CMS Cameron McKenna Nabarro Olswang LLP | Anna Burdzy | Charles Kerrigan | Erica Stanford
Cryptoassets for investment and financing
Regulatory threshold
What attributes do the regulators consider in determining whether a cryptoasset is subject to regulation under the laws in your jurisdiction?
The Financial Conduct Authority (FCA) has used The Cryptoasset Taskforce categorisation framework as a starting point in determining which types of cryptoasset fall within the regulatory perimeter. The two types of regulated token are:
- Security tokens. These provide rights and obligations analogous to ‘specified investments’, like a share or a bond. The holder has some rights such as ownership, or entitlement to a share in future profits. They are also potentially transferable securities under MiFID II.
- E-money tokens. These meet the definition of e-money under the EMRs and include those where issued by a credit institution, credit union or municipal bank.
The two types of unregulated tokens are:
- Exchange tokens. These confer no rights associated with specified investments on the holder, are an alternative to fiat currencies but not backed by any central authorities.
- Utility tokens. The holder does not have rights like those granted by specified investments and the holder has access to a current or prospective product or service within a blockchain or distributed ledger technology network or ecosystem.
Investor classification
How are investors in cryptoassets classified and treated differently?
Some common classifications are:
- Retail investors (individuals) who buy and hold cryptoassets for personal investment purposes, though not all products are accessible, such as derivatives. They may not have access to the same level of information as institutional investors.
- Professional investors (such as hedge funds) have larger capital and engage in more complex trading strategies. They have access to over-the-counter markets and receive tailored services from crypto exchanges. They are subject to higher capital requirements as well as additional reporting and compliance obligations.
High-Net-Worth Individuals. His Majesty’s Treasury (HMT), in a recent consultation response on financial promotion exemptions, stated that the financial thresholds to qualify for this classification will be increased. These thresholds will increase to £170,000 (from £100,000) for income and £430,00 for net assets (from £250,000 for net assets). Such investor trading activity can significantly impact the market.
- Sophisticated investors can self-certify. Government recently confirmed it will amend the criteria for the self-certified sophisticated investor exemption to be (1) an individual who has been a director of a company with an annual turnover of at least £1.6 million in the last two years (up from £1 million in line with inflation); (2) being a member of a network or syndicate of business angels for at least six months, and (3) working in the private equity sector or in the provision of finance for SMEs for at least two years. The government removed the exemption for individuals who have made an investment in an unlisted company in the previous two years as it no longer agrees that this as an indicator of sophistication.
Initial coin offerings
What rules and restrictions govern the conduct of, and investment in, initial coin offerings (ICOs)?
Most ICOs are not regulated. If the ICO involves securities or falls under the definition of a financial instrument, it will be subject to FCA regulation. Further, if the ICO involves the issuance of securities, it may be subject to the Prospectus Regulation (this is determined on a case-by-case basis). Companies conducting ICOs in the UK are typically required to implement Anti-Money Laundering (AML) and Know Your Customer (KYC) procedures.
Security tokens meet the definition of specified investment under the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO), and are therefore in the scope of regulation. This means the tokens have characteristics that are the same as, or similar, to traditional instruments like shares or bonds. A firm intending to carry on a regulated activity under the RAO regime will need to apply for a Part 4A permission if it is carrying on that activity by way of business in the UK.
An investor is very unlikely to have access to UK regulatory protection, such as the Financial Services Compensation Scheme or Financial Ombudsman Service.Security token offerings
What rules and restrictions govern the conduct of, and investment in, security token offerings (STOs)?
STOs that involve issuing or transferring securities that fall within the definition of specified investments under the RAO regime, such as shares, warrants, and debentures, are likely to be subject to the regime and the FCA rules and guidance. This means that issuers will need to obtain authorisation from the FCA, comply with the prospectus and disclosure requirements and adhere to market abuse and financial promotion rules.
Compliance with AML and KYC is required, and STO participants may be required to carry out due diligence on their investors and maintain records to prevent illicit activities.Stablecoins
What rules and restrictions govern the issue of, and investment in, stablecoins?
The rules relating to stablecoins are being actively developed.
HMT recently published a paper setting out how HMT will regulate the use, issuance and custody of fiat-backed stablecoins in UK payment chains. Secondary legislation to this effect should be published by early 2024 and will include fiat-backed stablecoins within the remit of the FCA, Bank of England (BoE) and Payment System Regulator.
Points to note include: (1) the regime will not regulate non-fiat backed stablecoins, unbacked stablecoins, algorithmic stablecoins, commodity-linked tokens, tokenised deposits or e-money; (2) the RAO will cover the activities of issuance and custody of UK issued fiat-backed stablecoins; (3) the Payment Services Regulations 2017 will be amended to encompass mixed and sole stablecoin payments and will take effect if the transaction involves UK customers or if a UK firm facilitates the transaction; (4) an arranger structure will possibly apply to overseas stablecoins to be used in UK payment transactions and such payment arrangers will have reporting obligations.
In addition, the FCA and BoE have each published discussion papers setting out views on the regulatory framework for systematic payment systems using stablecoins, and responses are required by 6 February 2024. Further, the regulators published a joint publication package looking at how UK authorities’ current and proposed regulatory regimes will interact, and the Prudential Regulation Authority (PRA) published a ‘Dear CEO’ letter on innovative uses of deposits, e-money and stablecoins. The FCA has also published a ‘Roadmap paper’ jointly with the BoE and PRA that aims to explain how the proposed regimes interact and FCA’s approach for dual regulation.
