Crypto View - March 2022

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Welcome to the slightly delayed March edition of Crypto View, with our thoughts on some interesting developments that have happened over the last month. As seems to be a common occurrence – there has been quite a lot of news! In particular, the delay has allowed us to include the latest developments in the UK as HM Treasury have published its long-awaited response to its consultation on stablecoins. We also look at developments in the Middle East.

HMT Stablecoin Response

On 04 April, HMT issued its response to the consultation it launched in January 2021. It was announced by John Glen, the Economic Secretary to the Treasury and City Minister, at the Innovate Finance Global Summit, and you can see a summary of both his speech, and the 10 key points that you should be aware of from the response to the consultation here.

The key takeaway from the response to the consultation is that the government is going to bring certain stablecoins within scope of the UK regulatory perimeter. Specifically, it seeks to regulate ‘payment cryptoassets’ (though this name is not yet confirmed), which would cover any “cryptographically secured digital representation of monetary value which is, among other things stabilised by reference to one or more fiat currencies and/or is issued and used as a means of making payment transactions.” The intention is that this will cover all fiat currency backed stablecoins, while excluding those that stabilise their value by referencing other assets (e.g. commodities). The aim is to capture those that can be used as a means of payment specifically, the regulation will cover both single currency stablecoins, as well as those based on a basket of fiat currencies.

This will lead to new regulated activities, including the issuing of stablecoins, providing custody for stablecoins, and providing payment services in relation to stablecoins. The FCA will be the regulator for these activities, and firms will need to be authorised. It remains to be seen what the authorisation process will be like, and whether the FCA will be more effective than it has been throughout the registration process. It will likely be similar to the process for being authorised as an Electronic Money Institution or Payment Services Provider, but it is not clear whether firms already authorised as such would need to seek a variation of their permission, or indeed whether they would also need to be registered under the AML regime – something which may restrict the number of firms actually able to carry out such activities.

It is not entirely clear what the territorial scope of the proposals are. The response states that wallet providers and other entities providing stablecoin activities for payments in the UK must be authorised by the FCA, however there is no further discussion of how cross-border activities would be treated, and indeed how stablecoins that meet the definition HMT propose but are issued outside of this jurisdiction and so not necessarily obliged to meet, for example, the safeguarding requirements would be treated. Hopefully more clarity on this will be forthcoming.

Also of interest in the response is the suggestion that there will be a further consultation on the regulation of other cryptoassets, including Bitcoin. HMT see the regulation of stablecoins as a first step, with additional regulation of other cryptoasset activities necessary. We look forward to the publication of that consultation and will keep you updated. There may also be further consultations on the use of stablecoins where they are not used as a means of payment. The response, and the proposed definition of “payment cryptoasset” above, is specifically looking at those stablecoins that can be used as a means of payment. HMT state that there will likely be a further extension of the regulatory regime to include other activities beyond stablecoins used as a means of payment, specifically mentioning their emergence as a function in DeFi applications.

One point to note, however, is that it would appear that four different pieces of legislation are going to have to be amended, as well as new rules and guidance being introduced at the FCA, Bank of England and Payment Services Regulator, so it is likely that this will take a while before it enters into force.

New Dubai Regulator

There have been a number of very important developments for crypto in the Middle East. This month saw the issuance of Dubai Law No. 4 2022, which establishes a new Crypto Regulator, the Dubai Virtual Asset Regulatory Authority (VARA) in the Commercial Free Zone of the Dubai World Trade Centre. VARA will oversee the regulation, licensing and governance of virtual assets in Dubai. We would note that VARA hasn’t published its rules yet, but we will be monitoring for updates.

This follows a consultation regarding the regulation of cryptoassets that the Dubai International Financial Centre (DIFC) regulator, the Dubai Financial Services Authority (DFSA), released earlier this month, which provides the groundwork of the regulatory framework and builds on the work already done. The DFSA licences businesses and activities in the DIFC, and is a separate regime from the developments within the Dubai World Trade Centre. The DFSA has stated that it is keen to hear from market participants as to the appropriate level of regulation to be introduced in the DIFC. This is a good opportunity to engage with the Regulator to understand their approach and provide useful guidance as to stakeholder’s views.

