why.

2.3 Among those that were generally in favour, it was however noted

that the FSMA 2023 definition of cryptoasset was very broad and therefore there was a risk of creating overlapping regimes for existing specified investments (e.g. e-money, security tokens or tokenised deposits), inadvertently capturing data objects such as book entry tokens, or casting the net too broadly by capturing NFTs or utility tokens which are not used for one of the regulated activities in Table 4A of the Consultation within financial services markets or as a financial services instrument (in the general sense), product or investment.

2.4 Those that disagreed with the proposal were mostly of the view

that cryptoassets (or at least certain types of cryptoassets – such as unbacked cryptoassets) should not be given legitimacy through being incorporated into the financial services regulatory perimeter (the ‘halo effect’ argument). Some of these respondents called for outright bans, or restrictions to prevent retail consumers from being able to purchase cryptoassets. Other suggestions included treating retail purchases of unbacked cryptoassets as a form of gambling. A small number of respondents agreed with the need to apply financial services regulation but disagreed with the mechanism of using the RAO, arguing that a standalone bespoke regime would offer greater flexibility and would be more proportionate given the nascency of the sector. Some respondents argued that HM Treasury’s approach should be much more cognisant of the risks associated with permissioned (private) vs permissionless (public) blockchains – typically arguing that the risks associated with the latter were generally higher and different in nature.

A few responses suggested that the legislative and regulatory

framework should actually be fundamentally structured around this distinction.

2.5 HM Treasury received 68 responses to this question. 82% of

respondents agreed or generally agreed with the proposal, while 10% disagreed and 7% of responses were neutral or mixed.

2.6 Those who were generally supportive of the proposal noted that

applying an existing regime to cryptoassets – a relatively new asset class with unique features and risks – would likely result in unsuitable and potentially onerous regulation. Even among supportive responses, however, there was some concern that not including cryptoassets within the definition of financial instruments could lead to uncertainty, including but not limited to how the cryptoassets regime and the financial instruments regime would interact.

Question 2

Do you agree with HM Treasury's proposal to leave cryptoassets outside of the definition of a "financial instrument"? If not, then please specify why.

2.7 At least one respondent queried how the proposal not to include

cryptoassets within the definition of financial instruments would impact other legislation using that term. This is not dealt with in this chapter but for further information see chapter 8. Other responses highlighted the need to ensure consumers who purchase cryptoassets benefit from the same level of safeguards as the holders of assets that do fall within the definition of financial instruments.

2.8 Those who disagreed with the proposal generally did so on the

basis that it would be a positive step to bring cryptoassets within the scope of the existing, well-developed regime for financial instruments. At least one response noted that the list of financial instruments is already relatively expansive and queried why – given the breadth of assets covered – it could not also extend to cryptoassets.

2.9 HM Treasury received 53 responses to this question. Of those, 38%

indicated that there were possible challenges, while 30% of responses were mixed or uncertain. 32% of respondents did not identify any potential challenges.

2.10 A common theme among responses was the need for greater

clarity on when HM Treasury would consider using the DAR to legislate for cryptoasset activities and, where it decided to do so, what the regime would look like. Some respondents suggested that HM Treasury should be required to consult in circumstances where it proposed to use the DAR to provide greater clarity to industry. Some respondents recognised the benefits offered by the DAR in terms of flexibility, but nevertheless felt there was some risk in two regimes – the DAR and the RAO – coexisting and potentially overlapping. At least one respondent queried how monitoring and enforcement would work under the DAR regime and made the point that if overseas enforcement under the DAR was more difficult, that might strengthen the case for the government/regulators to require cryptoasset firms to establish in the UK. HM Treasury’s assessment was that many of the concerns raised arose from lack of familiarity with the DAR, given its novelty. Most respondents pointed out potential challenges and risks in a constructive way but did not seem to be implying that the use of the DAR was unworkable.

2.11 Among those responses that were neutral or mixed, there was

likewise a call for greater clarity as to how and when the DAR would be used. At least one respondent highlighted the need to ensure the DAR provided consumers with safeguards equivalent to those in the RAO.

Question 3

Do you see any potential challenges or issues with HM Treasury’s intention to use the DAR to legislate for certain cryptoasset activities?

Government response

2.12 In general, the government intends to proceed as proposed in

the Consultation. In particular, the government will expand the list of ‘specified investments’ in Part III of the RAO and thereby require firms undertaking relevant activities involving cryptoassets by way of business to be authorised by the FCA under Part 4A of FSMA. FSMA is well-established and understood by firms. In line with feedback received, the government continues to consider that developing a fully bespoke regime outside of the FSMA framework would risk creating an un-level playing field between cryptoasset firms and the traditional financial sector. The government’s approach would also be in line with the approach taken by numerous other jurisdictions.

2.13 Likewise, the government does not plan to expand the definition

of ‘financial instruments’ in Part 1 of Schedule 2 of the RAO to include presently unregulated cryptoassets. Notwithstanding some limited feedback to the contrary, the government agrees with the majority of respondents that retrofitting the existing financial instruments regime to cryptoassets would likely result in unsuitable and potentially onerous regulation.

2.14 The government considers that the DAR is a strong, flexible tool

that will likely form part of the delivery of the future financial services regulatory regime for cryptoassets.

Definition of cryptoassets

2.15 The government has received a high volume of feedback – both

in responses to the Consultation and through wider stakeholder engagement – to the effect that the definition of cryptoassets in the Consultation is overly broad. As set out in Chapter 2 of the Consultation, the definition (which is taken from FSMA 2023) is drawn broadly so as to capture all current types of cryptoasset and ensure the government has the power to regulate not only those types of cryptoasset that currently exist but also those that may exist in future.

2.16 The Consultation noted that future financial services regulation

of cryptoassets created using HM Treasury’s powers will typically apply to a particular subset of cryptoassets depending on the matter being regulated and will accordingly use a narrower definition to capture these. That notwithstanding, the government is keen to reassure industry regarding some specific examples raised in feedback. The precise legal mechanism for distinguishing between tokens that are in and out of scope will be set out in the relevant secondary legislation and FCA rules.

2.17 As a general principle, the government’s intention is that

cryptoassets not being used for one of the regulated activities in Table 4A of the Consultation within financial services markets or used as a financial services instrument (in the general sense), product or investment should fall outside the future financial services regulatory

regime.11 Such cryptoassets may, though, still fall within existing regulated activities or financial instruments, products or investments, such as where they are the underlying asset or property for a CIS.

Where firms have specific concerns over whether a particular

cryptoasset or product would fall within the regime, a useful heuristic may be to consider how a similar product or activity (if there is one) would be treated in the traditional finance context (in line with the principle of “same risk, same regulatory outcome”).

2.18 Likewise, the government does not intend to capture

cryptoassets which are specified investments that are already regulated. This includes, but may not be limited to, security tokens representing debt or equities. Insofar as certain cryptoassets fall within the scope of already applicable existing regulatory regimes, they will largely continue to be regulated in line with the relevant existing rules and regulations. For example, firms carrying out regulated activities involving security tokens will need to obtain relevant permissions or fall within exemptions under the regulatory frameworks applicable to traditional financial services, and could be subject to existing requirements such as those relating to issuance. However, the unique qualities of cryptoassets will likely require a small number of specific adjustments to these existing regimes (for instance around custody– dealt with in more detail in Chapter 8) but the government does not expect these to be extensive. To the extent specific changes are required to accommodate for distributed ledger technology (DLT), these will likely be taken forward through the DSS initiative.

2.19 The government received a significant number of responses

requesting further clarity on the proposed treatment of NFTs and utility tokens. These categories of token are discussed in Chapter 4.

Calls to ban cryptoassets or regulate cryptoassets as gambling

2.20 The government acknowledges the responses it received

suggesting that certain cryptoassets should be banned or treated as gambling. As set out in its response to the Treasury Select Committee,12 the government firmly disagrees with the suggestion that retail trading and investment activity in unbacked cryptoassets should be regulated as gambling rather than a financial service. Such an approach would run counter to globally agreed recommendations from international organisations and standard setting bodies (SSBs) and would risk

11 At various points, this document refers to certain categories of cryptoassets or activities falling outside the future financial services regulatory regime for cryptoassets or includes wording to that effect. Such references refer to the regime that is the primary focus of this Consultation, namely that governing new regulated activities under the RAO and/or designated activities under the DAR. Such wording should not be taken to mean that said cryptoassets or activities might not be regulated under other regulatory regimes either now or in the future (including but not limited to the financial promotions regime, applicable existing regulatory regimes for traditional securities or generally applicable areas of law such as in relation to anti-money laundering/counter- terrorism financing or fraud).

12 https://committees.parliament.uk/publications/40999/documents/199652/default/

misalignment with international standards and the approaches of other major jurisdictions, including the EU.

2.21 Regulating cryptoasset activities as gambling would also risk

creating unclear and overlapping mandates between financial regulators and the Gambling Commission. Furthermore a system of gambling regulation could fail to appropriately mitigate many of the risks identified in the Consultation, including those associated with market manipulation, prudential arrangements, and deficiencies in core financial risk management practices. These are more appropriately addressed through financial services regulation.

2.22 The proposal to ban cryptoassets similarly fails to address other

risks associated with the industry. There would be adverse consequences in terms of innovation, and there is no guarantee that banning cryptoassets would protect consumers, given high public demand and the availability of services in other jurisdictions. Indeed, many countries that have banned cryptoassets – or significantly restricted their uses – have higher adoption rates than the UK.

2.23 The government considers that having robust and effective

regulation will boost innovation, by giving people and businesses the confidence they need to use new technologies safely. By making the UK a safe place for the use and development of these technologies, the UK can help attract investment, generate new jobs, benefit from tax revenues, and promote innovation in new products and services.

Permissioned (private) vs permissionless (public) blockchains

2.24 For the purpose of activities addressed in this Consultation, the

government aims to create the right conditions for crypto and digital asset innovation – on both private and public blockchains – to flourish in a safe environment. These proposals allow for certain activities (phase 2 activities listed in Table 4A) to be conducted across all blockchains subject to certain controls and disclosures being put in place.13The government proposes to address the risks in a flexible manner through, for example, disclosure/ admission requirements and obligations on cryptoasset service providers. Regulators will continue to consider the risks of using these new technologies to appropriately mitigate the risks they pose.

2.25 The detailed contents of disclosure / admission documents will

be defined by cryptoasset trading venues, subject to FCA principles (see

Chapter 5). However, this could include, for example, information about

a token’s underlying code and network infrastructure, known vulnerabilities, risks (including cybersecurity and governance risks) and dependencies (e.g. reliance on third party or decentralised blockchains or other infrastructure).

13 Note that certain regulatory authorities such as Basel Committee on Banking Supervision (BCBS) recommend a different approach for permissionless blockchains when they pertain to stablecoins issued by banks

2.26 Furthermore, the authorisation and supervision of firms

undertaking phase 2 regulated cryptoasset activities – which will be designed in more detail through FCA-led consultations and rulebooks – will consider operational risks (see Chapters 6, 7, 8 and 10). In line with

International Organisation of Security Commissions (IOSCO)

recommendations firms will be required to disclose material sources of operational and technological risks and have appropriate risk management frameworks in place to manage and mitigate such risks. Again, this would likely need to cover risks arising from dependencies on specific blockchains and networks.

Chapter 3

Overview of the current

regulatory landscape for cryptoassets

Recap on original proposals from the Consultation

3.1 The Consultation set out the government’s expectation that

those categories of cryptoasset that already fall within the perimeter of an existing regulatory regime (e.g. those that already qualify as ’specified investments’ or fall within the definition of a ’financial instrument’ in Part 1 of Schedule 2 to the RAO or as e-Money) will continue to be regulated under those regimes, rather than under the future financial services regulatory regime for cryptoassets. In terms of the delineation between phases 1 and 2, the Consultation set out that phase 1 would cover the regulation of activities relating to fiat-backed stablecoins used for payment, while phase 2 would cover the broader cryptoasset regime.

3.2 The Consultation also set out the expectation that once the

cryptoasset regime is in place, firms undertaking regulated cryptoasset activities would likely need to adhere to the same financial crime standards and rules under FSMA that apply to equivalent or similar traditional financial services activities. Relatedly, the introduction of an authorisation regime under FSMA for persons carrying out certain activities involving cryptoassets means that crypto firms already registered with the FCA under the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs) and carrying out those activities will need to also seek authorisation from the FCA under the new FSMA-based regime. This is because businesses will need to be assessed against a wider range of measures than they were as part of the MLR registration process.

Question 4

How can the administrative burdens of FSMA authorisation be

mitigated for firms which are already MLR-registered and seeking to undertake regulated activities? Where is further clarity required, and what support should be available from UK authorities?

3.3 HM Treasury received 54 responses to this question. Several

respondents made the point that it is important for the regime’s credibility that it be seen to be robust, rather than light touch. Multiple respondents also praised the FCA’s recent feedback statement on good and poor applications.14 That notwithstanding, respondents offered a wide range of proposals to mitigate the burden of applying for FCA authorisation for firms that are already MLR-registered. Common suggestions included: • transitional arrangements (e.g. a temporary permissions regime) to enable firms to continue undertaking business activities while their authorisation applications are processed • avoiding the need for firms to re-submit information in their authorisation application that was previously submitted as part of their MLR registration application • clear guidance from the FCA on timelines and expected content of applications, potentially including detailed checklists, worked examples, and Q&A documents • a collaborative approach between applicants and the FCA (e.g. providing a facility to correct minor errors or omissions rather than requiring applications to be withdrawn, ongoing engagement with authorisation case officers, and an obligation for the FCA to provide a statement of reasons when it asks for an application to be withdrawn) • a requirement for the FCA to anonymously publish metrics on the outcome of applications • ensuring the FCA is adequately resourced to allow the timely processing of applications

3.4 At least one respondent suggested the authorisation

applications of firms registered under the MLRs could be prioritised, while another highlighted the need to avoid a ‘first mover’ advantage for firms who are authorised early by virtue of being the first reviewed.

3.5 Finally, a small number of respondents proposed access to a

streamlined ‘variation of permission’ route for firms already authorised for one or more existing activities. At least one respondent went further and proposed automatic transition to the new regime for firms that have an existing Part 4A authorisation and are also registered under the MLRs.

14 https://www.fca.org.uk/firms/cryptoassets-aml-ctf-regime/cryptoasset-aml-ctf-regime-feedback-good-and-poor-quality-applications

Question 5

Is the delineation and interaction between the regime for fiat- backed stablecoins (phase 1) and the broader cryptoassets regime (phase 2) clear? If not, then please explain why.

3.6 HM Treasury received 50 responses to this question. 66% of

responses agreed or generally agreed that that the delineation and interaction between the regimes was clear, while 26% disagreed. 8% of respondents were either neutral on the point or their view was mixed.

3.7 A common theme across the responses was that industry would

appreciate greater clarity on the definitions of, and distinctions between, regulated stablecoins and cryptoassets more broadly. Likewise, many respondents were not clear on what was meant by stablecoins that are “used as a means of payment”. They highlighted that unbacked cryptoassets as well as so-called stablecoins are capable of being (and indeed are already) used for payments, as well as the fact that the way in which a particular stablecoin or cryptoasset is used can change over time and differ from user to user.

3.8 There was also some uncertainty around whether firms who

undergo an authorisation process for stablecoin custody activity as part of phase 1 would also be required to undertake a separate authorisation process for other stablecoin activities or wider cryptoasset activities once they come to be regulated as part of phase 2, with some suggesting this would be unduly burdensome. A small number of respondents also expressed concern that the phased approach to regulation would lead to confusion among consumers as to what categories of cryptoassets/stablecoins are and are not regulated at a given time.

3.9 HM Treasury received 54 responses to this question. 67% of

respondents felt the phased approach would or could create potential challenges, while 20% disagreed. 13% of respondents were either neutral on the point or their view was mixed.

3.10 Several respondents were concerned that the phased

introduction of regulations would create uncertainty for the industry. In particular, and as noted above in respect of question 5, respondents observed that some firms undertake activities proposed to be regulated under both phase 1 and phase 2. If it is necessary to undertake separate authorisation processes in respect of these then this could be unduly burdensome. Additionally, some activities proposed to be regulated in different phases (e.g. stablecoin custody and exchange) are interdependent. At least one respondent asked what the phased approach would mean for firms undertaking both activities at the time when some parts of their business are regulated and others are not. This could also lead to negative outcomes for consumers who may form the impression that all a firm’s activities are regulated, when in fact only some are.

Question 6

Does the phased approach that the UK is proposing create any potential challenges for market participants? If so, then please explain why.

3.11 Several respondents expressed more general concerns that the

phased approach would lead to a drawn-out process, with multiple responses requesting greater clarity on the timescales for each phase. The delay between phases could also lead to unintended gaps and/or conflicting definitions. Several respondents noted that delays would have adverse consequences for UK competitiveness.

3.12 Respondents also addressed prioritisation of particular activities

within the phased approach. Different respondents sought different approaches. Some activities (e.g. staking) were broadly felt to merit a higher priority, while at least one respondent disagreed with the proposal to prioritise stablecoins within phase 1. Several respondents highlighted DeFi as one area where the government’s proposed prioritisation was appropriate, with the approach allowing the understanding of the market and efforts at international cooperation to develop.

Government response

FSMA authorisation process for regulated cryptoasset activities

3.13 Regarding the FSMA authorisation process, the new regime will

be broader in scope than the current MLR registration regime and will include aspects of regulatory compliance that may not have previously been assessed. Authorisation will therefore not be automatically granted to MLR registered firms. However, the FCA will provide more detail on what the assessment will involve in due course and will also consider the regulatory histories of all applicant firms in those assessments. Similar to the current MLR registration regime, the FCA will seek to (i) provide feedback on good and poor-quality applications for the new regime as expeditiously as possible (ii) engage with the consultants and legal advisors supporting firms to contribute to the regulatory clarity that professional services are able to support applicant firms with, and (iii) provide data on the number of applications received and the outcomes of those applications.