Cryptocurrency businesses, including those dealing with stablecoins are required to comply with AML and KYC regulations. Further, the Financial Services and Markets Act 2023 includes measures to bring stablecoins into the scope of regulation and the payment rules.Airdrops
Are cryptoassets distributed by airdrop treated differently than other types of offering mechanisms?
Cryptoassets distributed through airdrops are subject to similar regulatory considerations as other types of offering mechanisms. Airdrops typically involve the free distribution of tokens or coins to individuals, and their treatment depends on the specific characteristics of the cryptoasset in question.
The regulatory approach focuses on whether the cryptoasset qualifies as a security, utility token, or e-money, as this classification determines the applicable rules. If the airdropped cryptoasset is considered a security, it may be subject to the same regulatory requirements as traditional securities offerings, such as prospectus and disclosure obligations.
Compliance with AML regulations is also essential for cryptoasset issuers, regardless of the distribution method.
The recent HMT updates include a push for government to clarify treatment of airdrops.Advertising and marketing
What laws and regulations govern the advertising and marketing of cryptoassets used for investment and financing?
As of 8 October 2023, the FSMA (Financial Promotion) Order 2005 (FPO) was extended to bring into scope ‘qualifying cryptoassets’, which must comply with the financial promotion regime set out in Chapter 4 of the FCA’s Conduct of Business sourcebook. The standards to comply with are markedly more detailed than those governed by the UK Advertising Standards Agency and require great care.
As a result, any invitations or inducements to engage in the following activities in relation to cryptoassets will be in scope of the FPO: (1) dealing in securities and contractually based investments; (2) arranging deals in investments; (3) managing investments; (4) advising on investments; and (5) agreeing to carry on specified kinds of activity. NFTs and cryptoasset custody services are not generally in scope.
To lawfully promote cryptoassets under the FPO the promotion will need to be (1) communicated by an authorised person; (2) approved by an authorised person; (3) communicated by, or on behalf of, a cryptoasset business registered with the FCA under the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs); or (4) communicated with conditions of an exemption in the FPO.
Permitting firms registered with the FCA under the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs) to approve their own financial promotions will capture cryptoasset exchange providers and custodian wallet providers.Trading restrictions
Are investors in an ICO/STO/stablecoin subject to any restrictions on their trading after the initial offering?
From the perspective of the trader, there are no trading restrictions in the UK for an unregulated token.
Trading restrictions such as lock ups may be included in terms of issue and may be embedded in smart contracts.
Any tokens, including security tokens, listed on an exchange or market will be subject to the rules of the exchange or market.Crowdfunding
How are crowdfunding and cryptoasset offerings treated differently under the law?
Crowdfunding and cryptoasset offerings are subject to different legal frameworks. Crowdfunding, which involves raising funds from a diverse range of contributors, is regulated by the FCA based on the specific crowdfunding type. Equity crowdfunding, where backers receive shares and peer-to-peer (P2P) lending platforms, facilitating loans between individuals, are both subject to regulation, including platforms needing to obtain authorisation from the FCA.
Cryptoasset offerings, like ICOs and token sales are subject to KYC and Prospectus requirements as mentioned above. A new activity of operating a cryptoasset lending platform will be brought within scope of the new HMT regime recently published.Transfer agents and share registrars
What laws and regulations govern cryptoasset transfer agents and share registrars?
Cryptoasset businesses, transfer agents and share registrars are subject to AML and KYC requirements.
If transfer agents and share registrars process personal data, they are subject to the General Data Protection Regulation.Anti-money laundering and know-your-customer compliance
What anti-money laundering (AML) and know-your-customer (KYC) requirements and guidelines apply to the offering of cryptoassets?
Entities offering cryptoassets are subject to a number of requirements under the AML and KYC guidelines such as:
- Registration with the FCA.
- Performing customer due diligence (CDD) procedures which involves verifying the identity of customers (full name, residential address, date of birth) and assessing the risks associated with them.
- Ongoing monitoring of customer relationships to detect and report suspicious transactions.
- Record keeping such as maintaining records of CDD, transaction data, and other relevant information for at least five years.
- Suspicious activity reporting and if there are any suspicions that a transaction is related to money laundering or terrorist financing, they are obligated to submit a Suspicious Activity Report to the National Crime Agency.
- Risk assessment of the cryptoasset activities and taking measures to mitigate these risks.
- Training and awareness for employees on AML procedures.
Sanctions and Financial Action Task Force compliance
What laws and regulations apply in the context of cryptoassets to enforce government sanctions, anti-terrorism financing principles, and Financial Action Task Force (FATF) standards?
The UK implemented (1) AML regulations, which include the obligation to conduct CDD and report suspicious transactions; (2) mandatory registration with the FCA for cryptoasset businesses; (3) sanction regimes which apply to individuals, entities and countries subject to sanctions and require businesses to check whether their clients or transactions are subject to sanctions; and (4) ensure UK regulation is reflective of FATF standards.
This article first appeared on Lexology. You can find the original version here.
