Partner Richard Cannon examines crypto regulation in Law360

Richard’s article was published in Law360, 20 February 2023, and can be found here.

The Financial Conduct Authority (FCA) recently found that a remarkable 85% of cryptoasset firms which applied for registration failed to meet the minimum regulatory standards. The failings included inadequate anti-money laundering and counter-terrorist financing compliance, and a lack of key controls such as customer risk assessments, due diligence, and ongoing monitoring.

The FCA said that “in many cases, key personnel lacked appropriate knowledge, skills and experience to carry out allocated roles and control risks effectively and were unable to evidence they met the standards for registration.”

These statistics further illustrate the difficulty which crypto firms are having when attempting to fit into the regulated sector. These are applications made by firms who are trying to demonstrate to the FCA that their anti-money laundering and other compliance processes are up to standard, so they could be registered in the UK.

For a sector to have an 85% application failure rate is a massive proportion, and arguably reflects wider corporate and regulatory compliance issues in the crypto sector. Perhaps this level of non-compliance and knowledge points to the naivety and inexperience of some of those engaged in the crypto sector. Given the evident lack of knowledge and expertise in-house, it’s clear that engaging external professional support is something which the crypto business community need to embrace rapidly, if they wish to gain credibility, obtain authorisation, and build greater trust in the crypto sector.

The crypto sector is currently in particular need of a boost to its image in the wake of the high-profile collapse of cryptoasset exchange FTX in recent months, having filed for bankruptcy in November 2022. The company’s former CEO, Sam Bankman-Fried, was later arrested in the Bahamas, and is now facing criminal charges in New York, including wire fraud, money laundering and conspiracy to commit fraud, amid reports that some $1 billion in customer’s funds are missing.

The insolvency professional appointed to run the FTX bankruptcy, John Ray III, said the FTX collapse is the worst case of corporate failure he has seen in over 40 years. In the United States, major audit firms have responded to the collapse by designating all cryptoasset companies as “high risk”. This means a more lengthy, robust and through audit process is required for crypto businesses.

In Europe too, cryptoassets are treated as highly risky assets. In December 2022, the Basel Committee on Banking Supervision published its proposed standard on the prudential treatment of cryptoasset exposures for financial institutions, which is due to be implemented by 1 January 2025. Pending its implantation, the European Parliament’s Committee on Economic and Monetary Affairs on 24 January 2023 reportedly recommended a 1,250% capital treatment for cryptoassets, implying that banks should be prepared for a potential collapse in their value.

The FCA’s succinct advice for UK consumers considering investing in crypto is that cryptoassets are considered very high risk, speculative purchases. If buying cryptoassets, people should be prepared to lose all their money.

The FCA has also banned the sale cryptocurrency derivatives to consumers.

There is little doubt that the crypto sector has significant reputational problems internationally, especially given the misuse of cryptoassets for money laundering and cybercrime. In January 2021, ECB President Christine Lagarde called for the regulation of cryptocurrencies on a co-ordinated global basis.

Regulators have struggled to keep pace with the sector as it has grown, and most have been slow to create dedicated regulatory regimes for these novel assets. However, some notable jurisdictions are now on the cusp of rolling out such regimes. The EU’s proposed regulatory regime for cryptoassets is due to be voted on by the European Parliament in April 2023. Some believe that it could follow the EU’s data protection regulatory regime and become a de facto standard for cryptoasset regulation around the world. The EU’s markets in crypto-assets (MiCA) regime will cover stablecoins, trading exchanges, unbacked crypto-assets, and crypto wallets.

The EU says that the MiCA regulations will “protect investors and preserve financial stability, while allowing innovation and fostering the attractiveness of the crypto-asset sector,” while also claiming that it will “put an end to the crypto wild west.”
The UK made it a requirement for firms engaging in cryptoasset activities in the UK to register with the FCA in January 2020. However, the FCA has proven a robust regulator of the crypto sector, even banning the world’s largest crypto exchange, Binance, from operating in the UK in 2021.

On 1 February 2023, the UK government took a major step toward creating a regulatory regime for crypto-assets by launching an open consultation on such a regime. This remains open until 30 April of this year.

Given the often negative sentiment expressed about the crypto sector in the media, the tone of the consultation document might surprise some. Indeed, the consultation document itself reveals a good deal about the U.K. government’s intentions with regards to cryptocurrency regulation, and its view of the sector’s economic potential.

In his foreword to the consultation document, Andrew Griffith MP, Economic Secretary to the Treasury, wrote that the government’s firm ambition is for the U.K. to be home to an open, well-regulated, and technologically advanced capital market. Delivering on this ambition means taking proactive steps to harness the opportunities of new financial technologies.
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 this should be managed, not stifled.

Such issues reinforce the case for clear, effective, timely regulation and proactive engagement with industry and the U.K. government’s 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.
It is also notable that former Chancellor of the Exchequer Philip Hammond was recently appointed as chair of crypto firm Copper.co, saying that the UK needs to be leading in this area post-Brexit and that it has allowed itself to slip behind. Switzerland is further ahead, the EU is also moving faster and there has to be appetite to take some measured risk.

It is therefore now becoming clear that, despite the often-mixed reputation the crypto sector has garnered, the UK government sees real potential for the use of cryptoassets in digital finance and intends to compete with the EU and other jurisdictions to attract innovative crypto companies and exchanges to the UK.

This is hardly surprising given the global cryptocurrency market has reached values approaching US$3 trillion in recent years. There is clearly remarkable growth potential in the sector. The key will be to strike the right balance between effectively regulating the sector, to prevent money laundering and fraud, and having a regime which is light-touch enough to attract major players in the crypto sector to London.

Major central banks in global economies including the US and EU are now planning to create digital currencies based on blockchain technologies. These will be linked to the existing euro and dollar currencies, but their rollout may help to bring about increased comfort with the concept of digital currencies in the public mind. The UK government recently launched a consultation on the creation of a digital pound on 7 February 2023.

The Chancellor of the Exchequer, Jeremy Hunt said that a digital pound issued and backed by the Bank of England could be a new way to pay that is trusted, accessible and easy to use. It is worth investigating what is possible first, whilst always making sure financial stability is protected. It now seems clear that blockchain based digital currencies are now going mainstream around the world.

It also appears that, far from wanting to regulate the crypto sector out of existence, the UK government believes that it is time for crypto to come in from the cold and to find a place in the UK’s burgeoning digital financial sector.

Yet, whatever the eventual shape of the UK’s forthcoming crypto regulations, firms across the crypto sector will face all the compliance issues which companies in all sectors have to deal with routinely.

The optics are that the crypto sector is struggling with basic corporate compliance. Yet the professional service providers are there to help these companies to achieve compliance in an efficient manner. These are hurdles which can be overcome.
There is little doubt that improved corporate control and audit across the crypto sector will help to enhance the sector’s reputation, and the stability of companies and cryptoassets themselves. This will in turn help the sector to attract greater investment in the long run.

Despite the travails it has faced in recent years, the crypto sector could soon become a respected and important part of the wider digital finance world. If the UK creates a regulatory regime which is effective yet attractive to the world’s major crypto companies, London could soon become a leading global crypto and digital finance hub.