A version of this post originally appeared on The FinReg Blog hosted by the Global Capital Markets Center at Duke Law School on January 28, 2019
It seems somehow ironic and fitting that the economic sector most hostile to centralized governments – cryptocurrency and initial coin offerings (ICOs) – faces renewed regulatory activity despite the UK Brexit and US shutdown chaos. On January 23, the Financial Conduct Authority (FCA) in the United Kingdom issued a new consultative paper regarding ICO regulation. Since comments are due in April, final decisions will be made after the current March 2019 Brexit deadline has passed.
The UK proposals suggest British policymakers are determined to go their own way regarding ICO regulation. If the proposals become regulation without any changes, the UK ICO regulatory framework will conflict with the emerging ICO regulatory framework in other major jurisdictions. The potential policy divergence creates an additional layer of irony given that the FCA was the prime mover behind last year’s proposal to create a Global Financial Innovation Network (GFIN). The GFIN proposal was analyzed HERE.
This post highlights the main areas of policy divergence and analyzes the global policy implications.
The UK Proposal
The proposal starts from the proposition that the cryptocurrency market continues to evolve, creating market segmentation along the way. The proposal indicates that three segments exist:
Exchange Tokens: items used as a means of exchange “without traditional intermediaries” that are not “issued or backed by any central authority.”
Security Tokens: items that fall within the definition of “debt” or equity.”
Utility Tokens: items that “grant holders access to a current or prospective product or service but do not grant holders” the same rights as debt or equity. The proposal notes that such tokens could meet the definition of “e-money” in certain circumstances.
These categories converge with those identified by Switzerland’s Financial Market Supervisory Authority in February 2018. However, FINMA expressly indicated that determinations regarding the regulatory perimeter would be undertaken on a “case-by-case basis.”
The FCA, however, has now clearly indicated that at least in England, Exchange Tokens and most Utility Tokens – aside from e-money – are outside the regulatory perimeter. This effectively creates incentives for ICOs and cryptocurrency issuers to shift activity to London and to structure their instruments in a manner that qualifies for this blanket exemption from securities regulation.
UK policymakers are not shy about touting the potential benefits of alternative mechanisms for intermediation, specifically citing “increased speed and a reduction in cost of cross border money remittance with cryptoassets as a vehicle for exchange.” (Section 2.19.) However, the guidance also acknowledges a much longer list of potential side-effects, including issues familiar to regulatory policy experts and commentators: (i) consumer protection concerns due to non-standard documentation, insufficient disclosure, and high market volatility/high potential loss rates; (ii) inability to enforce international anti-money laundering standards; and (iii) high potential for market manipulation and insider dealing due to high volatility and low liquidity.
The proposed guidance recommends that policymakers vigorously enforce consumer protection, AML/CFT, and market integrity/competition regulatory standards in the cryptoasset sector. However, the proposal makes clear that enforcement will only apply to instruments that are already within the scope of regulation. Consequently, all blockchain-based instruments that do not rely on central bank payment systems (“traditional intermediaries”) are deemed to fall outside the scope of regulation.
Potential Policy Divergences
By expressly exempting blockchain-based intermediation from the scope of regulation, the FCA creates the foundation for significant policy divergences globally. A more lenient, and clear, regulatory framework favoring cryptocurrency issuers would generate significant incentives for issuers to flock to the UK in order to conduct their intermediation activities.
In the United States, policymakers have been less willing to provide explicit guidance on cryptoassets. They have consistently taken the position that existing regulation is flexible enough to encompass these new instruments. This stance allows for significant regulatory discretion and has led to divergent outcomes across agencies.
For instance, the Commodity Futures Trading Commission (CFTC) permitted the introduction of cash-settled bitcoin futures contracts through existing self-certification processes for new commodity derivatives. The Securities and Exchange Commission (SEC) has also actively used its enforcement authority regarding a range of cryptocurrency entities. The CFTC self-certification process has attracted criticism from leading commentators, but that criticism has not deterred market participants from issuing new trading instruments based on self-certification. The CFTC’s leniency is tempered by the SEC’s informal position – backed by concrete high profile enforcement actions in 2017 and 2019 – that all ICOs are investment contracts subject to U.S. securities laws. The SEC has also thus far resisted attempts to list a bitcoin exchange-traded fund.