3.14 In line with the proposals previously set out, the expectation is for

firms that have an existing authorisation under Part 4A of FSMA (for example those authorised to operate a Multilateral Trading Facility (MTF)) to apply for a Variation of Permission (VoP), rather than having automatic permissions or exemptions to enable them to undertake newly regulated cryptoasset activities. This is deemed important since regulatory regimes for cryptoasset activities will be tailored according to the specific risks and characteristics of cryptoasset markets. A ‘pure lift and shift’ approach and, by extension, automatic granting of permissions for firms undertaking similar – but not identical – activities relating to existing specified investments would not be appropriate. Such firms are however likely to benefit from their existing capabilities and supervisory history as they undertake the VoP process.

3.15 The same would apply to a firm which had established FSMA

authorised status for phase 1 regulated activities relating to fiat-backed

stablecoins. Such a firm would be expected to apply for a VoP if seeking to undertake additional regulated activities that fall under the scope of phase 2.

Delineation between phase 1 and phase 2 activities

3.16 On the delineation between phase 1 and phase 2 activities and

the associated challenges, readers are pointed towards the separate Stablecoins Update for further clarity on this. By way of summary, the Stablecoins Update outlines the government’s intention to prioritise (i) the creation of FCA regulated activities under the RAO for the issuance and custody of fiat-backed stablecoins which are issued in the UK and (ii) the regulation of payment services relating to certain fiat-backed stablecoins where used in a UK payment chain under the Payment Services Regulations 2017. This creates the framework for a subset of fiat-backed stablecoins to safely operate and grow in the UK under the payments regime, within a regulated environment. This approach also focuses on stablecoin payments, with custody for the majority of other cryptoassets and other core activities (e.g. operating an exchange) generally coming in phase 2. The government expects that this will provide a degree of optionality and flexibility for firms wishing to undertake phase 1 activities as early adopters as well as those with business models more focused on phase 2-only activities. The Stablecoins Update also gives further detail on the legislative approach on custody for all cryptoassets - since the government envisages that the same framework will likely be extended and expanded to the broader perimeter of cryptoassets under phase 2.

3.17 Respondents who raised other challenges around the

government’s proposed prioritisation of activities (for example those that called for acceleration of certain activities in future phases) are pointed towards chapter 4, and also chapter 12 which provides updates on the government’s approach towards staking activities, cryptoasset investment advice and mining, amongst other activities.

Timelines

3.18 In response to calls for further clarity on timelines, and to

accelerate the overall implementation programme, the government’s aim is for phase 2 secondary legislation to be laid in 2024, subject to Parliamentary time.

Chapter 4

Scope and sequencing

of cryptoasset activities

Recap on original proposals from the consultation

4.1 The Consultation set out the government’s intention to create a

number of new regulated or designated activities tailored to the cryptoasset market where those activities mirror, or closely resemble, regulated activities performed in traditional financial services. The

Consultation also set out a list of illustrative cryptoasset activities to

bring into the regulatory perimeter and a proposed sequence for these activities across several phases. The Consultation noted the intention to capture cryptoasset activities provided in or to the United Kingdom and set out a number of challenges the government has identified in connection with different business models (namely those with a significant degree of vertical integration) and certain categories of cryptoassets (namely commodity-linked tokens, so-called algorithmic stablecoins and stablecoins backed by cryptoassets, NFTs, and utility tokens).

4.2 HM Treasury received 66 responses to this question. 67% of

respondents agreed or generally agreed with the proposed territorial scope but 20% disagreed. 14% of responses were neutral or mixed.

4.3 Those who broadly agreed with the proposal to capture activities

both in and to the UK observed that many of the recent market failures have involved overseas firms. They saw the proposed territorial scope as necessary to protect consumers and ensure regulators have oversight of firms that are domiciled overseas while providing services to UK consumers.

4.4 Some respondents – both those that generally agreed and

disagreed with the proposed territorial scope of the regime - queried how the UK would in practice enforce regulations over firms in other jurisdictions conducting activities in the UK. They observed that doing so will require cooperation between national regulators.

Question 7

Do you agree with the proposed territorial scope of the regime? If not, then please explain why and what alternative you would suggest.

4.5 Several of those respondents that disagreed with the proposal

considered capturing activities in or to the UK represented a departure from the territorial scope of the regimes governing regulated activities involving traditional assets. There was some concern that capturing activities undertaken in jurisdictions other than the UK would risk causing confusion or subjecting businesses to conflicting regulations. At least one respondent was concerned that subjecting international firms to UK regulation might be seen as unduly onerous and that overseas firms may choose to simply ignore UK regulation while continuing to offer services to UK consumers.

4.6 A frequent theme across responses was the call for government

to expand the scope of the OPE to cover regulated activities relating to cryptoassets as it does with regulated activities relating to certain traditional assets. Additionally, or in the alternative, many respondents were in favour of the future regime making provision for reverse solicitation and/or equivalence arrangements with other jurisdictions.

4.7 HM Treasury received 61 responses to this question, of which 80%

agreed or generally agreed with the list of activities. 7% of respondents disagreed, with 13% of responses being neutral or mixed.

4.8 Respondents supportive of the government’s proposals noted

with agreement that the government is proposing to regulate activities that are similar to those that exist in traditional financial services in a similar manner. There were, however, a number of activities that government did not propose to bring within the regulatory perimeter that respondents – including those who were generally supportive of the proposals – felt should be included. Many respondents requested that the regulatory treatment of staking should be clarified as a priority, rather than reserved for future phases of regulation. Additionally, some raised discretionary portfolio management services and the provision of investment advice as activities that could give rise to harms to consumers if undertaken improperly.

4.9 Both those respondents who were generally supportive and

those who were generally critical of the proposals raised the need for greater clarity over the scope of certain activities. Respondents also highlighted how activities that might on the surface appear to be broadly analogous to traditional financial services activities would differ in the cryptoasset context.

4.10 Some respondents urged the government not to be unduly hasty

about bringing DeFi activities within the regulatory perimeter. Their concern was to avoid misinterpreting or mis-categorising the

Question 8

Do you agree with the list of economic activities the government is proposing to bring within the regulatory perimeter?

underlying nature of DeFi activities and thereby risk discouraging innovation in this rapidly evolving space.

4.11 Some respondents felt strongly that certain activities should be

permanently left outside the financial services regulatory perimeter. Mining and validation activities were frequently mentioned examples.

Some respondents also disagreed with the proposals in the

Consultation on the basis that banning cryptoasset activities would be a

preferable approach to regulating them.

4.12 51 responses were submitted to this question. 69% agreed with

the proposed phasing but 25% disagreed. 6% of responses were either neutral or mixed.

4.13 The majority of responses to this question were broadly

supportive of the government’s proposals. That notwithstanding, alternative proposals for prioritisation did emerge as themes across multiple responses. As discussed in paragraph 4.8 above, several respondents were concerned at the proposal to omit or delay the regulation of portfolio management activities and the provision of investment advice in connection with cryptoassets.

4.14 Likewise, a high number of respondents encouraged the

government to prioritise providing clarity on the treatment of staking. Those who did so emphasised the importance of staking as part of the technology underpinning the sector, sought to distinguish it from the provision of a financial service, and highlighted the potential competitive advantage the UK could derive from being an early mover in this space.

4.15 Smaller numbers of respondents felt that higher priority should

be afforded to other activities, including custody of unbacked cryptoassets and the development of rules for the admission of new tokens (both currently slated for phase 2). A smaller group raised concerns with the proposed prioritisation on the basis that a ban would be preferable to regulation.

4.16 Across a range of different responses, a key theme was the need

for government to act quickly and minimise delay between phases. In general, respondents were clear that they would appreciate additional clarity on the government’s plans around the timing of the different phases.

Question 9

Do you agree with the prioritisation of cryptoasset activities for regulation in phase 2 and future phases?

4.17 53 responses were received to this question. 74% of those agreed

or generally agreed with the assessment. 6% disagreed and 21% were neutral or mixed. Responses to this question mostly agreed with the challenges and risks identified in the Consultation. That notwithstanding, responses did include a number of additional challenges and risks respondents felt the government ought to consider in connection with vertically integrated business models. In particular, respondents noted: (i) that platforms requiring the use of a native token could increase risks for consumers, (ii) that the predominance of a small number of vertically integrated firms’ risks could have a negative effect on competition and innovation (as newer, smaller firms struggle to compete), and (iii) the potential for large-scale market disruption or the failure of a large firm to lead to systemic risk and contagion effects. Some respondents also queried how any requirements on vertically integrated firms would be applied to decentralised entities.

4.18 While it is important to acknowledge the challenges and risks

associated with vertically integrated firms, a significant number of respondents noted these risks and challenges are not unique to cryptoasset firms. Responses frequently noted the same or similar risks are present - and with appropriate governance and risk management can be effectively mitigated - in the traditional financial sector.

4.19 Those responses that were more critical of the government’s

assessment of the challenges and risks expressed a preference for restrictions or bans on cryptoassets or noted that the recent failures of large cryptoasset exchanges appear to have been the result of fraudulent activity and the failure to safeguard client funds rather than risks specifically associated with vertically integrated business models.

4.20 Relatively few responses (24) were submitted to this question. Among those, 50% of those responses supported the proposition that existing commodity linked tokens would either fall within scope of existing regulatory frameworks as they apply to the underlying commodity or could be adequately catered for through the broader cryptoasset regime. Only 17% of responses disagreed (with the

Question 10

Do you agree with the assessment of the challenges and risks associated with vertically integrated business models? Should any additional challenges be considered?

Question 11

Are there any commodity-linked tokens which you consider would

not be in scope of existing regulatory frameworks?

remaining 33% neutral, mixed or unsure). That notwithstanding, some responses recognised that the pace of development in this area means this will need to be kept under review with commodity-linked tokens considered on a case-by-case basis.

4.21 53 responses were received to this question. 71% of those agreed

or generally agreed with the proposal. 13% disagreed and 15% were neutral or mixed. Responses to this question mostly agreed that so- called algorithmic stablecoins and crypto-backed tokens should be regulated in the same way as unbacked cryptoassets. Those responses that supported the proposal tended to oppose any suggestion of equivalence between fiat-backed stablecoins and other types of tokens which seek to maintain a stable value. Supportive responses also commonly noted that regulating algorithmic stablecoins and crypto- backed tokens in the same way as unbacked cryptoassets was in line with the principle of “same risk, same regulatory outcome”.

4.22 Responses that opposed the proposal observed that regulating

algorithmic stablecoins and crypto-backed tokens as unbacked cryptoassets would risk divergence with the European Union’s approach under the Markets in Crypto-Assets Regulation (MiCA). Some responses also noted that it is not possible at present to say how algorithmic stablecoins can or might be used in future and bespoke category would therefore be appropriate. At least one response suggested it might be beneficial to determine the approach to regulation on a case-by-case basis, taking into account the unique characteristics, design and function of a token.

4.23 HM Treasury received 62 responses to this question. 65% of

respondents felt the proposed treatment was not clear, compared to 19% who thought it was entirely or generally clear. A further 16% of responses were mixed or neutral on the question.

4.24 A significant proportion of respondents felt the definitions of NFT

and utility token in the Consultation were not clear, either because they were factually incorrect or not sufficiently exhaustive. Likewise, many respondents objected to the statement that “[a]ll cryptoassets featured

Question 12

Do you agree that so-called algorithmic stablecoins and crypto- backed tokens should be regulated in the same way as unbacked cryptoassets?

Question 13

Is the proposed treatment of NFTs and utility tokens clear? If not, please explain where further guidance would be helpful.

in Box 2.A – including NFTs and utility tokens – would have the potential to be in included in the future regulatory perimeter if they were used in one of the activities in Table 4A”. Respondents submitted that some activities in Table 4A, such as custody, might be necessary for an NFT or utility token and thereby bring NFTs within the scope of the future regulatory regime without introducing a recognisable financial services activity.

4.25 Other respondents suggested a bespoke regime for NFTs would

be necessary. Some also suggested that if government’s intention was generally not to capture NFTs, then it would need to publish regular guidance on the features that would differentiate an NFT from other categories of cryptoasset.

4.26 Finally, some respondents noted that if NFTs were ultimately not

captured within the financial services regulatory regime, it would be important to ensure they are subject to relevant anti-money laundering legislation to mitigate the money laundering risks NFTs share with similar non-financial services asset classes, such as artworks.

Government response

Scope of regulated cryptoasset activities

4.27 By and large, the government intends to implement the

territorial scope of the future regulatory regime as proposed in the

Consultation. This means – subject to the token category exceptions

discussed in more detail below – a person (whether legal or natural) will generally be required to be authorised by the FCA under Part 4A of FSMA if: • they are undertaking one of the regulated activities; • by way of business; and • they are providing a service in or to the UK. Table 4.A Proposed scope of cryptoasset activities to be regulated under Phase 2

Activity category Phase 2 sub-activities

(indicative, non-exhaustive) Chapter

Issuance activities

Admitting a cryptoasset to a cryptoasset

trading venue Chapter 5

Making a public offer of a cryptoasset Chapter 5

Exchange

activities

Operating a cryptoasset trading venue

which supports: (i) the exchange of cryptoassets for other cryptoassets (ii) the exchange of cryptoassets for fiat currency (iii) the exchange of cryptoassets for other assets (e.g. commodities)

Chapter 6

Activity category Phase 2 sub-activities

(indicative, non-exhaustive) Chapter

Investment and

risk management activities

Dealing in cryptoassets as principal or

agent

Chapter 7

Arranging (bringing about) deals in

cryptoassets

Making arrangements with a view to

transactions in cryptoassets

transactions in cryptoassets Lending, borrowing and leverage activities

Operating a cryptoasset lending platform Chapter 10

Safeguarding and

/or administration (custody) activities

Safeguarding or safeguarding and

administering (or arranging the same) a cryptoasset other than a fiat-backed stablecoin and/or means of access to the cryptoasset (custody)

Chapter 8

4.28 On the topic of market access, the government shares industry’s

view of the benefit of working towards deference/equivalence type arrangements and is committed to cooperating with international partners – including through the UK’s ongoing work with standard setting bodies such as IOSCO and the Financial Stability Board (FSB) – to deliver a framework that can accommodate this.

4.29 However, it is recognised that the conditions required for

equivalence/deference are not currently in place. Given this, an approach is required that will facilitate access to global liquidity pools under specific circumstances (for example where the global liquidity pool is being operated in a jurisdiction which is meeting international recommendations and standards). This would apply on a time-limited basis for the interim period before appropriate equivalence/deference type arrangements are in place.

4.30 Such an arrangement is important to ensure that UK consumers

achieve satisfactory execution outcomes for their cryptoasset orders. A highly restrictive location and market access policy would be unlikely to achieve this due to limited order book depth (since a UK order would only be able to be matched against another UK order).

4.31 A way of achieving this could be to permit UK firms who are

operating a regulated cryptoasset trading venue in an overseas jurisdiction to be able to apply for authorisation for a UK branch extension of their overseas entity. The branch could be authorised to specifically handle trade matching and execution activity.

15 e.g. a wallet or cryptographic private key

4.32 The specifics of these requirements on physical location would

be determined by the FCA (and informed by the FCA’s framework for international firms) in line with existing practice in the UK.

4.33 For clarity, the government does not support expanding the OPE

to cover cryptoassets. The cryptoasset industry is growing and developing rapidly, but the context of cryptoasset markets is not the same as those for traditional financial products to which the OPE already applies. The government’s position is that firms dealing directly with UK retail consumers should be required to be authorised irrespective of where they are located.

Prioritisation of activities

4.34 In general, the government intends to proceed on the basis of

the priorities as set out in the Consultation. A significant number of respondents said the government should bring forward its work on staking (originally proposed for future phases) and that portfolio management and the provision of investment advice should be included as regulated activities. Both these issues are dealt with in

Chapter 12. The government will bring forward its work on staking but

does not agree that portfolio management and the provision of investment advice on cryptoassets should be brought within the regulatory perimeter at this stage. This latter position will be kept under review.

Vertically integrated business models

4.35 The government intends to regulate vertically integrated

business models as envisaged in the Consultation. At the most basic level, this means vertically integrated businesses should be required to follow the relevant regulatory rules for each regulated activity undertaken.

4.36 While there are risks to vertical integration it should be possible

to mitigate said risks with appropriate governance, controls and risk management systems, as happens in the traditional financial sector.

4.37 As discussed in Chapter 6, the government does not intend to

explicitly endorse or prohibit specific business models or corporate structures in legislation. Doing so at this point would limit the flexibility of a future regulatory regime at a stage when business models are still evolving at pace. It could also shape and influence market structures in unintended or suboptimal ways.

4.38 However, the government’s expectation is that firms will be

required to evidence that conflicts of interest and risks to market integrity are appropriately managed within their specific business models as they seek authorisation. In that regard, trading platforms that admit self-issued tokens or that intend to undertake proprietary trading against customer orders, will require particular scrutiny and ultimately the FCA may determine that some conflicts are impossible to manage. It should be noted that the FCA already has rules on conflicts of interest and will be considering and consulting on how these rules should apply to cryptoasset firms. Managing conflicts of

interest is also one of the FCA’s Principles for Business to which all authorised persons are required to adhere.

4.39 The government recognises that certain firms undertaking

several regulated activities may present a higher risk to the wider ecosystem in the event of failure and the government and regulators will continue to consider whether and how such firms should be subject to proportionate prudential requirements. The requirements will be addressed in detailed FCA rules, but the issue is also being explored in the DSS and could be explored by further Financial Market Infrastructure (FMI) sandboxes – in particular the example of where a firm operates a MTF/organised trading facility (OTF) and simultaneously acts a central securities depository.