While there have been a number of erroneous reports of licences being issued by VARA, currently we have only seen provisional approvals for limited activities pending the rollout of the full and formal licensing regime. The regulatory framework for VARA is expected to be released shortly which will provide guidance as to the roadmap for obtaining a permit to provide cryptoasset services in Dubai, including the activities that will be regulated, the permits required and what activities will require a permit.

Our Dubai crypto team recorded a video regarding the developments which you can watch here. You can also contact Muneer Khan, Adam Wolstenholme and Nina Fischer for more information.

Coordinated notifications from UK regulators

There was a coordinated release of notices, letters and updates from UK regulators on 24 March. The Bank of England’s Financial Stability Committee published its update on cryptoassets and decentralised finance, the Prudential Regulation Authority (PRA) issued a Dear CEO letter regarding regulated firms’ exposure to cryptoassets, the FCA published a notice to firms with exposure to cryptoassets, and the Bank of England published responses to its discussion paper last year on stablecoins and digital money.

FSC: The Financial Stability Committee paper looked at the financial stability implications of cryptoassets and associated markets, specifically discussing the risks from use as payments, the impact on real economy balance sheets and the risks to systemic financial institutions and core financial markets. The general position across all of these areas is that the FPC sees the current risk as low, due to the limited exposure each of these industries has to cryptoassets. However, they note that the pace of growth and potential for interconnections with the wider financial system mean that they will present a number of financial stability risks in the future. It sees international cooperation as key to the ongoing mitigation of these risks. In particular, it sees a need for an international approach to unbacked cryptoassets, agreed standards for systemic stablecoin providers, and the treatment of cryptoasset exposures under the prudential regime for banks.

PRA: The PRA’s Dear CEO Letter is directed at banks and designated investment firms. It suggests several points that firms should be focussing on with regard to their risk management frameworks to mitigate any risk from exposure to cryptoassets. It confirms that these firms will need to use all aspects of the prudential framework, and consider the risks from first principles, to ensure that these risks are appropriately considered, and mitigated and/or capitalised as needed. In particular:

• An individual approved by the PRA to perform an appropriate Senior Management Function (SMF) should be actively involved in reviewing and signing off on the risk assessment framework for any planned business with direct exposure to cryptoassets and/or entities heavily exposed to cryptoassets.
• Direct holding of cryptoassets will be classified as an intangible asset under applicable accounting frameworks. Intangible assets are deducted from Common Equity Tier 1 (CET1) under Article 36(1)(b) of the Capital Requirements Regulation (CRR), and the amount of deduction determined under Article 37. In most cases this is likely to result in a full deduction of any direct holdings from CET1.
• The PRA expects firms to take into account and reflect the extreme volatility and/or limited price history of cryptoassets in determining an appropriate capital requirement. It suggests that for most cryptoassets (particularly unbacked crypto) an appropriate capital requirement will be 100% of the current value of the firm’s position.
• Firms should use the commodity framework in Articles 357 and 358 of the CRR to determine the current value of positions arising from derivatives referencing cryptoassets.
• Hedging or diversification benefits across different cryptoassets would not typically be recognised in the standardised approach to counterparty credit risk.
• To the extent that firms outsource their crypto activities (eg custody of crypto keys), firms should have a detailed understanding of their residual liability. Firms may have additional potential exposure where customers believe they will step in if their outsourced provider fails. Firms should consider their ability (both legal and operational) to access and gain control of relevant assets in the event of third-party service provider failures.

Please contact us if you would like any more information on this.

FCA: The FCA’s notice outlined areas of risk that they believe firms with exposure to cryptoassets should consider. It does not really say anything new, but rather restate points that have been raised previously.