American banking regulators have been similarly stringent in their approach to a range of blockchain-based FinTech innovations. While the Office of the Comptroller of the Currency finally created a “FinTech charter” option in 2018, the regulatory requirements for that charter have been criticized as not generating sufficient regulatory incentives to attract innovative firms in the payments and banking sectors.
Singapore policymakers are also less generous than the UK regarding the regulatory perimeter for ICOs and cryptoassets. In December 2018, their updated formal guidance to ICO and cryptocurrency issuers stops short of creating a blanket exemption for instruments that do not use “traditional intermediaries.” Like the SEC and Switzerland, policymakers in Singapore expressly retain the option to determine that an instrument meets the definition of a security. The only ex ante exceptions available to potential issuers relate to offerings that target traditionally defined accredited investors. Moreover, even if the securities laws do not apply, Singapore policymakers have made clear that issuers must still comply with AML/CFT regulations.
Japanese policymakers have also recently started changing the trajectory of regulatory policy regarding cryptocurrency issuers and ICO issuers. In December 2018, the Financial Services Agency’s Study Group On Virtual Currency Exchanges released a report laying the groundwork for substantial expansions of the regulatory perimeter. No formal guidance has been proposed or released yet in Japan. But the general trend in the Study Group report suggests strongly that policymakers in Tokyo may not adopt as lenient a position as the proposed FCA guidance.
Regulators in Dubai and Abu Dhabi are expected to provide a regulatory framework for cryptocurrency and ICO issuers in the middle of 2019. Public speeches indicate that their approach to the regulatory perimeter could be even more restrictive than other jurisdictions. Issuers will only be able to operate within an official sandbox structure which, by definition, would limit the scope of product offerings to third parties.
In 2018, a range of policymakers with jurisdiction over various FinTech market segments proposed creation of a GFIN to facilitate cross-border consensus building activities with the UK’s FCA serving as the secretariat for the group. The proposal arguably raised more issues than it would resolve, as noted in this analysis. The commentary period closed in October 2018, but no formal organizational announcement has yet been made.
Addressing divergence in regulatory standards regarding ICO and cryptocurrency issuers would initially seem to be the ideal first project for the GFIN. However, the FCA remains silent regarding forward direction for the international group.
The most comprehensive statement provided on behalf of the GFIN occurred on January 16, 2019 from an official at the Abu Dhabi Global Markets in a podcast. The official indicated that the GFIN’s initial high priority tasks would be more administrative in nature (creating lists of relevant officials, providing increased transparency regarding market entry requirements for individual markets). Neither of those deliverables is expected before “early 2020.” Regarding standard-setting, the podcast interview indicates GFIN officials seek to provide “expert opinion” to existing international organizations. The precise example provided was with respect to “security tokens.” The GFIN would in this case provide expert opinion to the International Organization of Securities Commissions (IOSCO) rather than create its own standards. IOSCO provides on its website a collection of statements issued by individual regulators regarding ICOs, but there is no indication that an active workstream aimed at cross-border regulatory policy consensus-building is underway.
Inertia at the international level leaves open the possibility for domestic policymakers to continue pursuing policy trajectories in support of local objectives. This week’s proposal from the UK suggests that policymakers in London seek to maximize their attractiveness to ICO and cryptocurrency issuers as they build a post-Brexit financial system. Since the Bank of England’s Financial Policy Committee concluded in March 2018 that electronic currency issuers “do not currently pose a material risk to UK financial stability,” it seems that at least in England, a policy consensus is emerging that is more friendly to blockchain-based intermediation than in other sectors.
Barbara C. Matthews (JD/LLM ’91) is the Founder and CEO of BCMstrategy, Inc., a start-up technology company providing predictive analytics regarding cross-border policy risk using patented processes. She is also a non-resident Senior Fellow at the Atlantic Council. She is a recognized global regulatory policy expert and has served in the U.S. government in senior positions including as the first U.S. Treasury Attache to the European Union with the Senate-confirmed diplomatic rank of Minister-Counselor. She has also served as Senior Counsel to the House Financial Services Committee under the leadership of Chairman Michael G. Oxley.