4.40 Additionally, as proposed in the Consultation, trading venues will

be required to keep and make available at all times accurate and comprehensive order book data for relating to trading on their exchanges to support effective market abuse and systemic risk monitoring.

Activities relating to asset-referenced tokens

4.41 Very few respondents identified the need for a bespoke

framework for these tokens, and the government notes this continues to be a small percentage of the market in terms of value and trading volumes. On that basis, as set out in the Consultation, to the extent these products do not meet the definition of an existing specified investment or collective investment scheme but do meet the relevant definition of cryptoasset, they will be regulated under the wider regime for unbacked cryptoassets, and other relevant legislation including the financial promotions regime. Where asset-referenced tokens do meet the definition of a specified investment or a collective investment scheme, they should be regulated under the relevant regulatory framework as applicable to that product.

4.42 The government recognises the feedback regarding the speed of

development in this space and will continue to monitor the development of the market for these tokens.

Activities relating to so-called algorithmic or crypto-backed

stablecoins

4.43 As with asset-referenced tokens, the government intends to

regulate these products along the lines set out in the Consultation, as well as under the financial promotions regime. In general, this means so-called algorithmic or crypto-backed stablecoins will be regulated under the wider framework for unbacked cryptoassets. They will not fall within the scope of the forthcoming regulatory regime for fiat-backed stablecoins as they are not backed by fiat currency.

4.44 This approach should not be taken to imply that so-called

algorithmic or crypto-backed stablecoins behave in exactly the same ways as unbacked cryptoassets, but rather the broader framework the government intends to put in place for unbacked cryptoassets has the flexibility to accommodate all these varieties of token.

4.45 As with asset-referenced tokens, this category currently

represents a small percentage of the market in terms of value and trading volumes, but the government will continue to monitor this situation.

Activities relating to NFTs and utility tokens

4.46 Generally, the government’s view is that NFTs of themselves are

more akin to (for instance) digital collectibles or artwork than a financial services product. So, in the same way the sale of art is not regulated as a financial services activity, the government considers that in general activities in connection with NFTs are not appropriate for regulation as a financial service. That said, the government acknowledges that a range of tokens currently on the market are described as NFTs but perform other functions, and it is possible this may become more common in future. As such, when assessing whether a NFT falls within the future financial services regulatory regime, the government’s focus will be on whether the token is used for one of the regulated activities in Table 4A of the Consultation within financial services markets or as a financial services instrument (in the general sense) or product, rather than how it describes itself.

4.47 By way of example, an in-game purchase (such as an object that

can be used or displayed in-game) could be structured as an NFT. It is possible that this NFT might fall within the definition of a cryptoasset (either as defined in FSMA 2023 or in future, as more narrowly defined in secondary legislation). The sale of that in-game purchase (either within a specific game or on a marketplace external to the game) would not necessarily be subject to the financial services regulatory regime for dealing in cryptoassets, as the NFT is not being sold within financial services markets or as a financial services instrument (in the general sense) or product. Likewise, an exchange on which said NFT is traded is unlikely to be subject to the admission and disclosure obligations that would apply to a regulated financial services exchange admitting exchange tokens, or the regime governing the operation of a cryptoasset trading venue.16 In this example, the closest real-world analogy might be to a collectible being sold on an auction site.

4.48 Conversely, something marketed as an NFT could fall within the

future financial services regime for cryptoassets if it was in practice used as an exchange token. For example, a large class of NFTs technically unique but largely indistinguishable from each another could be minted. If buyers purchased these as a financial services instrument (in the general sense) or product without having a preference of one NFT over another (for example, if there was little or no price differentiation between the different tokens), this could be considered an exchange token for those purposes and exchanges trading in the token subject to the applicable financial services regulatory regime. The fact that a token is designed or marketed as an

16 Such an exchange could, of course, be subject to admission and disclosure obligat ions in respect of e.g. exchange tokens admitted to the platform.

NFT will not necessarily preclude the application of financial services regulation.

4.49 The government expects utility tokens to be subject to a similar

assessment as NFTs. Utility tokens are designed to (for example) provide digital access to a specific service or application and use technology such as DLT to support the recording and storage of data. Notwithstanding the purpose for which they were originally designed, a utility token could potentially be traded on cryptoasset trading venues for investment purposes. When assessing whether a utility token falls within the scope of the future financial services regulatory regime, the government’s focus will be on how the token is used, rather on than a hypothetical application of the technology. For example, if a token could be used to access storage, but is also used for one of the regulated activities in Table 4A of the Consultation within financial services markets or as a financial services instrument (in the general sense) or product, it will likely be regarded as an exchange token for those purposes and the relevant activities subject to the appropriate provisions of the future regulatory regime.

4.50 As is the case in traditional finance, cryptoasset firms will need to

consider the relevant regulatory regime applicable to products they offer when designing them and introducing them to the market.

Chapter 5

Regulatory outcomes for

cryptoasset issuance and disclosures

Recap on original proposals from the Consultation

5.1 The Consultation set out government’s intention to establish an

issuance and disclosures regime for cryptoassets grounded in the intended reform of the UK Prospectus Regime: the Public Offers and Admissions to Trading Regime (POATR) and tailored to the specific attributes of cryptoassets. Two regulatory trigger points were proposed: (1) admitting (or seeking the admission of) a cryptoasset to a cryptoasset trading venue, and (2) making a public offer of cryptoassets (including initial coin offerings (ICOs)). For admission of cryptoassets to a UK cryptoasset trading venue, the government proposed to adapt the MTF model from the POATR. Under this framework, venues would write detailed requirements for disclosure documents required for admission, in accordance with principles established in the FCA’s rulebook. For public offers, the current Prospectus Regime applies to offers of cryptoassets where those cryptoassets fall within the definition of securities in scope of the regime. This will continue to be the case under the new POATR, once implemented. For public offers of other cryptoassets the government is considering an alternative route (e.g. using the DAR). All admission and disclosure documents would be stored on the National Storage Mechanism (NSM) maintained by the FCA. Venues would be required to search the NSM before new admissions and ensure information is consistent with other documents lodged.

5.2 HM Treasury received 54 responses to this question. 94% of those

responses agreed or generally agreed with the proposed regulatory trigger points, with 4% disagreeing and 2% of responses being neutral or mixed. Amongst those who fully supported the proposal it was

Question 14

Do you agree with the proposed regulatory trigger points – admission (or seeking admission) of a cryptoasset to a UK cryptoasset trading venue or making a public offer of cryptoassets?

argued that this should help bring about an appropriate level of due diligence as well as increased transparency and trust to tokens that are made available to the UK public. Others noted that the proposed trigger points would also provide room for innovation given that they would not apply to newly minted tokens which are not yet made available to the general public. Many responses also felt that the alignment to the issuance regime for transferable securities was logical.

5.3 Of those who were generally in favour of the proposals, many

requested further clarity on the definition of ‘issuance’, ‘offers’ and other key terms and concepts. At least five responses called for exemptions or transitional arrangements17 for cryptoassets already in circulation (especially those that are relatively well-established) – arguing that these tokens benefit from increased transparency and trust given their trading history. Some responses suggested that the government should clarify the treatment of launchpads, airdrops and decentralised exchanges,18 while others sought greater clarity on issuance obligations for specific token types – e.g. NFTs, fan tokens, governance tokens and other types of utility tokens.19 Some industry associations recommended that currently regulated UK platforms (including currently designated MTFs and OTFs) – in addition to future authorised cryptoasset trading platforms - should be able to undertake primary issuance activities of cryptoassets. Finally, a number of responses cautioned against a ‘lift and drop’ approach based too heavily on the framework for transferable securities.

5.4 A small number of responses disagreed with the proposed

trigger points. At least one of these disagreed with the extra territorial scope, arguing that overseas firms making offers of tokens which may be available to UK customers should not be caught as long as those firms are not directly marketing to UK customers.

5.5 Treasury received 54 responses to this question. 72% of those

responses agreed or generally agreed with the proposal – but a significant minority (26%) disagreed. Those that fully supported the proposal generally felt that centralised venues were the most appropriate market participants to take on oversight and responsibility for setting content requirements given their central role within the

17 Sometimes referred to as “grandfathering” in the feedback received

18 Readers should refer to Chapter 11 (on Decentralised Finance) for further clarity on this

19 Readers should refer to Chapter 4 (on activities relating to NFTs and utility tokens) for further information

Question 15

Do you agree with the proposal for trading venues to be responsible for defining the detailed content requirements for admission and disclosure documents, as well as performing due diligence on the entity admitting the cryptoasset? If not, then what alternative would you suggest?

ecosystem, and the fact that information provided by venues is often the primary source of information for investors. Some responses pointed out that the government’s proposal was preferable to an alternative model whereby a regulator determines a list of ‘approved’ or ‘accepted’ cryptoassets – as is the case in some jurisdictions – since such a model would not be sufficiently scalable or dynamic and would put an excessive burden on the regulator.

5.6 Amongst those who generally supported the proposal, the most

commonly mentioned caveat was the potential for lack of consistency.

The concern here was that giving responsibility for admission

requirements to trading venues could lead to inconsistent and heterogenous disclosure documents, raising costs for the industry and making disclosure documents harder to navigate and interpret for investors. Related to this, some responses warned of venue acceptance arbitrage risks arising from different disclosure standards, a potential race to the bottom, and concentration risks driven by the ability of the largest venues to outcompete smaller players. At least 10 responses suggested that the FCA should play a more prominent role in defining detailed content requirements – for example by developing a template, or through establishing or endorsing some sort of central body to do so. One response also highlighted potential conflicts of interest for trading venues admitting self-issued tokens. Some responses called for further clarity on certain aspects of the proposals – e.g. ongoing disclosure requirements, the obligation for venues to investigate the potential for investor detriment, how requirements would apply to venues only catering only for wholesale or sophisticated investors, and the application of requirements for tokens distributed via decentralised networks.

5.7 26% of responses disagreed with the government’s proposal. This

included those that disagreed with the overall premise of regulating cryptoassets as financial services, as well as those who felt that the proposals put excessive burdens on firms. Within the latter population, some responses felt that the proposals went beyond the EU’s equivalent framework (MiCA) in particular due to the potential disclosure responsibilities on venues admitting assets with no identifiable issuer. Some felt very strongly that the FCA (or even HM Treasury) should play this role instead of cryptoasset trading venues. One respondent suggested that the regulator should instead oversee a register of approvers to enable other market participants – not just cryptoasset trading venues – to approve disclosure documents.

5.8 47 responses were received to this question. 64% of responses

agreed or generally agreed with the proposed options but a significant minority (34%) objected to the approach on liability. Those in favour of

Question 16

Do you agree with the options HM Treasury is considering for liability of admission disclosure documents?

the proposals felt that some form of liability would be necessary to make the disclosures regime meaningful and effective. It was also pointed out that the proposed approach would align to the disclosures regime for transferable securities.

5.9 Some respondents were generally supportive of the approach

towards liability but pointed out that costs arising from the use of law firms and other third parties could be transferred to investors. Others cautioned that the approach could favour more established cryptoassets and called for early-stage exemptions or minimum thresholds to help foster innovation in newer tokens. On a related note, some responses warned that prudential requirements could favour larger, more established exchanges and issuers.

5.10 Several responses argued that preparers of disclosure /admission

documents should be permitted to use public information sources and provide information on a ‘reasonable endeavours’ basis – especially for more decentralised tokens. A number of cryptoasset exchanges pointed out that they would be extremely reluctant to take on liability for information that relates to the underlying token and network / protocol which is fully outside of their control (for example information concerning the token supply schedule, the vesting schedule, and the operation of the underlying consensus mechanism). Their view was the authorities should therefore consider the degrees of separation between the information and the organisation which produces the admission disclosure document.

5.11 Responses which disagreed with the government’s proposed

approach generally took stronger positions on the arguments outlined above. Several strongly objected to the suggestion that venues should take any form of liability for tokens they admit for trading where there is no clearly identifiable issuer. Some warned of the potential for a major ‘chilling effect’, limiting the availability of tokens and the depth of information in disclosure documents. A few responses suggested that the current proposals would push venues to locate elsewhere.

5.12 HM Treasury received 53 responses to this question, with 92%

agreeing or generally agreeing and 6% disagreeing. Most respondents felt that this was a sensible basis or starting point - though there were various suggestions to include additional information including: • Further information relating to the issuer or person controlling the project – e.g. relevant financial information, their location / domicile, previous cryptoasset products and services and ICOs

Question 17

Do you agree with the proposed necessary information test for cryptoasset admission disclosure documents?

• Information relating to the token economics – e.g. token supply, distribution, inflation, reward mechanism • Information relating to the token’s governance – e.g. distribution of voting rights, governance processes for code changes, use of time locks, review periods • Information around potential conflicts of interest as well as available redress mechanisms or compensation arrangements (or lack thereof)

5.13 Extensive feedback was received on the proposals to include risk

information. Many responses pointed out that risk information should be focused, specific and useful – and that care should be taken to avoid a framework which results in forward-looking risk disclosures which are excessively long, unhelpfully exhaustive about every conceivable risk type, generic, and unlikely to be read by the typical investor. Others pointed out that risks are difficult to measure objectively for unbacked cryptoassets.

5.14 In terms of style, many responses suggested that disclosures

should be required to be made in simple, understandable language – and should feature standardised, easily comparable information. A few respondents recommended that the necessary information test is kept flexible and not overly prescriptive. However, others noted that accompanying guidance would be helpful or necessary to assist firms in meeting the necessary information test.

5.15 HM Treasury received 39 responses to this question, with 90%

agreeing or generally agreeing and 8% disagreeing. Many responses again recommended caution in mirroring the POATR too closely, without sufficient regard to the specific risks and characteristics of cryptoasset markets. Another common theme was proportionality and international competitiveness, with many stressing the need to avoid excessive barriers to entry, such that innovation from smaller players can be encouraged and accommodated.

Government response

Disclosure requirements for well-established tokens and tokens

without identifiable issuers

5.16 In general, the government intends to take forward the proposed

approach, including the basis for the regime and trigger points. The government’s view is there should be disclosure documents in place for all cryptoassets which are made available for trading on a UK

Question 18

Do you consider that the intended reform of the Prospectus Regime in the Public Offers and Admission to Trading Regime (POATR) would be sufficient and capable of accommodating public offers of cryptoassets?

cryptoasset trading venue. This would include all well-established tokens (i.e. those characterised by relatively high levels of liquidity and at least several years of trading history) as well as those which do not have a clearly identifiable issuer - e.g. Bitcoin. The key purpose of this regime is to make available consistent, minimum standards of information to consumers for all tokens used for activities within the regulatory perimeter. From this perspective it does not make sense to have a two-tier regime which differentiates between well-established tokens and more recently launched tokens. Indeed, these well- established tokens are likely to continue to be the most important tokens in terms of market share and consumer exposure for the foreseeable future, making them even more important from a consumer information perspective.

5.17 To reduce the risks and impacts of ‘cliff edges’ and avoidable

removals from trading20 relating to the back book of tokens already in circulation, there will need to be sufficient transitional arrangements for bringing activities into the regulatory regime – i.e. sufficient time periods between laying the legislation and the regulatory regime becoming effective.

5.18 In addition, the government agrees that those preparing

documents could make use of publicly available information when preparing relevant sections of their disclosure / admission documents, but they would need to be clear where this information originated and the level of due diligence they had done over it. This would be consistent with the approach under the UK’s POATR. Venues could also work together to jointly gather disclosure information, make use of third parties, or distribute the administrative burden in other ways that are mutually agreeable.

5.19 The government agrees with responses which suggested that

some degree of token withdrawals from platforms may be beneficial through identifying and removing cryptoassets which no party is willing to stand behind (or where the necessary information simply cannot be reliably gathered and assessed) from the public sphere. This could increase trust and confidence levels in the remaining population of tokens which are publicly accessible.

5.20 For cryptoassets which are issued after the regime becomes

effective, the government’s position – based on the current and historical situation – is that the quantum or flow of these newly issued tokens which do not have an identifiable issuer is likely to be limited. It is a proportionate requirement for cryptoasset trading venues – which are seeking admission of such assets for commercial purposes – to prepare disclosure documents for these tokens. Given that most major

20 Historical examples show that the admission of a token to a venue (especially a relatively illiquid token to a major cryptoasset exchange) can have a significant effect on the market valuation of the cryptoasset – driven by perception of greater trust, credibility and the anticipation of increased adoption and demand. Conversely, a removal from trading could significantly undermine the market capitalisation of a cryptoasset, thereby impacting the cryptoasset portfolios of individual investors.

crypto exchanges already have extensive coin admission policies it is anticipated that this should not be a major lift beyond existing policies and procedures.

Responsibilities for defining detailed content requirements

5.21 The government also intends to take forward the proposal for

venues to define detailed content requirements for admission disclosure documents. However, the government acknowledges the appetite from industry for more prescriptive rules on content requirements; the government is supportive in principle of the idea of a centralised coordinating body (e.g. industry association) to coordinate this effort – with FCA oversight. This should help address concerns raised about heterogeneity or inconsistency of disclosures.

Wholesale versus retail

5.22 The government notes the call for clearer differentiation between

venues which cater to retail consumers versus those which only admit institutional investors. While these sorts of details would typically be covered in firm-facing rules defined by the FCA, the government agrees, in principle, with the idea that disclosure requirements would differ – and be less prescriptive – for venues which only admit institutional investors (on the basis of “same risk, same regulatory outcome”). The benefit of allowing trading venues to define the detailed content requirements for admission and disclosure documents is that this kind of differentiation would be within their remit, and as much or as little differentiation as needed would be possible.