BoE: In the Responses to the Discussion Paper, the BoE makes clear that it hasn’t in fact made any decision on any of the topics raised. However, they see the responses as showing strong support for it to continue with its work in this area. They do note that there were three common themes that came through from the responses, namely: access to cash should be preserved; the BoE should continue to engage with stakeholders including the wider public; and any regulation for systemic stablecoins should be clear, proportionate, and risk-based. Let’s see what they come back with when decisions have been made.

FCA AML Registration Extension?

In news that will come as a surprise to no one, the FCA quietly updated its page on the AML/CTF regime to confirm that while the Temporary Registration Regime will definitely be closing today (01 April), it will in fact continue for “a small number of firms where it is strictly necessary to continue to have temporary registration.” The FCA has said that it will be necessary to do so where the firm may pursuing an appeal or winding-down. This follows criticism from the Treasury Select Committee in January that said that the FCA had been too slow in dealing with the applications for registration, something we, and a number of our clients have seen first-hand. The end of the temporary regime, and the inadequate handling of the registration process to date, will unfortunately make it more likely that firms will avoid setting up in the UK. We hope that the contrasting statements from HMT and the government about a desire for the UK to be leading the world in FinTech will eventually manifest in changes to policy, as at the moment the UK seems to be making life as difficult as possible for firms in the industry.

Blockchain developers do not owe fiduciary or tortious duty to users

In an important decision for developers of blockchain networks, the High Court has ruled that they do not owe a fiduciary or tortious duty to network users to alter the software that operates the network so as to return misappropriated assets. The decision arises from the claim brought by Craig Wright (via Tulip Trading Ltd) against the core developers of the BSV, BTC, BCH and BCH ABC networks. Tulip claims that in 2020 it was the victim of a £3 billion hack of assets on those networks. It sought an order from the Court requiring the developers to implement a software "patch" that would enable it to regain control of the assets. In order to obtain such an order Tulip needed to establish that the developers owed it a duty which they had breached. The Court rejected Tulip’s argument that the developers owed either a fiduciary duty to act in Tulip’s interest or a tortious duty not to act negligently towards it. In particular, the Court noted that a fiduciary duty (which would apply to all network users) could not exist in circumstances where the inter-ests of the users could come into conflict, since this would be incompatible with the duty of undi-vided loyalty owed by a fiduciary. Had the Court agreed with Tulip’s arguments the ramifications for cryptoassets would have been huge, and it is therefore to be welcomed that the Court did not do so. It remains to be seen whether Tulip will try to appeal the decision.

John Glen’s Speech at Innovate Finance

As well as announcing the response to the stablecoin consultation, John Glen also provided a couple of other interesting points. First, he confirmed that Rishi Sunak, the Chancellor of the Exchequer has asked the Royal Mint to issue an NFT by the summer. There are no more details on this yet, but it does raise a some questions – the key one being whether the Royal Mint need to be registered under the MLRs. If they do, we’d question whether Mr Sunak’s target of issuing in the summer is realistic. It will also be interesting if we can have confirmation from the FCA that if the Mint does not need to be registered, if this is due to the fact that it is a quasi-governmental organisation (though there are no exemptions in the legislation), or whether NFTs are out of scope of the registration requirement. We will keep an eye on developments.

Another announcement from Mr Glen was that the government is looking to review the Investment Manager Exemption regime, which currently disincentivises UK fund managers from including cryptoassets in their portfolios. At the moment, the IME regime doesn’t explicitly cover transactions in cryptoassets, and where the IME regime doesn’t apply, profits from relevant UK trading activities would be subject to UK corporation tax. The lack of certainty over the treatment of transactions in cryptoassets is clearly not helpful to the industry, and has led to challenges for managers that wish to deploy particular investment strategies. We imagine that this announcement, along with the government’s review into the approach to the taxation of DeFi related activities, will be welcomed by the industry. If you have any questions related to the taxation of cryptoassets, please do reach out to my colleagues Martin Shah and James Cherry, who would be happy to discuss this with you. If you missed the overview of the treatment of tax for DeFi lending and staking activities, you can read our summary here.