Public offers (including ICOs), airdrops and tokens earned via

reward mechanisms

5.23 For tokens made available through a public offer (e.g. ICO or

other similar issuances) rather than admitted to trading via a regulated platform, disclosure requirements and exemptions will likely be similar to those proposed in the new draft POATR.21 Such exemptions would therefore be expected to include offers of free cryptoassets (e.g. via an airdrop or similar distribution mechanism) or offers made only to professional / sophisticated investors. Value thresholds may need to be calibrated differently due to the typical size of an ICO and specific risks.

5.24 For tokens earned via a reward mechanism, this is unlikely to

constitute a public offer as these tokens would be awarded in return for a service (staking and validation, mining, or providing liquidity in cryptoassets to receive new tokens in the case of ‘liquidity mining’). The government will keep this matter under review since it is important that any such determination is not used to game the system to avoid appropriate disclosure obligations.

21 https://www.gov.uk/government/publications/public -offers-and-admissions-to-trading-regulations-2023-draft- si-and-policy-note

5.25 Notwithstanding the above, firms will still need to consider

obligations around cryptoasset financial promotions for tokens which are exempted from, or out of scope of, the cryptoasset issuance regime. Liability arrangements (including for tokens without identifiable issuers)

5.26 Regarding liability, the government maintains the position that

all firms required to publish cryptoasset disclosure documents should be liable for their accuracy. However, the government agrees that cryptoasset exchanges – which choose to take responsibility for the disclosure documents - should not be held liable for all types of consumer losses arising from events relating to that token, provided that they have taken reasonable care to identify and describe the risks. For example, where a loss is caused by a failure of the underlying protocol or network that is not controlled or operated by the trading venue, this would be unlikely to constitute a liability event providing, for example, that the trading venue had (i) performed a reasonable degree of due diligence on the token and the underlying network, (ii) made very clear to consumers their findings and (iii) avoided misleading statements guaranteeing the performance and resilience of the network.

5.27 This is similar to the envisaged approach to liability under the

POATR, for statements believed to be true based on reasonable enquiries. In contrast, under a strict liability regime – as proposed in some other jurisdictions - reasonable steps may not be a defence. Trading venues can therefore manage their liability if they make reasonable enquiries in preparing disclosure documents (which would be within their control).

5.28 In addition, certain types of protected forward looking

statements (e.g. relating to the project, and future use cases of the token) should be held to a different liability standard than historical, factual statements (e.g. relating to code audits which have been conducted in the past and vulnerabilities which have been identified through these). The former would generally be subject to recklessness/dishonesty standards22 whilst the latter would be subject to negligence standards.23 This is consistent with the proposed approach underpinning the POATR and should encourage issuers to include helpful and relevant forward-looking information to the market, without undue fear of a deluge of liability claims. This is a more flexible and proportionate approach than a regime with strict liability standards and should mitigate the “chilling effect” that some responses warned of.

Necessary information test

5.29 Regarding the proposed high-level necessary information test, the government intends to use this as a starting point but will consider

22 See s 90A and Schedule 10A of FSMA. 23 See s 90 and Schedule 10 of FSMA.

suggestions for additional categories of information. A necessary information test will ensure that an overall standard of preparation for disclosure / admission documents remains in statute whilst providing flexibility. However, the government expects that many of the more specific categories of information suggested by respondents would, in practice, be captured by the test. For example, it would be difficult to demonstrate that the necessary information test would be met if information about conflicts of interest and the availability (or not) of redress mechanisms was absent. The government agrees with the suggestions for HM Treasury, the FCA, industry and other stakeholders to work together to further shape disclosure requirements and the associated necessary information test. Some of this external engagement has already commenced for example through roundtables with industry participants.

Mitigating barriers to entry

5.30 Several respondents noted that onerous disclosure / admission

requirements can act as a barrier to entry, deterring participation from SMEs and stifling innovation. The government is cognisant of this and therefore views the following features of the proposed regime as important: • Disclosure / admission requirements will apply only to tokens that are made available to the UK public (i.e. not to all newly created tokens) • Certain exceptions will apply – for example offers made for no consideration or where the value of consideration is below a certain threshold, offers made to a limited number of persons or only to professional investors, and tokens acquired solely through a consensus protocol reward mechanism • Disclosure / admission documents will need to be focused and fit- for-purpose and would likely not take the same shape or form as long equity prospectus-like documents • For any prudential requirements on issuers, professional indemnity arrangements - as an alternative to own financial resources - will be considered – subject to regulator rules

Chapter 6

Regulatory outcomes for

operating a cryptoasset trading venue

Recap on original proposals from the Consultation

6.1 The Consultation set out government’s proposals to establish a

regulatory framework for persons operating a cryptoasset trading venue which would be based on existing RAO activities of regulated trading venues – including the operation of an MTF. Accordingly, persons carrying out these activities would be subject to prudential rules and various other requirements including consumer protection, operational resilience, and data reporting.

6.2 HM Treasury received 48 responses to this question, with 85%

agreeing or generally agreeing and 8% disagreeing. A large number of responses suggested that the existing Markets in Financial Instruments Directive (MiFID) and FSMA frameworks were largely adequate – or at least served as a good starting point. Many also noted that the proposed approach would bring beneficial consistency and familiarity and could encourage firms that operate already-regulated platforms to participate in the cryptoasset sector.

6.3 Of those who generally agreed with the approach, a common

theme of concern was proportionality and international competitiveness. In particular, many responses warned that excessively stringent prudential requirements and onerous reporting requirements could result in crypto trading venues choosing to locate elsewhere. Several responses pointed out differences between cryptoasset trading venues (as they typically operate today) and MTFs which would need to be carefully considered. Specifically, the current prevalence of matched principal execution protocols in crypto trading venues arguably makes them more akin to OTFs rather than MTFs. In addition, most crypto

Question 19

Do you agree with the proposal to use existing RAO activities covering the operation of trading venues (including the operation of an MTF) as a basis for the cryptoasset trading venue regime?

trading venues permit direct retail access, whereas MTFs admit only institutional investors. One response also highlighted that, unlike crypto trading venues, MTFs do not take custody of participant funds, issue their own securities, extend credit to members, or act (in effect) as a central clearing counterparty.

6.4 Amongst those that disagreed, there were some suggestions to

use different existing regimes as a basis – for example regulations for Recognised Investment Exchanges (RIEs), the regulated activity of ‘arranging deals’ or that of operating a peer-to-peer lending platform.

Some felt that the proposed approach would push cryptoasset

matching activity to other jurisdictions (or decentralised protocols), especially if similar prudential and data reporting requirements were adopted, together with the obligation to subsidiarise in the UK.

6.5 The government received 59 responses to this question. Again, a

common theme in the feedback was international competitiveness and avoiding excessive barriers to entry for example, by permitting firms to make use of professional indemnity insurance arrangements as an alternative to own funds – in order to meet prudential requirements.

6.6 The proposals on data reporting also generated significant

feedback with some arguing that order book reporting requirements would be disproportionate since they would require the sharing of sensitive and proprietary information. Some responses suggested that order book reporting should be limited to off-chain transactions only, or that reporting requirements should be introduced when the industry has matured further. However, others argued that the authorities should go further suggesting, for example, that real time reporting should be required.

6.7 Another area where many responses suggested that the

requirements should go further was operational resilience, with recommendations relating to contingency planning, testing, third party audits, proof of solvency, proof of reserves and proof of liability. Various responses highlighted the need to address risks – including supplier failure, service deterioration, concentration risk, political risks and transfer of ownership – through appropriate business continuity and recovery and resolution plans. 6.8 Proposed location requirements were a contentious theme. Many were in support of the indication that firms operating cryptoasset trading venues would likely require subsidiarisation in the UK. But there were also strong objections to this on the basis that it would increase costs and regulatory burdens and fragment liquidity pools. Some also argued that this position would represent a departure from similar

Question 20

Do you have views on the key elements of the proposed cryptoassets trading regime including prudential, conduct, operational resilience, and reporting requirements?

activities in traditional finance (where, for example, MTFs and OTFs can make use of the OPE under specific circumstances).

6.9 Other common themes of feedback have been briefly

summarised below, noting that most of these detailed firm-facing rules will be addressed through subsequent FCA consultations and rulebooks: • Fee structures: some responses highlighted issues with current fee structures on some crypto exchanges and called for measures to ensure fair and transparent fees as well as rules to ensure that investors do not become unfairly ‘locked in’ to exchanges • Outsourcing: a large number of firms highlighted the importance of being able to procure support services from third parties (including overseas service providers and overseas entities within the same parent group) • Resolution and insolvency: a few responses suggested that Part

24 of FSMA may not be fit for purpose in the context of crypto

asset business activities, and has not yet been properly tested on complex FinTech business models • Execution protocols: several respondents again underlined the need for a regime to accommodate matched principal trading as well as central limit order book matching • Business model segmentation: many responses talked of the need to distinguish between venues only admitting wholesale market participants versus those which also admit retail consumers. Another suggestion was for clear distinctions between venues which undertake primary issuance activity versus those that only offer secondary market trading.

Government response

Basis for the regime and consideration of specific trading models and execution protocols 6.10 The government intends to take forward the proposed approach, including the basis for the regime - but reiterates the need to take into consideration specific characteristics and risks of cryptoasset trading activities. The consultation process has helpfully highlighted specific examples of this. In response to the questions about certain execution protocols and trading models (e.g. OTFs / matched principal trading and proprietary trading), the government does not intend to explicitly endorse or prohibit specific business models or execution protocols in legislation. Doing so at this point would limit the flexibility of a future regulatory regime at a stage when business models are still evolving at pace. It could also shape and influence market structures in unintended or suboptimal ways. However the expectation is for firms to be able to

evidence that conflicts of interest and risks to market integrity are appropriately managed within their specific business models as they seek authorisation. Separately, the government notes that some requirements applicable to MTFs and OTFs will be reviewed more broadly as part of the government and FCA’s implementation of the Wholesale Market Review reforms.

Location requirements

6.11 Location policy and overseas market access is addressed in

further detail in chapter 4.

Retail versus wholesale

6.12 Regarding the feedback on customer segmentation, the

government agrees, in principle, with the idea that certain requirements (e.g. disclosures) would differ – and be more appropriate– for venues which only admit institutional investors (on the basis of “same risk, same regulatory outcome”). The benefit of allowing trading venues to define detailed content requirements for admission and disclosure documents is that this kind of differentiation would be within their remit, and as much or as little differentiation as needed would be possible.

Primary versus secondary markets activities

6.13 In response to calls for distinctions between cryptoasset trading

venues which undertake “primary issuance” activity versus those which only support secondary market trading, the government intends to take an activities-based approach to regulation, as articulated in the original proposals. This would have the flexibility to accommodate different business models. Firms which intend to operate a cryptoasset trading venue will be required to obtain FSMA authorisation for that activity (Chapter 6). They will provide a crucial function in terms of admitting cryptoassets to their venues and conducting due diligence over the cryptoassets (Chapter 5). Other firms may choose to seek FSMA authorisation under one of the other activities outlined in the Consultation where they are acting as intermediaries (Chapter 7). Further regulatory obligations will apply whereby those firms would need to ensure that appropriate admission disclosure documents are in place for any cryptoassets in connection with which they offer services (Chapter 7). They will be reliant upon trading venues to admit the cryptoassets rather than perform this function themselves, so, to some degree will function in a similar way to secondary market trading venues.

6.14 Additionally, for those firms which are seeking to introduce an

asset to the UK, further regulatory obligations will apply whereby those firms would need to ensure that appropriate disclosure / admission documents are in place for any cryptoassets admitted for trading (see Chapter 5).

Insolvency and restructuring

6.15 The government intends to apply the insolvency provisions in

Part 24 FSMA as these provisions provide the FCA with the same rights

to protect consumers of crypto firms, and itself participate, in standard insolvency procedures (e.g. administration and liquidation) as it has for FSMA authorised firms and payment/e-money firms.

Other considerations

6.16 Chapter 11 covers the government’s response on decentralised

exchanges and other DeFi protocols. Chapter 4 (on the perimeter of cryptoasset activities) provides further clarity on considerations around vertically integrated business models. Most of the other feedback related to aspects of the regime which will need to be tackled through detailed regulator consultations and rulebooks (e.g. specific data reporting and operational resilience requirements). This feedback has been shared with the regulators and will be considered through future regulator consultations and firm-facing rules. The FCA has statutory obligations to consult and conduct cost benefit analyses for the measures they introduce. Furthermore, the FCA’s Regulatory Initiatives Grid will give industry a forward plan of the various planned consultations.

Chapter 7

Regulatory outcomes for

cryptoasset intermediation activities

Recap on original proposals from the Consultation

7.1 The Consultation proposed that requirements applying to

analogous regulated activities – such as ‘dealing in investments as agent’ and ‘dealing in investments as principal’ set out in Article 25 of the RAO – would be used and adapted for cryptoasset market intermediation activities. The potential need for additional rules or guidance to address specific risks and characteristics of cryptoasset market intermediation activities was noted.

7.2 HM Treasury received 49 responses to this question, with 86%

agreeing or generally agreeing and 10% disagreeing. Those that supported the proposal felt that it was well aligned to the principle of “same risk, same regulatory outcome”, and that existing regimes for market intermediation provided an appropriate and familiar framework to address most of the key risks. Some of the more specific proposals received explicit support – for example the focus on ‘best interest’ as opposed to ‘best execution’ since the former concept is more appropriate and proportionate. Several respondents who were in favour of the proposals did however note that ongoing assessment would likely be required as the industry matures.

7.3 The majority of the responses were generally supportive but

caveated. Some called for more clarity around the definition and scope of these intermediation activities. For example, one response pointed out that the term ‘making arrangements’ is used in both the RAO and MLRs but the application is different, with exemptions applied to the RAO but not the MLRs. Another response suggested that specific activities or business models should not fall within scope – for example

Question 21

1. Do you agree with HM Treasury's proposed approach to use the

MiFID derived rules applying to existing regulated activities as the basis of a regime for cryptoasset intermediation activities?

DeFi technology providers which create software used for the

intermediation of cryptoassets, or e-money providers that arrange funds for payment for a customer that wants to trade in cryptoassets.

7.4 Several respondents pointed towards specific aspects of

cryptoasset markets which are unique and therefore require special consideration. A prominent example was the concept of acting in accordance with the best interests of clients which many suggested was hard to demonstrate in cryptoasset markets due to the fragmentation of liquidity across a large number of venues globally and more limited transparency around price formation versus traditional exchanges.

7.5 Amongst those that disagreed with the proposals most argued

for a bespoke approach, but these responses typically contained limited detail on alternative proposals. One response did point towards the global code of conduct for spot foreign exchange as an alternative basis.

7.6 The government received 46 responses to this question. Proportionality and international competitiveness were frequently mentioned – with similar warnings to those highlighted in the feedback to Chapter 6. In particular, several responses recommended that firms should be able to make use of professional indemnity insurance arrangements as an alternative to own funds in order to meet prudential requirements. Some also noted that the Prudential sourcebook for MiFID Investment Firms (MiFIDPRU) presents challenges for venture capital-funded enterprises. 7.7 Client segmentation was also a common theme in the feedback.

Some responses stated that the requirements to assess

appropriateness and make certain disclosures should not apply when carrying out services for institutional counterparties. Some responses called for exemptions or clarifications for specific market participants – for example, those administering trusts and estates on a professional basis.

7.8 More specifically, many responses noted that concepts of ‘best

execution’ or ‘best possible result’ are difficult to define and apply in cryptoassets due to the globalised and fragmented nature of execution venues and specific features of cryptoasset transactions such as slippage in liquidity pools.

7.9 The other two most common themes in the feedback were

location requirements and operational resilience. On location requirements firms again raised concerns around the potential

Question 22

Do you have views on the key elements of the proposed cryptoassets market intermediation regime, including prudential, conduct, operational resilience, and reporting requirements?

fragmentation of liquidity and higher costs for firms which could be passed on to investors. A more specific point for clarification posed by several firms was on the treatment of UK authorised intermediaries that intended to route UK customer orders to cryptoasset trading platforms operated by overseas group entities. On operational resilience, similar risks to those summarised in Chapter 6 were described.

Government response

Basis for the regime

7.10 In general, the government intends to take forward the proposed

approach, including the basis for the regime. Specifically, the government intends to define a set of new regulated activities relating to the intermediation of cryptoassets, drawing from analogous activities in the existing regulatory perimeter.24 As previously set out, the legislative approach, and subsequent rules set by the FCA, will need to carefully consider specific aspects of crypto markets and implications for concepts which may not map across well from the traditional financial services sector. An important example of this would be the appropriate methods for defining and evaluating whether an intermediary has acted in accordance with the ‘best interests’ of a client.

Location requirements

7.11 Location policy and overseas market access is addressed in

further detail in Chapter 4.

7.12 If all international cryptoasset exchanges were to seek

authorisation in the UK as cryptoasset intermediaries (and not as cryptoasset trading venues), this would be problematic since the proposed issuance and market abuse regimes ‘hang off’ regulatory trigger points that are controlled by authorised cryptoasset trading venues.25 To ensure that issuance and market abuse regimes are ‘activated’ for tokens bought and sold by UK investors, the government intends to require a disclosure / admission document to be lodged on the NSM by a trading venue, prior to any intermediary being able to deal or arrange deals in a given token (similar to the requirement for a trading venue to search the NSM before a new admission to ensure disclosure / admission documents are in place).

24 For analogous activities in the existing regulatory perimeter, readers should refer to i) Article 14 of the RAO (“Buying, selling, subscribing for or underwriting….as principal); ii) Article 21 of the RAO (“Buying, selling, subscribing for or underwriting….as agent); iii) Article 2 5(1) of the RAO (“Making arrangements for another person (whether as principal or agent) to buy, sell, subscribe for or underwrite…”); and iv) Article 25 (2) of the RAO (“Making arrangements with a view to a person who participates in the arrangements buyi ng, selling, subscribing for or underwriting…(whether as principal or agent)…”) 25 For issuance: Admitting (or seeking admission of) a cryptoasset to a UK cryptoasset trading venue or making a public offer of a cryptoasset (including ICOs), which would need to be done via a UK regulated platform; for market abuse: Admitting (or seeking the admission of) a cryptoasset to a UK cryptoasset trading venue

Retail versus wholesale

7.13 Regarding the feedback on customer segmentation, the

government agrees, in principle, with the idea that certain requirements (e.g. disclosures, appropriateness checks) would differ for intermediaries when dealing with eligible counterparties since this would mirror existing conduct regimes and meet the core design principle of “same risk, same regulatory outcome”.

Other considerations

7.14 Most of the other feedback related to aspects of the regime

which will need to be tackled through detailed regulator consultations and rulebooks (e.g. specific conduct, prudential and operational resilience requirements). This feedback has been shared with the regulators and will be considered through future regulator consultations and firm-facing rules. The FCA has statutory obligations to consult and conduct cost benefit analyses for the measures they introduce. Furthermore, the FCA’s Regulatory Initiatives Grid will give industry a forward plan of the various planned consultations.

Chapter 8

Regulatory outcomes for

cryptoasset custody

Recap on original proposals from the Consultation

8.1 The Consultation proposed to apply and adapt existing

frameworks for traditional finance custodians under Article 40 of the RAO for cryptoasset custody activities, making suitable modifications to accommodate unique cryptoasset features, or putting in place new provisions where appropriate.

8.2 53 responses were submitted to this question. 79% agreed or

generally agreed with the proposal. 15% disagreed and 6% of responses were neutral or mixed. Those that agreed felt that the Consultation appropriately acknowledged the conceptual similarities to traditional finance custody, as well as key differences – for example the various technology solutions which are used to secure the asset and safely manage private keys. These respondents agreed with the basis for the regime as long as the specific characteristics and risks associated with cryptoasset custody are considered and accommodated. Others noted that this approach would help deliver a level playing field and generate trust and confidence in the system, with cryptoasset custody regulated on a par with traditional financial asset custody. Several responses stated that forthcoming regulation should be ‘technologically agnostic’ to allow for scope to be future proofed as the technology in this market develops.

8.3 Amongst those that generally agreed with the approach, a

common reservation was uncertainty around the scope and definition of the regulated activity of custodying assets. 26 In particular, further

26 “Safeguarding, or safeguarding and administering (or arranging the safeguarding or safeguarding and administering) of a cryptoasset other than a fiat backed stablecoin and / or means of access to a cryptoasset (e.g. a wallet or cryptographic private key)”

Question 23

Do you agree with HM Treasury’s proposal to apply and adapt existing frameworks for traditional finance custodians under Article

40 of the RAO for cryptoasset custody activities?

clarity was requested around concepts like ‘arranging’ custody, use of third parties (including sub-custody and outsourcing arrangements), custody software and hardware providers and use of self-hosted wallets (also known as unhosted wallets or non-custodial wallets). A number of respondents took the position that software developers or providers of self-hosted wallet infrastructure, whose functions are limited to the development and/or sale of the software/hardware for self-hosted wallets, should be excluded from the scope. Several responses also highlighted the importance of the UK’s underlying legal framework and the need for clarity around issues such as bankruptcy remoteness of customer assets.

8.4 A few responses disagreed with the proposal to apply and adapt

existing frameworks for traditional finance custodians. One respondent suggested that modern technology (in particular modern cryptographic tools) could provide the opportunity to replace legacy frameworks with a distinct and cleaner alternative cryptographic custody regime under which owners would never have to relinquish control of their assets.

8.5 Some responses felt that the differences in cryptoasset were so

fundamental that a bespoke framework was necessary as the risks were significantly higher with crypto such that the current framework wouldn’t suffice. Examples of these differences included (1) the various novel technology solutions (e.g. hot versus cold storage, multi-signature verification, multi-party computation and the use of smart contracts to hold private keys), (2) the conceptual differences around ‘control’ of the asset and (3) scenarios which are unique to cryptoassets (e.g. the custody of tokens distributed via smart contracts or airdrops). One response noted that lack of recoverability (if the private key is lost, the owner cannot retrieve their cryptoassets) is unique to cryptoassets. Another response suggested that certain types of tokens may require a separate custody framework. For example, commodity-backed tokens may not be suitable for a regime based on the Client Asset Sourcebook (CASS) – since product and service providers typically outsource physical custody to secure asset storage companies rather than traditional finance custodians.

8.6 55 responses were submitted to this question. There was a

significant degree of overlap in the content discussed in response to this question with that of question 23 – in particular on the need to further clarify the scope of the regulated activity and how it would apply to different business models, as well as the importance of the legal construct under which custody can be delivered under English and Welsh law.

Question 24

Do you have views on the key elements of the proposed cryptoassets custody regime, including prudential, conduct and operational resilience requirements?

8.7 The topic of liability generated significant interest. For the most

part, there was strong support for the government’s proposal to pursue a proportionate approach which would not impose full, uncapped liability on the custodian in the event of a malfunction or hack that was not within the custodian’s control. One response helpfully pointed out the difficulties in drafting legal text that creates a clear distinction between events that are within the control of the custodian, and those that are not – based partly on experiences from the EU’s equivalent process. This response suggested ways to address or mitigate some of these challenges including: (i) developing an agreed analytical and terminological framework for the custody of cryptoassets; (ii) allowing custodians and their clients the ability to agree bilaterally in their custody contracts an appropriate set of liability arrangements and (iii) setting out an appropriate liability standard for custodians linked to the concept of control. Also on the topic of liability, some respondents did not agree with applying the same (strict) standards as for depositaries under the Alternative Investment Fund Managers Regulation to custodians of cryptoassets.

8.8 Storage solutions and wallet structures were a recurrent theme

in the feedback received. Some responses argued that regulatory rules should require segregation of individual client cryptoasset wallets while others argued that omnibus accounts should be permitted. However, there was overwhelming support for the proposal that a firm’s own assets should be segregated from their clients’ assets. Cold storage requirements were another area where there was no clear consensus. Some responses suggested that regulated custody providers should be required to keep a minimum proportion of customer assets in cold storage in line with certain other jurisdictions. Others argued for a more flexible, outcomes-based approach – especially while the industry is still in its more formative stages.

8.9 A number of responses had views on the Financial Services

Compensation Scheme (FSCS). Some responses felt that cryptoasset custodian failures should be covered, pointing out that this would be consistent with the traditional finance custody regime. Others called for clarification as to how this might work – e.g. regarding levy structures and treatment of vertically integrated businesses.

8.10 The government also received many suggestions on operational

resilience requirements for cryptoasset custody providers – including recommendations on regular reconciliations, third party audits, cybersecurity practices and controls, recoverability of critical IT systems, and business continuity planning.

Government response

Basis for the regime

8.11 The government intends to take forward the previously proposed

approach, including the basis for the regime. Specifically, the government will legislate to define a new regulated activity for custody covering the (i) safeguarding, (ii) safeguarding and administration, or

(iii) the arranging of safeguarding or safeguarding and administration, of a cryptoasset. Existing frameworks for traditional finance custodians under Article 40 of the RAO will be used as a basis for the regime. However, the government reiterates the importance of making suitable modifications to accommodate unique cryptoasset features or putting in place new provisions where appropriate. The novel and unique scenarios, risks and technology solutions that were raised in the feedback will be taken onboard as the UK authorities proceed with secondary legislation, detailed consultations, and rulemaking processes.

8.12 The Law Commission published its Final Report on Digital Assets

on 28 June 2023, recommending selective reform and development of the private law on digital assets to secure UK’s position as a global financial hub.27 This important piece of work provides further clarity on foundational legal concepts, as well as specific recommendations and next steps to further clarity the concept of ‘control’. HM Treasury and the FCA will also consider this carefully in forthcoming work on custody.

Self-hosted wallets

8.13 On the use of self-hosted wallets, generally speaking, the activity

of providing self-hosted wallet technology to a consumer is, in itself, not expected to fall under the definition of ‘safeguarding’ or ‘safeguarding and administering’ (i.e. the new regulated activity for custody). However, regulators will continue to keep this under review and assess how and if certain custody requirements might apply to self-hosted wallets including whether aspects of these products and services – in particular relating to operational resilience – could be addressed through the FCA's outsourcing and third parties rules and guidance.

Use of third parties

8.14 Regarding arrangements with third parties – either to provide

the custody or some of the underlying technology or infrastructure – the scope of regulation for these arrangements will be considered in the new regulated activity for custody. The FCA will also consider detailed rules for third party arrangements, including whether to apply similar rules to those which apply to traditional finance custodians.

Where firms outsource physical custody to secure asset storage

companies, the government expects that such arrangements could be captured by the ‘arranging’ limb of the custody regulated activity depending on the terms of the contract between the firm and secure asset storage company.

Custody liability

8.15 On the topic of liability, the government confirms the intention to

take forward a proportionate approach which would not impose full, uncapped liability on the custodian in the event of a malfunction or hack that was not within the custodian’s control. This was broadly

27 See the June 2023 Law Commission report (Digital assets: Final report), in particular: Chapter 5

supported by most (though not all) respondents – and would be in line with the approach for traditional finance custody.

Custody of security tokens

8.16 The government expects that security tokens which meet the

definition of an existing specified investment - will, for the most part, continue to be regulated in line with existing rules and regulations (e.g. issuance, reporting and prudential rules). However, custody of security tokens will no longer be regulated in the same way as other specified investments and will instead be specified by a new regulated activity to address fundamental differences in the way that cryptoasset custody operates versus traditional custody arrangements (e.g., firms that solely safeguard cryptographic private keys which provide access to cryptoassets). The government intends that this will achieve the same regulatory outcome as is in place currently.

8.17 The Stablecoins Update and subsequent phase 1 legislation will

provide clarity on the custody regime for UK-issued fiat-backed stablecoins and security tokens. This regime for cryptoasset custody will be expanded to cover a broader set of cryptoassets in the future as they come into the regulatory perimeter. Overall, this approach will ensure that there is not duplicative or overlapping regimes applied to security tokens.

Other considerations

8.18 Detailed rules (e.g. regarding safeguarding clients’ ownership

rights, record-keeping and controls and governance) will also be addressed through FCA consultations and regulatory regime, taking into account existing frameworks as well as the Law Commission’s recommendations on what constitutes ‘factual control’, including the Law Commission’s view that factual control might work in different ways across different assets and products. Regarding FSCS protections, while some responses felt that the government should legislate for this, this will be determined by the regulator as part of its usual public consultation and rulemaking governance.

Chapter 9

Regulatory outcomes for

market abuse

Recap on original proposals from the Consultation

9.1 The Consultation proposed to introduce a cryptoassets market

abuse regime based on elements of the Market Abuse Regulation (MAR) regime for financial instruments. The market abuse offences would apply to all persons committing market abuse on a cryptoasset that is admitted (or requested to be admitted) to trading on a UK cryptoasset trading venue. This would apply regardless of where the person is based or where the trading takes place. The proposed regime would entail obligations for certain market participants, for example cryptoasset trading venues (who would be expected to detect and disrupt market abuse behaviours) and cryptoasset market intermediaries (who would have obligations placed on them, in particular those around the handling of inside information).

9.2 50 responses were received on this question. 88% agreed or

generally agreed with HM Treasury’s assessment of the challenges. 12% of responses were neutral or mixed and 0% disagreed. The vast majority of responses were supportive of HM Treasury’s effort to introduce standards to manage and mitigate the identified risks of market abuse. Most of these agreed that the assessment of risks was accurate, with many also noting that the ambition levels were sensible and realistic.

9.3 The bulk of the feedback was focused on distinctive aspects of

cryptoasset markets (in addition to those already identified in the

Consultation) which do not clearly map across from traditional asset

classes and therefore require specific attention. Some of these unique issues arise from the nature of the underlying consensus mechanisms.

For example, with proof-of-stake (PoS) and proof-of-work (PoW)

mechanisms, pending transactions may be queued in a publicly visible waiting area called a ‘mempool’, until a miner or validator selects them to be incorporated into a transaction block. Miners and validators have

Question 25

Do you agree with the assessment of the challenges of applying a market abuse regime to cryptoassets? Should any additional challenges be considered?

found ways to profit from this called Maximal Extractable Value (MEV) strategies which may involve excluding, or reprioritising transactions from the mempool. This can result in sub-optimal outcomes for investors and may create opportunities for frontrunning or at least frontrunning-like behaviour.28 Another challenge may be around liquidity incentive schemes, where a protocol issues reward tokens to those that provide liquidity. This can induce users into providing exit liquidity for the token’s creators or other insiders.

9.4 Other responses identified specific risks arising from limitations

in market data since cryptoasset trading data is often fragmented and incomplete, making it difficult to gain a comprehensive view of market activity. In addition, many cryptoasset exchanges do not currently provide the same level of transparency as traditional exchanges. Another specific issue which was frequently raised was the prevalent use of social media and prominent media figures to influence the market. Although this is not unique to cryptoassets it is more prevalent in cryptoassets in part due to the more retail-driven nature of the market and the more speculative nature of valuations associated with certain tokens. Other specific risks raised included regulatory coverage gaps given the UK’s proposed phased approach and the potential for a single cryptoasset to be traded across both Centralised Finance (CeFi) and DeFi market structures.

9.5 Some responses mentioned other novel risks such as those

arising from the hoarding of computational capacity to manipulate the ledger, and the use of large language models to carry out market abuse. Risks associated with governance exploits, exploits of coding errors and technical flaws (e.g. Sybil attacks29) were also mentioned, as well as risks arising from the use of crypto specific products and services like flash loans and tumblers / mixing services.

9.6 Several responses highlighted that the cryptoasset sector offers

major potential improvements as well as challenges when it comes to market abuse. For example, the increased transparency around wallet information and on-chain transactions could be a major advantage. However, several responses noted the difference between on-chain and off-chain transactions, noting that off-chain data is relatively opaque and harder to track. More mature Regulatory Technology (RegTech) solutions will also be required to fully capitalise on the potential associated with cryptoasset technologies.

28 Frontrunning occurs when a trader obtains inside knowledge about a forthcoming order that could move the market price of the asset and uses this to buy or sell ahead of the corresponding transaction in order to make a profit from the price differential. Note, however, that information obtained from a mempool would not generally be regarded as inside information since mempools are typically publicly accessible – with the requisite technology and know-how 29 A type of attack on a computer network where the attacker subverts the service's reputation system by creating a large number of pseudonymous identities and uses them to gain a disproportionately large influence

9.7 49 responses were received on this question. 86% agreed or

generally agreed with the proposed scope of the regime and 14% of responses disagreed. Those that fully agreed with the proposal felt that the extra territorial scope (regardless of where the trading activity takes place) was important due to the globalised nature of cryptoasset trading and the fact that it is not typically linked to specific jurisdictions. Others also suggested that the proposed scope would ensure some level of consistency with the wider market abuse regime.

9.8 Of those who generally agreed with the proposal, one common

reservation was around the ability of the regulator to take enforcement action against offshore market participants. There were concerns that this could be impractical and prohibitively costly, thus undermining the prospect of achieving a level playing field for all market participants. Another concern raised was the potential for prices to be impacted by market abuse behaviour conducted on decentralised exchanges or lending platforms – and the associated cross-platform arbitrage opportunities that could arise from that. Some responses specifically challenged the ‘requesting’ or ‘seeking’ component of the proposed scope, arguing that this that the obligations in respect of pre-admission cryptoassets may be excessively broad. 9.9 Other responses suggested broadening the scope of the regime. One response argued that the scope should be broadened to also include private coin offerings which can also be impacted by market abuse behaviour. Another response suggested inclusion of cryptoassets that are available via lending platforms and over the counter (OTC) desks.

9.10 Responses which disagreed with the proposals mostly argued

that the scope was excessively broad – especially while approaches towards international coordination are still being developed. Some of these respondents felt that the market abuse regime should not (at any stage) extend beyond transactions where there is no clear UK nexus (e.g. activities taken by UK residents, or in relation to UK venues). These responses noted that cryptoassets admitted to a UK venue will likely be available on hundreds of other venues around the world, and that the suggested approach would therefore introduce an unduly broad perimeter. The design principle of proportional and focused regulation may therefore not be met since trading venues would have to devote

Question 26

Do you agree that the scope of the market abuse regime should be cryptoassets that are requested to be admitted to trading on a cryptoasset trading venue (regardless of where the trading activity takes place)?

significant resources to identifying bad actors in other jurisdictions and then taking the appropriate actions.

9.11 47 responses were received on this question. 98% agreed or

generally agreed with the proposal on prohibitions. 2% of responses were neutral or mixed. Many responses strongly supported the proposal, noting the benefits from consistency with the wider financial system and potential to encourage more institutional participation in crypto markets. Some cryptoasset exchanges noted that MAR is already used as the basis for alerting surveillance logic that is already deployed on cryptoasset venues (in addition to unique surveillance measure which are tailored to crypto markets).

9.12 Some of the feedback again mentioned novel and distinct types

of market abuse in cryptoassets (see also the summary of question 25 feedback) – but generally noted that these were compatible with the high-level categories of prohibitions under MAR. A handful of responses pointed out that, whilst the categories of prohibitions under MAR were suitable, the relative importance of market manipulation is likely to be greater because individuals can more easily influence the price of individual cryptoassets since their valuations are not driven by fundamental factors. For the same reason insider trading is likely to be relatively less important since value of most cryptoassets is generally not based on fundamental attributes of a business (such as earnings or mergers and acquisitions) which are knowable by insiders. On a related note, some respondents felt that the MAR definition of inside information is largely incompatible with the cryptoasset market and that it should only apply to a subset of cryptoassets – e.g. stablecoins.30

9.13 Other responses pointed out that ways in which market abuse is

carried out– and the shape and structure of the cryptoasset market more generally – are not static; prohibitions would therefore need to be reviewed periodically as trading strategies evolve. There were also calls for additional guidance – for example a non-exhaustive list of specific market abuse practices (as exists for MAR). One response suggested that the government considers the REMIT market abuse framework31 as an alternative basis to MAR. The REMIT market abuse framework –

30 Presumably because the role and characteristics of an issuer are very different for most cryptoassets versus an issuer of a security – though more comparable for some cryptoassets such as fiat -backed stablecoins with clearly identifiable issuers that stand behind the token and hold reserves to enable their redemption for fiat currency. 31 Regulation (EU) No 1227/2011 of the European Parliament and of the Council on wholesale energy market integrity and transparency

Question 27

Do you agree that the prohibitions against market abuse should be broadly similar to those in MAR? Are there any abusive practices unique to cryptoassets that would not be captured by the offences in MAR?

used to promote wholesale energy market integrity - adopts a similar definition of market abuse to MAR but is regarded by some as a simpler framework from a compliance perspective.

9.14 One response took the view that banning access to cryptoasset

markets for retail investors was a more appropriate approach than implementing a market abuse regime.

9.15 52 responses were received on this question. 46% of responses

received felt that the proposals put a proportionate burden of responsibility on crypto trading venues, with 46% disagreeing and 8% neutral or mixed.

9.16 A significant number of responses took the view that the

proposed level of responsibility on trading venues was appropriate. In many cases, these respondents argued that cryptoasset trading venues play a critical, central role in the cryptoasset ecosystem and are the only entities that have full access to all the data necessary to conduct market surveillance in a meaningful way. Some of these responses did however suggest that the size, complexity, and risk profile of different venues should be considered when establishing regulatory requirements and that obligations should be reviewed periodically. There were also calls for detailed guidance and technical standards to bring clarity on how exact responsibilities would be expected to be discharged.

9.17 Of the 45% of responses who disagreed with the proposed level

of obligations on cryptoasset trading venues, a common line of argument was that it is unreasonable to expect the surveillance responsibilities of cryptoasset trading venues to extend beyond their own venues or beyond trades without a clear UK nexus. Most of these responses argued that the FCA should instead play the centralised surveillance role in line with the securities market framework, or that authorities should design and implement a ‘dual competency’ for the development and monitoring of market abuse practices involving both crypto trading venues and the FCA. One respondent noted that securities market supervision was transferred from exchanges to the regulator in 2000 because individual market operators were unable to look across the entire market. Another line of argument suggested that other private sector market participants – e.g. issuers and brokers – should also play an important role in terms of managing inside information and conducting appropriate market surveillance, rather than focusing obligations so heavily on cryptoasset trading venues.

Question 28

Does the proposed approach place an appropriate and

proportionate level of responsibility on trading venues in addressing abusive behaviour?

9.18 In particular, the suggestion that trading venues establish

systems, controls and methods of disruption which could indicatively include cross-venue information sharing arrangements and public warning lists / deny lists received a high degree of opposition. Firms and industry associations pointed out that data sharing requirements would be complex and resource intensive and would generate liability risks due to data protection laws in the UK, and other jurisdictions (including the EU’s General Data Protection Regulation (GDPR). There were also concerns that this could necessitate the sharing of proprietary, commercially sensitive data with competitor firms – depending on the nature of the information that was required to be shared. Regarding public warning lists / deny lists, firms also raised concerns relating to data protection challenges as well as due process risks if required to add a natural person to such a list.

9.19 One counterproposal was to have a phased approach towards

implementation. Under the first phase, venues would be responsible for activity on their own venues and may have more limited information sharing arrangements (e.g. trades with a clear UK nexus – where at least one counterparty is UK-based).32 Under the second phase, information sharing capabilities could be enhanced with broader participation and/or additional data fields. Under the third phase there could be a more comprehensive information sharing and surveillance mechanism across venues and across jurisdictions. The government received various permutations of this counterproposal, some of which involved a more prominent coordination role played by the FCA.

9.20 45 responses were received on this question. Many emphasised

the need for legal and regulatory clarity through the continued (or accelerated) programme of work to deliver legislation and regulatory rules and guidance – at both domestic and international levels. Several respondents suggested that the government should also support initiatives that promote international standardisation of cryptoasset activities. This would include, for example, the use of standardised product or token codes, legal entity and natural person identifiers, and the adoption of common lexicons such as financial crime taxonomies.

9.21 Many responses also highlighted the importance of supporting

and promoting regulatory sandbox initiatives and digital innovation pathways. Some respondents recommended that the government take steps to protect intellectual property (IP) to promote the development of RegTech products and services – for example

32 Cryptoasset trading venues could potentially use the same data fields and capabilities developed for compliance with the Travel Rule for cryptoassets to identify such trades

Question 29

What steps can be taken to encourage the development of RegTech to prevent, detect and disrupt market abuse?

automated surveillance tools and solutions which make use of artificial intelligence and machine learning. Finally, some responses suggested that the government should proactively promote specific, novel technologies such as anti-market abuse measures or controls which can be coded into the cryptoassets themselves.

9.22 49 responses were received on this question. 76% of those agreed

or generally agreed on the proposal but 22% disagreed (2% were neutral or mixed). Some responses argued strongly in favour of the proposal, stating that this was an essential measure to build trust in the system. Some of these responses highlighted major concerns relating to insider trading in cryptoasset markets today, noting the ability for insiders to benefit significantly from their inside knowledge of, for instance, future token admissions by an exchange. Another point made here was that responsibilities for managing inside information should not rest solely on issuers and/or crypto trading venues, but rather a broad set of actors in the ecosystem given that inside information is not exclusively (or perhaps even primarily) a challenge for trading venues.

9.23 Those that generally agreed with the proposal, typically stressed

the importance of providing much more detailed guidance and concrete examples of what constitutes inside information – and how it should be managed - given the different characteristics of cryptoasset markets compared to traditional ones. Others called for a ‘reasonable endeavours' test and an approach which is based on information and analysis that is reasonably available to the regulated firm. One response highlighted a specific challenge arising from the fact that the industry employs various non-standard communication channels that may be technically complex to monitor – e.g. social media platforms, peer-to- peer networks, decentralised applications (‘dApps’) and dark web forums. Another response suggested that certain industry participants including miners, validators, and oracles should not be subject to inside information requirements since they generally handle only public data. Their activities would perhaps be more analogous to high frequency trading actors that benefit from performing an activity.

9.24 Amongst those that disagreed with the proposals, a few noted

that the approach would represent a significant departure from MAR (under which only issuers - and persons acting on their behalf or on their account - have such obligations to manage inside information). A significant number of responses were concerned that this approach would put excessive burdens on regulated firms with limited upside. Some argued that such a regime would be administratively unworkable in practice, particularly for larger firms that have major international

Question 30

Do you agree with the proposal to require all regulated firms undertaking cryptoasset activities to have obligations to manage inside information?

operations, and that crypto-native employees of regulated firms may hold inside information on new crypto projects without the knowledge of the firm.

9.25 Counterproposals suggested applying these obligations only to

issuers, or only to cryptoasset exchanges (or both) rather than all regulated firms. Another suggestion was to have an industry-led solution that was more appropriately tailored to the cryptoasset sector – rather than something based on MAR and extended beyond issuers to all regulated firms.

Government response

Basis for the regime, and scope

9.26 The government intends to take forward most aspects of the

proposed approach set out previously, including the suggested scope of the regime, the regulatory trigger points, and the use of MAR as the basis for the regime including the prohibitions (covering insider dealing, market manipulation and unlawful disclosure of inside information). Obligations will apply to cryptoasset trading venues and other regulated market participants.

9.27 The government disagrees with the position that the overall

scope of the regime should be more narrowly defined (e.g. with respect to UK venues only) since this would not deliver adequate protection to UK consumers for reasons previously described. Furthermore, some of the responses argued that the proposed geographic scope was not feasible or practicable. The government also disagrees with this position noting that UK financial services regulation already affects firms based overseas in many areas such as consumer credit, market abuse and financial promotions. The government will discuss this challenge with the FCA to devise ways to mitigate the risks posed by overseas firms in this context. This is not an unprecedented challenge and the regulator may be able to address it using established approaches. Where a breach meets the FCA’s threshold for action there are a variety of tools that can be used to mitigate harm such as engaging with other authorities or stakeholders including foreign regulators and opening an enforcement investigation.

9.28 It is also important to retain the ‘requesting admission’ or

‘seeking admission’ element in scope. As highlighted by other respondents, insider dealing can and does occur prior to the point of token admission to a cryptoasset trading venue.

Surveillance and information sharing

9.29 Regarding suggestions relating to information sharing, the

government acknowledges the challenges presented around technical complexity, data privacy, and the protection of confidential IP - and therefore the need for a staggered implementation for cross-venue data sharing obligations. This will be factored into the approach as the government legislates. The government stresses that lighter touch arrangements on information sharing – which do not fully meet the

regulatory objectives set out in the Consultation – should only be available on a time-limited basis. The government maintains that cryptoasset market participants should ultimately be able to trade in a fair and orderly environment. Furthermore, through extensive consideration of the challenges raised by industry through written submissions and in-person engagement, the government does not believe these to be insurmountable – but agrees that they are relatively complex and will necessarily take time to implement.33

9.30 In response to the many suggestions for a central organisation to

coordinate and harmonise information sharing, the government agrees and is supportive in principle of the idea of a centralised coordinating body (e.g. an industry association) to coordinate this effort – with FCA oversight. This should be an industry-led solution, leveraging the expertise of cryptoasset exchanges and their proximity to the various products and customers. Such an approach would also benefit from greater flexibility and adoption of innovative RegTech solutions. HM Treasury will continue to work closely with the FCA, industry and other external stakeholders to help shape the structure and function of an industry-led market abuse information sharing platform.

Obligations to manage inside information

9.31 In terms of obligations to manage inside information, the

government will take forward proposals to require regulated cryptoasset firms - such as operators of cryptoasset trading venues and cryptoasset intermediaries - to appropriately manage price sensitive information in relation to cryptoassets.34 Regulated firms will be expected to have policies and procedures in place to identify price sensitive information and put controls around this (which may include insider lists for example), and to release that information to the public domain as soon as possible for example via primary information providers.35 This is expected to extend beyond cryptoasset trading platforms as other market participants in the ecosystem – such as cryptoasset intermediaries - have an important role to play in managing inside information.

Other considerations

9.32 Where respondents have raised features and risks which are

unique to cryptoassets, the government considers that the framework proposed will be flexible enough to address them. In some cases this may be achieved by the regulator setting firm-facing rules or guidance. On the point around celebrity endorsements and pump and dump

33 It should also be noted that market abuse regimes and supporting infrastructur es for traditional financial services asset classes – e.g. financial instruments – were developed over many decades. Expecting the same level of sophistication and coordination on day 1 of the broader cryptoasset regime is unrealistic, especially for an industry which is currently characterised by a high degree of fragmentation across venues and jurisdictions 34 Regarding the scope of regulated firms, readers are pointed towards chapter 12 which provides an update on the government’s approach regarding mining and validation; this chapter clarifies that the government considers that the specific process of mining and operating a validator node using on-chain staked cryptoassets would generally constitute a technical function and not a financial services activity

35 https://www.handbook.fca.org.uk/handbook/DTR/8.pdf

schemes perpetrated through social media, the government draws attention to the recent Financial Promotions SI (with the corresponding regulatory regime going live in October 2023) which will apply to cryptoasset financial promotions capable of having an effect in the UK, regardless of where in the world the promotion originates and the medium it takes (i.e. social media will be captured). The FCA has also published two guidance consultations on financial promotions for cryptoassets and social media respectively. 36 Finally, the government is supportive in principle of two other broad points that came up frequently in the feedback. Firstly, the government agrees that additional guidance should be made available by the regulator to provide clarity on what constitutes market abusive behaviour (including a non-exhaustive list of examples). The government also agrees that key aspects of the regime will need to be periodically reviewed and assessed given the dynamic nature of the industry.

36 GC23/1 & GC23/2

Chapter 10

Regulatory outcomes for

operating a cryptoasset lending platform

Recap on original proposals from the Consultation

10.1 In the Consultation, the government highlighted that firms

offering cryptoasset credit and borrowing services were likely to be captured by requirements proposed within the cryptoasset intermediation and custody regimes. In addition, for cryptoasset lending firms, the Consultation proposed a bespoke set of rules and ongoing monitoring arrangements and the creation of a newly defined regulated activity – ‘operating a cryptoasset lending platform’. Through this, the government proposed that lending platforms would have requirements to put in place adequate risk warnings, adequate financial resourcing and clear contractual terms of ownership.

10.2 HM Treasury received a total of 41 responses to this question with

83% agreeing or generally agreeing that the assessment of challenges was correct. Several responses did however note that HM Treasury should consider additional challenges. Of these, the most common themes were the need for distinction between retail and wholesale lending activities, and the need for alignment with broader financial services regulation. Some respondents also noted that staking activity should not be subject to the same regulation as lending or borrowing activities. Others recommended that HM Treasury gave further consideration to the challenges faced by borrowers/consumers, with one response suggesting an amendment to the Consumer Credit Act 1974 to achieve adequate protection for retail borrowers. DeFi lending was also mentioned as an additional challenge with some respondents adding that DeFi lending regulation should be addressed in parallel to centralised cryptoassets lending. Of those disagreeing with the approach, respondents noted that regulation of this activity would be

Question 31

Do you agree with the assessment of the regulatory challenges posed by cryptoasset lending and borrowing activities? Are there any additional challenges HM Treasury should consider?

inconsistent with the way securities lending transactions are treated and thus the government should not take forward a blanket approach.

10.3 HM Treasury received 32 responses to this question. Several

respondents noted that adequate prudential requirements in the form of capital and liquidity safeguards, reserve requirements, ring-fencing of retail funds,37 stress testing and leverage limits could have prevented such a collapse. Other respondents discussed the need for adequate disclosures to consumers, including adequate risk warnings, clarity on legal ownership, compensation agreements and information on insolvency procedures. At least one respondent suggested that all such information should be clearly presented in the customer-facing terms and conditions, so that all investors are informed of the risks associated with using a cryptoassets lending platform. A significant number of respondents also noted that stricter custody arrangements, appropriate segregation of client assets and limitations on rehypothecation could have also been helpful. Other responses discussed the inappropriate governance structures in place for lending platform business models and added that any regulation should cover appropriate governance, transparency and accounting standards.

10.4 HM Treasury received 40 responses to this question with the

majority of respondents (83%) agreeing or generally agreeing with the proposal. At least one respondent outlined several transferable elements from traditional lending that could be extended to cryptoassets lending including risk warnings, capital requirements and collateral reporting. Several responses noted that FSCS protections should be extended to cryptoasset lending for consumer protection reasons. A significant portion of responses asked HM Treasury to differentiate between cryptoasset retail lending and wholesale lending. More specifically, some responses suggested that firms lending solely to institutional counterparties should be permitted to engage in certain

37 though other responses suggested that retail participation should be wholly prohibited

Question 32

What types of regulatory safeguards would have been most

effective in preventing the collapse of Celsius and other cryptoasset lending platforms earlier this year?

Question 33

Do you agree with the idea of drawing on requirements from different traditional lending regimes for regulating cryptoasset lending? If so, then which regimes do you think would be most appropriate and, if not, then which alternative approach would you prefer to see?

activities without the same authorisations that would be required to lend to retail customers. Of those disagreeing – several respondents felt that securities lending regulation should be the basis for a cryptoassets lending regime.

10.5 Most respondents agreed that a bespoke regime would be most

appropriate for cryptoassets lending with this regime focusing on credit risk, disclosure requirements, collateral, and margin calls. Among other traditional lending regimes that HM Treasury could consider, respondents mentioned the Consumer Credit Act in the UK and the

Capital Requirements Regulation (CRR) and the Mortgage Credit

Directive (MCD) in the EU.

10.6 HM Treasury received 36 responses to this question, with an

overwhelming majority (89%) agreeing or generally agreeing with the proposal. However, a number of responses qualified this view by asserting that the reporting requirements for these firms should not be as stringent as those applying to traditional lending. Other respondents suggested that regular audits would attract investors to these platforms and so should be welcomed. A few responses questioned whether the availability of cryptoasset lending to retail participants should be allowed. Others suggested that a warning requiring express consent should be displayed before retail customers pledge their assets. Of those disagreeing with the proposals, respondents highlighted that the suggested option would be too burdensome for firms and not likely to benefit retail clients. Instead, one respondent suggested that prescriptive ratios should be defined with regards to collateral, liquidity and rehypothecation, with a bespoke risk management framework rather than a regime focused on transparency.

10.7 HM Treasury received 44 responses to this question with 89% of

those agreeing or generally agreeing with differentiating between these activities for regulatory purposes. The majority of these responses were of the view that lending (where there is transfer of legal title) presented a higher degree of risk than staking due to potential harms arising from rehypothecation, counterparty default, and greater information asymmetries. Other respondents asked HM Treasury to clarify the difference between staking and lending through clear

Question 34

Do you agree with the option we are considering for providing more transparency on risk present in collateralised lending transactions?

Question 35

Should regulatory treatment differentiate between lending (where title of the asset is transferred) vs staking or supplying liquidity (where title of the asset is not transferred)?

definitions (with these responses generally recommending that a transfer of legal or beneficial title should be the key distinction). Some respondents also noted that staking in itself was a technological process that should not be covered by financial services regulation. Others suggested that a carve out from Collective Investment Scheme (CIS) regime would be appropriate for the regulation of staking activities.

Government response

Basis for the regime, and scope

10.8 The government intends to take forward the approach outlined

in the Consultation, including the proposal to establish a newly defined regulated activity of ‘operating a cryptoasset lending platform’, in line with broad support from both industry and consumer groups.

10.9 The Consultation feedback correctly noted that there are many

different types of cryptoasset borrowing and lending arrangements, involving different business models, market participants and risks. As such, it would not make sense to regulate all borrowing and lending activities in the same way or adopt a single model of traditional lending regulation for all cryptoasset lending arrangements.

Retail versus wholesale

10.10 The government agrees on the need for a clear differentiation

between lending to retail consumers and lending between wholesale counterparties and will therefore consider additional requirements for retail lending arrangements. For clarity, the framework set out in

Chapter 10 of the Consultation was designed primarily with retail

consumers in mind (taking into account learnings from the failure of platforms like Celsius) rather than wholesale bilateral lending arrangements. The intention is to prioritise regulation of these types of lending business models (i.e. centralised platforms) given concerns around retail consumer risks.

10.11 With this in mind, the government agrees, in principle, that

wholesale bilateral cryptoasset lending arrangements would not be subject to the same types of regulatory requirements. However, as previously set out, there are some similarities between wholesale cryptoasset lending and securities lending that could result in the build-up of systemic risk. The government, therefore, maintains that some requirements similar to those found in the UK Securities Financing Transactions Regulation (SFTR) (e.g. requirements relating to counterparty and transactions details, collateral composition, rehypothecation, substitution of collateral at the end of the day and haircuts) could help improve transparency associated with cryptoassets financing activities. These may be considered in future phases of regulation.

Lending versus staking

10.12 The government agrees with the feedback recommending

differentiated regulatory treatment between cryptoasset lending and

cryptoasset staking (where the latter does not involve transfer of legal title of the asset). Readers are pointed towards chapter 12 for further detail on this.

Chapter 11

Call for evidence:

Decentralised Finance

(DeFi)

Recap on original proposals from the Consultation

11.1 In the Consultation, the government noted that Decentralised

Finance (DeFi) was a nascent, complex area carrying unique challenges. As such, the Consultation requested further evidence from respondents before setting out any prescriptive frameworks. The government noted that the work of international organisations was pertinent, and that the government was not seeking to front run this by developing a prescriptive framework for the UK that would need to be fundamentally re-shaped once international approaches and standards crystalise. There was recognition that work was already being undertaken at various international organisations to address risks emanating from DeFi.

11.2 The government also outlined that the regulatory outcomes and

objectives described in the preceding chapters should apply to cryptoasset activities regardless of the underlying technology, infrastructure, or governance mechanisms. However, due to the challenges specific to DeFi, this would take longer to clarify. The consultation noted that one way of achieving this would be to regulate DeFi through a set of DeFi-specific activities.

11.3 Overall, HM Treasury sought a proportionate approach which

recognised the opportunities offered by DeFi new business models and encouraged a thriving and well-regulated UK DeFi industry, whilst delivering similar regulatory outcomes across centralised financial services activities and their DeFi equivalents, thereby preventing risks of regulatory arbitrage.

11.4 HM Treasury received a total of 55 responses to this question with

80% of respondents agreeing or generally agreeing that the

Question 36

Do you agree with the assessment of the challenges of regulating DeFi? Are there any additional challenges HM Treasury should consider?

assessment of the challenges of regulating DeFi was appropriate. At least five responses supported HM Treasury’s view that it would be unwise to front-run international work on DeFi, especially with regards to coordination and alignment on taxonomy. Other respondents asked HM Treasury to clearly define what activities fall in the scope of DeFi.

11.5 Respondents noted that DeFi projects often involved complex

financial products and protocols that would be difficult for consumers to understand. Many of the respondents highlighted that DeFi business models should be identified on a spectrum of centralisation rather than a binary delineation between centralised and decentralised, with some business models shifting over time from decentralised to centralised (though the shift could also occur in the other direction). One respondent argued that HM Treasury should determine what degree of centralisation merits regulation, noting that fully decentralised solutions cannot and should not be regulated. Another respondent noted that as many DeFi firms were on a journey to decentralisation, regulating the action of establishing or operating a protocol could cripple the DeFi sector.

11.6 Respondents agreed that a DeFi framework should focus on the

entity managing access to a protocol rather than the software providers or developers of the protocols. At least two respondents noted that any DeFi regulatory framework should recognise and facilitate the unique features of DeFi (particularly decentralisation and disintermediation).

Another respondent noted a more prescriptive framework whereby

FSMA should apply either to grant authorisation or to bring relevant enforcement actions would be key. The challenge of enforcement was also recognised by other respondents.

11.7 Of those disagreeing with HM Treasury’s assessment of

challenges, one respondent noted that existing regulatory frameworks were not fit for purpose to address DeFi’s unique risks. Specifically, the respondent highlighted challenges associated with the lack of oversight of Decentralised Exchanges (DeXs), lack of specified guidance on regulating initial DeX offerings, lack of custody and insurance, and challenges associated with cross-border transactions.

11.8 HM Treasury received a total of 26 responses to this question.

Respondents highlighted several metrics that could be used to

evaluate the size of the UK’s DeFi market. This list included data on

Question 37

How can the size of the “UK market” for DeFi be evaluated? How many UK-based individuals engage in DeFi protocols? What is the approximate total value locked from UK-based individuals?

Total Value Locked (TVL)38, active users, volume, liquidity, fees, token price, governance participation, market share and smart contract audit. One respondent noted that this information could be obtained from regulated Know Your Customer (KYC) compliant exchanges on DeFi- specific token transfers which could be augmented with further tax data – though the respondent noted that this would be an underestimation as this would only focus on on-chain activity.

11.9 A few respondents noted the difficulty of obtaining such

information given the borderless nature of DeFi transactions. This could be addressed by crowd-sourcing information from market participants although achieving extensive compliance could be difficult. Alternatively, several respondents noted that existing data could be sourced from DeFi Llama and Chainalysis’ DeFi adoption rates.

11.10 One respondent put forward an estimate of approximately 1.38

million UK DeFi users in 2022 and 0.64 million UK individuals participating in yield farming. Estimates varied on TVL in DeFi. At least three respondents put the global estimate at ~$50 billion, with estimates of the UK “market share” comprising varying from around 5% to 20% ($2.5 to $10 billion).

11.11 HM Treasury received a total of 54 responses with 81% of

respondents agreed or generally agreed with the proposed approach.

One respondent suggested that although DeFi involves new

technologies and approaches to governance, the activities occurring on a DeFi protocol (trading, lending, hedging) were analogous to those that exist in traditional finance. The goal for the regulators should thus be the prevention of regulatory arbitrage between DeFi and CeFi infrastructure.

11.12 A significant number of respondents agreed that DeFi regulation

should be implemented according to a longer timeline to enable a more internationally coordinated approach as the market was relatively small and at an early stage of development. One respondent further raised the anonymity of transactions being a significant obstacle to achieve the same regulatory outcome across DeFi and CeFi activities.

11.13 Of those disagreeing, respondents argued that DeFi was

fundamentally different to traditional financials services which are heavily centralised and intermediated financial services activities. These

38 TVL represents the amount of assets deposited by the liquidity providers in the different protocols developed in the DeFi space

Question 38

Do you agree with HM Treasury's overall approach in seeking the same regulatory outcomes across comparable "DeFi" and "CeFi" activities, but likely through a different set of regulatory tools, and different timelines?

responses further set out the importance of maintaining the user’s freedom of choice to use DeFi services as long as they maintain control of their own assets and funds and the protocols are automated, self- executing and based on based on open-sourced code. Another respondent agreed that prescribing uniformity between CeFi and Defi should not be the only ambition as this could stifle innovation within the DeFi space. Given the complexity of financial products involved in DeFi, one respondent noted that an educational approach was more appropriate than imposing a specific, potentially restrictive regulatory regime.

11.14 Collectively, respondents noted that DeFi had five main features

which separated it from CeFi. First, self-custody – whereby only the owner has possession of the private key to access their private keys. Second, autonomous nature – DeFi is reliant only on the execution of transactions through smart contracts. Third, transparency – DeFi activity is recorded on a public blockchain and based on open sourced code. Fourth – composability allowing interoperability of DeFi protocols and dApps. Lastly, DeFi by its nature is decentralised and controlled by a network of users; CeFi is controlled by a single person/small, centralised group. As such, one response argued that the regulatory tools used to regulate DeFi would have to be separate to those used in CeFi. Other respondents highlighted that defining standards could be used to address DeFi-specific risks. This could include conducting regular, independent code audits and IT security tests, in addition to standards around information disclosures about the services provided and their associated risks.

11.15 HM Treasury received a total of 38 responses. Most respondents

agreed that decentralisation should be seen as a process/spectrum rather than a static choice between centralisation and decentralisation. A significant number of respondents also noted that most ‘centralised’ DeFi firms were on a path to decentralisation (‘progressive decentralisation’) and as such a prescriptive DeFi framework that only applies to fully decentralised firms would be unhelpful.

11.16 Voting rights/governance token distribution was raised by nearly

all respondents as a metric that could be used to measure decentralisation. At least one respondent added that, although decentralisation was a spectrum, if a single body within the DeFi chain holds 50% or more of voting rights this should not be considered decentralised. Another respondent cited 60% as the threshold figure. Furthermore, respondents added it was also important to account for the nature of the control of the governance tokens, i.e. the extent to

Question 39

What indicators should be used to measure and verify

“decentralisation” (e.g. the degree of decentralisation of the underlying technology or governance of a DeFi protocol)?

which token-holders vote on the direction of the organisation or more immaterial matters. Distribution of nodes was also raised as a metric for measurement of decentralisation, if a small number of nodes control the majority of the network’s processing power, it would indicate a more centralised protocol. Other respondents also raised ‘code openness’ (the transparency and accessibility of the code) as a measure. One respondent also highlighted that reliance on self-executing smart contracts, non-custodial arrangements (no intermediary has access to client assets) and self-governance were pillars of DeFi arrangements, the lack of this therefore would indicate a centralised entity.

11.17 HM Treasury received a total 39 responses to this question. A

significant proportion of the responses agreed with the Consultation in that regulating on and off-ramps, especially exchanges, would be the most suitable regulatory hook. However, a number of responses noted that interface providers or front-end platforms would not be appropriate regulatory hooks. These respondents argued that this would go against the principle of activity-based regulation given that these interface providers were not necessarily connected to the governance or decision-making side of the DeFi protocol. An alternative approach suggested that regulators consider regulation of DeFi applications rather than the underlying protocol.

11.18 Other suggestions in responses included regulators working with

smart contract audit companies looking for bugs and stress-testing dApps for vulnerabilities. Other suggestions included attaching regulatory hooks to token issuers and smart contract developers, although it was noted that these in many cases could be less appropriate and relatively complex to enforce.

11.19 At least one response asked HM Treasury’s approach to follow

that of the International Monetary Fund in DeFi regulation by focussing on the elements of the cryptoassets ecosystem that enable DeFi. Thus, focusing on stablecoin issuers, centralised crypto exchanges, hosted wallet service providers, reserve managers, network administrators and market makers could all serve as appropriate regulatory hooks.

Question 40

Which parts of the DeFi value chain are most suitable for establishing "regulatory hooks" (in addition to those already surfaced through the FCA-hosted cryptoasset sprint in May 2022)?

Question 41

What other approaches could be used to establish a regulatory framework for DeFi, beyond those referenced in this paper?

11.20 A total of 39 respondents returned answers on other approaches

not referenced in the Consultation that could be taken forward. At least

5 respondents noted the importance of international coordination on

setting DeFi standards noting the work of supranational bodies including the FSB and the Bank for International Settlements (BIS). Responses also added that the UK should prioritise international engagement with regulators outside of the UK on DeFi to ensure a harmonised regulatory framework.

11.21 A number of respondents raised that a licensing and certification

approach could be applied to DeFi whereby certain activities would not be permitted without an official license. A few respondents reiterated that mandatory compliance with overly prescriptive rules could stifle innovation and thus recommended voluntary frameworks. Other respondents also highlighted that a DeFi regulatory sandbox could be a useful tool to enable firms to decentralise.

11.22 Respondents also noted that a self-regulatory approach through

Self-Regulatory Organisations (SROs) could be useful alternate

approach to that proposed in the Consultation. This could, for example, be achieved through embedding supervisory functionality within the technical design of the protocol (such as supervisory nodes). Responses also suggested that the FCA could provide guidance to promote good practice.

11.23 Other suggestions included establishing an equitable tax

framework, requiring every protocol to have separate retail-facing and institutional-facing protocols, and requiring protocols to elect a responsible regulatory board with liabilities similar to those set out in the Senior Managers and Certification Regime (SMCR).

11.24 HM Treasury received 37 responses on existing best practices

that could be formalised. Several respondents asked that the FCA should develop and recognise voluntary best practices through formalisation of a certification process for interfaces and protocols. Certified protocols would feature on approved lists allowing them to be used in regulated financial institutions. A number of respondents also asked for the standardisation of code audits as these would be a key element to mitigate risks, facilitate consumer protection and curtail illicit market activity. Several responses noted that IT security tests and information disclosures would be pertinent to enable the growth of the DeFi market. At least one respondent noted however that these should be industry standards rather than regulatory obligations. Another respondent added that a “Know Your Smart Contract” could be adopted whereby firms would have to consider whether their smart

Question 42

What other best practices exist today within DeFi organisations and infrastructures that should be formalised into industry standards or regulatory obligations?

contract had been verified, their dApps had been tested, that they were able to track movements of assets under the contract, and whether there were other contracts dependent on their smart contact. Amongst other suggestions were DeFi organisations having clear policies and procedures for providing liquidity to their protocols, including risk management strategies.

Government response

11.25 Although the DeFi market is currently small, the government

recognises that DeFi may play an important role in financial services as the cryptoasset sector becomes larger and blockchain-based solutions continue to be adopted by financial markets. As such, and in line with the government’s innovation-forward approach, the government does not intend to ban DeFi.

11.26 As identified by numerous international bodies, important

challenges remain for authorities to be able to regulate the DeFi ecosystem. HM Treasury recognises, for example, that some firms operating within the DeFi space currently could not be classified as decentralised. HM Treasury agrees with respondents that a spectrum of decentralisation needs to be recognised within the DeFi ecosystem rather than a binary between centralised or decentralised.

11.27 The government envisions a potential for fully decentralised DeFi

service models, if achievable, to play a role in financial services in the future but this will require careful consideration on the management of future risks and extensive international collaboration. For safe and wider adoption of these models, the government would expect them to achieve equivalent regulatory outcomes to those performed in traditional finance.

11.28 However, in line with Consultation responses, HM Treasury

recognises that it would be premature and ineffective for the UK to regulate DeFi activities currently. Instead, the government will support efforts at the international level through work at both the FSB and standard setting bodies (SSBs) to inform a future domestic framework.

The government will also continue bilateral engagement with

authorities in other jurisdictions and to engage with industry to ensure that cooperation and efforts on DeFi matters remains pertinent.

Chapter 12

Call for evidence: other cryptoasset activities

Recap on original proposals from the Consultation

12.1 In the Consultation, the government noted that cryptoassets are

currently not in scope of the regulated activities of advice and discretionary portfolio management services. The government also noted that cryptoasset investment advice and discretionary portfolio management services were limited and risks to retail consumers were relatively modest. However, there was potential for risks to emanate from conflicts of interest, fraud and loss of customer assets with the risk that these activities could expand to retail consumers. Per the government’s overarching approach on cryptoassets, the Consultation noted that the government is considering whether a case exists for bringing these activities into the regulatory perimeter through Article

53 of the RAO and Article 37 of the RAO. Despite these parallels, HM

Treasury noted that there were clear differences especially as the value of unbacked cryptoassets is driven by speculative decisions rather than objective market fundamentals.

12.2 Post-trade activities were another area where the government

sought further input before outlining a prescriptive framework. The

Consultation noted that some functions such as settlement could be

performed on the blockchain with different structures. Thus, there were benefits in regulating settlement to mitigate settlement failure risk and ensuring clarity of ownership – this would be in cases were the activity was deemed to be systemic and proportionate to the scale of the risk. Clearing was noted as another area where future-proof regulations may be of benefit although no central counterparties clearing services were being provided by cryptoasset exchanges.

12.3 The Consultation highlighted that mining and validation

occurring in the UK made up a very small percentage of global mining power. The difficulty in regulating the decentralised nature of certain cryptoassets also extended to how and where cryptoassets are mined. Simultaneously, the challenge of attempting to enforce any regulation at protocol level may simply push mining / validation and certain software development activity abroad. As such, the government outlined that there may not be justification to regulate the activity of mining in and of itself.

12.4 HM Treasury also noted staking activities could be an area to

bring within the regulatory model. The Consultation noted that some models may already fall within the perimeter. However, with a lack of data on staking activity in the UK, the government thought it sensible to seek further data before outlining anything overly prescriptive.

12.5 HM Treasury received 30 responses to this question with the

majority of respondents (77%) agreeing or generally agreeing that investment advice and portfolio management on cryptoassets should be a regulated activity. Responses to support this position included the increasing proliferation of cryptoassets in the retail space, that regulation would increase consumer confidence, and for consumer risk management. Others noted that customers were often seeking unqualified views as current financial advisors were limited in their ability to advise on such products. One respondent suggested that any regulation should differentiate between advisors servicing retail investors and those servicing HNW persons and institutional investors. Several respondents noted that HM Treasury should seek to bring the activity in scope under phase 2 and take an approach similar to that of Switzerland and the European Union. 12.6 Of those disagreeing with regulation of the activity at this stage, many responses noted the difference in value of public market instruments whose value is derived from market fundamentals and unbacked cryptoassets whose value is currently driven from speculative decisions. This speculative nature would render it difficult for an investment advisor to meet the existing criteria set out in Article 37 and

53 of the RAO. Respondents also added that given the limited scope of

the activity currently, HM Treasury should not prioritise the issue and let the market develop before outlining a prescriptive framework.

12.7 41 respondents provided a response to this question with 59% of

respondents disagreeing or generally disagreeing that mining and validation activities should be regulated in the UK. A majority of respondents agreed with HM Treasury’s assessment that regulation of the limited mining activity would lead to offshoring. A significant number of respondents also asked for the HM Treasury to collaborate with international partners to ensure coherent international standards

Question 44

Is there merit in regulating mining and validation activities in the UK? What would be the main regulatory outcomes beyond sustainability objectives?

Question 43

Is there a case for or against making cryptoasset investment advice and cryptoasset portfolio management regulated activities? Please explain why.

for mining. Respondents noted that there was a downward trend in mining given a significant portion of cryptoassets rely on proof-of-stake models instead of proof-of-work. Some respondents also added that mining and validation in and of themselves were technology services and did not constitute a financial service which could be regulated.

12.8 Those agreeing that mining and validation activities should be

regulated listed prevention of abuse/evading sanctions as the major reason. One respondent also asked HM Treasury to regulate any entity which has a presence in the UK or provides UK contracts to clients.

12.9 HM Treasury received 39 responses to this question with the

majority of respondents disagreeing that staking should be an activity to be regulated alongside cryptoasset lending. A significant number of respondents also noted that staking as an activity should be separate from the definition of a Collective Investment Scheme (CIS). Respondents argued that should staking fall within the CIS framework, this would kill off a significant number of products (e.g. staking for the purpose of governance). At least one respondent argued that classifying staking arrangements as CIS would restrict access to staking for UK users who do not meet the conditions for participating in a CIS. Thus, it would burden staking providers with compliance costs resulting in the concentration of larger players. Ultimately, this would severely restrict staking. One respondent suggested that this would result in a de facto ban on the activity. Respondents thus suggested that this could be mitigated by the UK introducing staking-as-a-service as a regulated activity which would cover platforms allowing customers to participate in proof-of-stake consensus mechanisms.

12.10 Respondents were also clear in distinguishing staking from

lending with some responses suggesting the activity was more akin to mining. Specifically, respondents defined staking as a technological process that should not be regulated under financial regulation noting that risks in cryptoassets lending, i.e. rehypothecation, counterparty credit risk and information asymmetries were not apparent in staking.

12.11 A significant number of respondents also asked HM Treasury to

set out a more explicit definition of what would constitute staking. One response noted that the definition should be explicit that processes such as CeFi lending, yield farming and liquidity farming do not constitute staking. A few responses also outlined that staking pools should fall under CIS (especially where a liquid staking token is received by token holders). Some respondents noted that without a definition and further data, it would not be appropriate to seek to regulate this

Question 45

Should staking (excluding “layer 1 staking”) be considered alongside cryptoasset lending as an activity to be regulated in phase 2?

activity. Others noted that cryptoasset staking should be regulated under phase 2.

12.12 HM Treasury received 23 responses. A significant number of

respondents highlighted that centralised intermediaries providing the staking services should be the focus of regulation. One response suggested that providing a staking intermediary service (staking-as-a- service) should be an RAO activity in and of itself. Some responses noted that validators themselves could be regulated given that there were a few participants. Other responses pushed back noting the difficulty in regulating validators and that validation in and of itself was a technological service and thus should not fall under financial regulation. Respondents had mixed reactions to whether staking pools would be an appropriate regulatory hook. There were also suggestions that regulatory hooks should be placed on points of centralisation as these were areas of concentration risks.

Government response

Cryptoasset Investment Advice

12.13 The government recognises the strong sentiment on the need to

bring cryptoassets investment advice and portfolio management within regulatory perimeter. The government also recognises concerns on how the intended approach may create divergence versus MiCA and other jurisdictions. However, regulated investment advice is often defined differently between jurisdictions. In the UK, the market structure of regulated advice is markedly made up of many independent and restricted network advisors, whereas some other jurisdictions are dominated by bancassurance advisors. The government maintains the view that the price and value of most cryptoassets is driven by speculative investment decisions rather than market fundamentals which can be objectively assessed. This, coupled with a lack of professional qualifications concerning cryptoassets and the challenges of conducting due diligence on the issuers of cryptoassets competently, results in difficulty for an investment adviser to provide suitable cryptoasset recommendations to customers. We therefore intend to keep this under review, focusing for the time being on the cryptoasset activities which have been prioritised for phase 1 and phase 2 legislation.

Question 46

What do you think the most appropriate regulatory hooks for layer 1 staking activity would be (e.g. the staking pools or the validators themselves)?

Mining and Validation Activities

12.14 In line with responses to the Consultation, the government does

not intend to regulate mining as a regulated activity at this stage. As respondents have rightly identified, mining in the UK makes up an insignificant amount of global activity. Any unilateral action taken by the UK therefore would simply push the minimal activity occurring in the UK to jurisdictions with more lenient or no regulation. The government also recognises that mining, in and of itself, does not constitute a financial services activity.

Staking

12.15 HM Treasury has listened to industry concerns and understands

that clarifying the future regulatory treatment of staking in the UK is a key priority for many stakeholders. Therefore, HM Treasury is accelerating exploratory work which involves extensive engagement with stakeholders and a clear set of steps to work through, including: (i) developing a clear definition of cryptoasset staking on a PoS blockchain and distinguishing this from other, riskier, activities which may be referred to, or marketed as ‘staking’; (ii) establishing a taxonomy of the different PoS staking business models currently in the market; and (iii) identifying how to mitigate the associated risks and take advantage of the potential benefits of a carefully defined, permitted form of staking in the UK.

12.16 The government is also cognisant of various live or recently

closed consultations which should not be prejudged, such as the Law Commission’s Final report on Digital Assets, HM Revenue & Customs’ consultation on lending and staking, and the FCA’s planned consultation on Non-Handbook Guidance for cryptoasset financial promotions which is seeking responses to guidance on staking.

12.17 HM Treasury proposes a definition of staking as the process

where a given amount of native cryptoassets are locked up (staked) on smart contracts in a PoS consensus mechanism blockchain (on-chain), in order to activate validator nodes (computers) which collaboratively validate subsequent transactions and achieve consensus on the network’s current state. Rewards, consisting of newly minted native tokens and/or a portion of transaction fees on the blockchain, are then subsequently allocated to the network participants staking their cryptoassets and to the validator node operators. Any activities, services, or products marketed as ‘staking’, but which do not directly facilitate a validation process on a PoS blockchain should not currently be considered staking.

12.18 A proposed taxonomy of current staking business models which

consumers use to engage in this activity covers four archetypes (which may or may not involve intermediaries who stake cryptoassets on behalf of participants and may, in some cases, take custody of those assets) is set out in Fig 12.A. It should be noted that this typography does not represent a regulatory definition of staking nor text that would be used in any future legislation. Rather, the below sets out HM

Treasury’s thinking on existing business models to inform the policy approach: Fig 12.A. Taxonomy of current staking business models (simplified, not exhaustive)

12.19 While different staking business models exist, the same can be

said for PoS blockchains with regard to how they perform validation and governance functions at the protocol level. At present, the government considers that the specific process of operating a validator node using on-chain staked cryptoassets would generally constitute a technical function essential to the operational activities and security of a PoS blockchain, rather than a financial services activity.

12.20 While the government does not intend to ban staking, there is

recognition that many of the activities performed by intermediaries in the pooled staking categories (3 and 4), such as taking custody of and/or pooling cryptoassets and issuing liquid tokens present risks for consumers which need to be addressed. However, there is potentially a case for these activities to be appropriately captured by other regimes – including financial promotions, custody, lending, and intermediation, without needing further regulation. Many of these activities currently labelled as staking present significant consumer risks which will be at least partially addressed through financial promotions, custody, lending, and other cryptoasset conduct regimes.

12.21 In addition, the Consultation feedback highlighted that existing

UK rules for collective investment schemes may capture on-chain staking services provided by intermediaries but may not provide effective regulation of these services. HM Treasury is therefore signalling an intent to carve out certain manifestations of staking within the taxonomy outlined above from the CIS rules; provided that risks are appropriately captured in regulation as set out above – or, alternatively, to introduce a regulatory regime for "operating a staking platform" outside of the CIS framework.

Chapter 13

Call for evidence: sustainability

Recap on original proposals from the Consultation

13.1 In the Consultation the government reiterated its firm

commitment to making the UK a competitive location for sustainable finance. It was suggested that environmental, social and governance (ESG) related reporting requirements may be a proportionate way of achieving the “same risk, same regulatory outcome” principle. The

Consultation therefore sought further views on what information about

environmental impact or energy intensity would be useful for consumers making decisions about investing in cryptoassets, and at what time in the investor journey these would be particularly helpful to consumers.

13.2 The government received 31 responses to this question (though

there was a significant degree of overlap between questions 47 and 48 with some respondents choosing to combine their answers). In addition to the quantitative measures and indicators discussed below, respondents frequently mentioned the following types of information as being potentially useful to investors: • The type of consensus mechanism, and the network infrastructure • The energy source mix (and associated trends and initiatives) • Sustainability policies and ESG initiatives

13.3 Many responses noted that this type of information should be

supported by standardised rating systems and consistent terminologies and taxonomies to enable meaningful interpretation and comparisons. On a related note, several responses emphasised that getting this right is complex and needs careful international coordination.

Question 47

When making investment decisions in cryptoassets, what

information regarding environmental impact and / or energy intensity would investors find most useful for their decisions?

13.4 The government received 25 responses to this question (again

noting the overlap with question 47), suggesting the following types of indicators: • Energy / electricity consumption (total energy use, average energy use per transaction or block, average energy use per node) • Carbon emissions (total emissions, average emissions per transaction, average emissions per hash) • Number of total nodes, number of total transactions • Other metrics already used in existing frameworks (e.g. the

Crypto Climate Impact Accounting Framework)

• Trends over time or time series data for all of the above

13.5 As above, many responses emphasised the need for extensive

international coordination. Much of the feedback also warned of the difficulties in developing accurate and standardised indicators (e.g. due to lack of consistency in definitions and taxonomies, different accounting standards and systems of measurement, and fundamental differences in the underlying infrastructures and protocols of different tokens). Indeed, some responses fundamentally disagreed with the merits of having obligatory sustainability disclosures for this reason suggesting that the upsides would be outweighed by the significant costs and complexity. Others in this camp also argued that sustainability disclosures would go above and beyond the requirements which exist for some activities or asset classes which are in some ways comparable. For example, these types of disclosures are not required for market participants to trade currency pairs.

13.6 The government received 18 responses to this question. Many

existing frameworks and indicators for cryptoassets were highlighted including the Cambridge Centre for Alternative Finance (CCAF) indices (e.g. the Cambridge Bitcoin Electricity Consumption Index), the Crypto Carbon Ratings Institute (CCRI) indices, the Crypto Climate Impact

Question 48

What reliable indicators are useful and / or available to estimate the environmental impact of cryptoassets or the consensus mechanism which they rely on (e.g. energy usage and / or associated emission metrics, or other disclosures)?

Question 49

What methodologies could be used to calculate these indicators

(on a unit-by-unit or holdings basis)? Are any reliable proxies available?

Accounting Framework, the Luxor Hashrate Index, and the World

Economic Forum’s Guidelines for implementing Blockchain’s

Environmental, Social and Economic Impact. Some responses also discussed well established indicators and frameworks which are used in traditional financial services (or other established industries) that could be extended to cryptoassets – for example, traditional OECD indicators as well as the Greenhouse Gas (GHG) Protocols, the Green Claims Code, and Renewable Energy Certificate (REC) procurement mechanisms.

13.7 The government received 17 responses to this question. Most

agreed that a high degree of standardisation and interoperability was desirable and ultimately necessary, with many arguing that further international coordination work was required before defining requirements. Some pointed out that there are various consortia already committed to globally standardised approaches – e.g. the

Crypto Climate Accord and the Crypto Impact and Sustainability

Accelerator (CISA) and that some useful metrics are already very standardised (e.g. emissions per OECD standards). Some responses again highlighted practical difficulties – e.g. arising from different consensus mechanisms, underlying infrastructures and accounting standards.

13.8 The government received 15 responses to this question. Many

argued for disclosures to be made at the initial decision-making stage of the consumer journey (i.e. prior to investment). Some also argued that information should be made available on a regular basis thereafter (e.g. every 1 to 2 years) to help monitor for improvements. Some warned of risks of overloading consumers and recommended extensive consumer engagement and consumer research. A few organisations again voiced their objections to a mandatory sustainability disclosures regime in their response to this question.

Question 50

How interoperable would such indicators be with other recognised sustainability disclosure standards?

Question 51

At what point in the investor journey and in what form, would environmental impact and / or energy intensity disclosures be most useful for investors?

Question 52

Will the proposals for a financial services regulatory regime for cryptoassets have a differential impact on those groups with a protected characteristic under the Equality Act 2010?

13.9 Only 11 responses were received on this question. One response

suggested that the proposed approach – since it would involve leveraging the existing FSMA framework – could have a disproportionate approach on groups with protected characteristics. This response took the view that the existing financial services industry (and the policymaking which has shaped it) perpetuates inequality, discrimination and exclusionary practices based on race. The majority of the other responses did not see any differential impact on protected characteristic groups arising from the government’s proposals but talked more broadly about potential benefits from financial inclusion in a world with increased adoption of cryptoassets.

Government response

13.10 The government will proceed with the approach of tackling

sustainability issues primarily through disclosures in the first instance. While there is a robust debate about the environmental impact of the cryptoasset sector (and the magnitude of this compared to traditional financial services), sustainability disclosures will play an important role in fulfilling the government’s overarching policy objectives and commitments on climate.

13.11 However, the government agrees that there is a clear need for

significant international cooperation to develop interoperable metrics to facilitate meaningful comparisons. The government’s intention is to advance this through existing international forums (e.g. IOSCO).

13.12 The cryptoasset sector is rapidly evolving and metrics that are

relevant now may become less relevant over time. For instance, the metrics best suited to evaluating PoW blockchains may be less suited to the increasingly prevalent PoS model. So as to avoid committing to a bespoke disclosure requirements too early, and to mitigate the risk of an un-level playing field, further exploratory work on whether existing frameworks and indicators could be applied will be undertaken. Authorities will continue to monitor developments in the industry, and should it become apparent in time that a bespoke regime is desirable or necessary then this could be developed.

Annex 1: Glossary

Acronym Definition Acronym Definition

BIS Bank for International

Settlements

ESG Environmental, Social

and Governance

CASP Crypto Asset Service

Provider

FCA Financial Conduct

Authority

CASS The FCA’s Client Asset

Sourcebook

“Fifteenth

Report-

Regulating

Crypto”

A Treasury Select

Committee inquiry

published in May 2023

CCAF Cambridge Centre for

Alternative Finance

Financial

Promotions

SI

The Financial Services

and Markets Act 2000 (Financial Promotion) (Amendment) Order

CCRI Crypto Carbon Ratings

Institute

FMI Financial Market

Infrastructure

CeFi Centralised Finance FSB Financial Stability Board

CIS Collective Investment

Scheme

FSCS Financial Services

Compensation Scheme

CISA Crypto Impact and

Sustainability

Accelerator

FSMA Financial Services and

Markets Act 2000

CRR Capital Requirements

Regulation

FSMA 2023 The Financial Services

and Markets Act 2023

Custody Safeguarding or

safeguarding and administering (or arranging the same) a cryptoasset other than a fiat-backed stablecoin and/or means of access to the cryptoasset

GHG Greenhouse Gas

dApps Decentralised

Applications

HNW High Net Worth

DAR Designated Activities

Regime

IOSCO International

Organisation of

Securities Commissions

DeFi Decentralised Finance IP Intellectual Property

DeXs Decentralised

Exchanges

KYC Know Your Customer

DLT Distributed Ledger

Technology

MAR Market Abuse

Regulation

DSA Digital Settlement Asset MCD Mortgage Credit

Directive

DSS Digital Securities

Sandbox

MEV Maximal Extractable

Value

MiCA The EU’s Markets in

Crypto-Assets

Regulation

MiFID The EU’s Markets in

Financial Instruments

Directive

MIFIDPRU The FCA’s prudential

sourcebook for MiFID

Investment Firms

MLRs Money Laundering,

Terrorist Financing and

Transfer of Funds

(Information on the

Payer) Regulations 2017

MTF Multilateral Trading

Facility

NFT Non-Fungible Tokens

NSM National Storage

Mechanism

OPE Overseas Persons

Exclusion

OTF Organised Trading

Facilities

PoS Proof of Stake

PoW Proof of Work

RAO Financial Services and

Markets Act 2000

(Regulated Activities)

Order 2001

REC Renewable Energy

Certificate

Reg-Tech Regulatory Technology

RIEs Recognised Investment

Exchanges

SFTR Securities Financing

Transactions Regulation

SMCR Senior Management

and Certification

Regime

SRO Self- Regulatory

Organisation

SSBs Standard Setting Bodies

Stablecoins

Update

HM Treasury’s update

on plans for the regulation of fiat-backed stablecoins

TVL Total Value Locked

VoP Variation of Permission