Crypto View - February/March 2024

A slightly delayed Crypto View this month, but it is no less full of news. As we've seen the price of Bitcoin rocket to new highs on the back of investment into crypto ETFs, the big news out yesterday was the FCA confirming that it "will not object" to the creation of a UK listed market segment for crypto ETNs - we discuss this further below. We also take a look at two publications from the Law Commission - the first is a draft of the legislation of the "third category" of property following its report of June last year, the second is the long awaited call for evidence on private international law issues. As ever with Law Commission publications, it's pretty hefty, so we've prepared a handy summary for you if you don't want to get stuck in to the 284 pages... Elsewhere we look at some news on the regulatory regime in the UK, with the FCA publishing data on financial promotions action, as well as an interesting intervention from the City Minister, Bim Afolami, on staking. We also look a couple of important cases in Singapore regarding lex situs for cryptoassets, some other UK news on use of DLT in financial instruments, and finally an update from Italy regarding MiCA.

Crypto Exchange Traded Notes - FCA Confirms Non-Objection to Professional Investors Market Segments

The FCA issued a statement yesterday confirming it would not object to requests from Recognised Investment Exchanges (RIEs) to create a UK listed market segment for cryptoasset-backed Exchange Traded Notes (cETNs). Those cETNs would be available only to professional investors, with no changes to the long-standing FCA prohibition on marketing, distributing and selling cETNs (and crypto derivatives) to retail investors. The announcement strikes a similar tone to the SEC's approval of US spot crypto ETFs in January 2024 - and has likely come in response to pressure to keep pace with developments on the other side of the Atlantic - and may provide a boost to the UK cETN market as well as facilitating greater liquidity in due course.

The LSE concurrently announced that it would start accepting bitcoin and ether cETNs in the second quarter of 2024, and published a cETN factsheet setting out the process for admitting cETNs on its exchange. For cETNs to be eligible to be admitted on the LSE, cETNs (i) must be physically backed (i.e. non-leveraged), (ii) must provide for reliable and publicly available reference price benchmarks), (iii) refer to either bitcoin or ether as underlyings (iv) provide for the relevant underlying assets to be wholly or principally held in cold storage (or with an equivalent outcome) and (v) provide for the relevant underlying assets to be held by custodian(s) that are subject to AML regulation in the UK, EU, Jersey, Switzerland or the US. In describing the cold storage requirement it also made an interesting reference to the ability for custodians of cETN assets to do "cold staking", which is an interesting addition.

For further details on cETNs more generally, see our earlier client briefing or speak to my colleague, Oliver Ward.

UK Minister speech on Stablecoins and Staking

I was able to attend a "fireside chat" with the Economic Secretary to the Treasury, Bim Afolami, hosted by Coinbase in London a couple of weeks ago. In an important signal to the industry, he confirmed the UK government's commitment to introduce legislation around stablecoins and cryptoasset staking within the next six months. The statement on staking in particular was very welcome, with the industry having faced uncertainty over the past few months with the FCA arguing on a number of occasions that it sees many staking services offered in the UK as falling within the definition of a collective investment scheme (CIS). It would appear that the government intends to make explicit that this is not the case in most circumstances, by introducing changes to the Financial Services and Markets Act 2000 (Collective Investment Schemes) Order 2001, which would see an exemption for certain staking services.

The mention of stablecoins was more surprising (in terms of timing at least), coming as it does on the back of the FCA's Discussion Paper on stablecoins published in November, as it would seem to us that there is a lot to be finalised in terms of the approach to legislation in this area.

If you would like to discuss either of these areas, please do get in touch.

FCA Publishes Financial Promotion Data

The Financial Conduct Authority (FCA) announced that it intervened to withdraw or modify over 10,000 financial advertisements and promotions in 2023, marking a 17% increase, year-on-year. The regulator issued 450 consumer alerts between 8 October 2023 and 31 December 2023 in relation to cryptoasset promotions to UK consumers that the FCA deemed to be in breach of s.21. Interestingly, the vast majority of these consumer alerts relate to frauds and scam websites, which were able to be included in the warning list prior to 08 October, with only a handful of bona fide cryptoasset firms on the list.

In its publication of 2023 financial promotions data, the FCA highlights a few common issues that relate to cryptoasset financial promotions:

• The use of affiliates and "finfluencers" (bloggers and influencers) to promote cryptoasset firms.
• The use of generic risk summaries without tailoring them for product-specific risks.
• Risk warnings used by cryptoasset firms not being sufficiently visible due to small fonts, hard-to-read colouring, or non-prominent positioning.
• The use of regulated status in a promotional manner.
• Promotions making claims about "safety", "security" or ease of using cryptoasset services without supporting evidence or highlighting relevant risks.

The published data demonstrate that cryptoasset promotions are an issue that the FCA continues to focus on, especially while this remains its only regulatory tool to deal with cryptoasset firms dealing with UK customers.

FCA publishes feedback on AML Application

The FCA also published feedback on the applications made to them by UK cryptoasset businesses under the money laundering regulations. Of note, the FCA highlights the following requirements when preparing an application:

• Business plan: Firms' business plans should outline its business models, roles and responsibilities of business partners, sources of liquidity, detailed customer journey and flow of funds (including both fiat and cryptoassets).
• Description of products and services: Firms should include a comprehensive and accurate description of the applicant's products and services, including a description of any cryptoassets associated with the firms and relevant whitepapers, token classification and functionalities within their businesses.
• Risk assessment and management: Firms must exhibit comprehensive comprehension of the risks associated with engaging in cryptoassets and develop a Business-Wide Risk Assessment (BWRA) customised to suit their business model. This includes identifying and assessing the inherent risks of money laundering, terrorist financing and proliferation financing to which firms are subject to.
• Policies, systems & controls: Firms should establish policies, systems and controls to effectively manage and mitigate risks identified in the BWRA and provide sufficient evidence of the effectiveness of these controls.
• Transaction monitoring and blockchain analysis coverage: Firms must showcase effective transaction monitoring and blockchain analysis suitable for its scale and complexity, covering both fiat and cryptoasset transactions where appropriate.
• Group structure and reliance on group policies and procedures: Firms should clarify how their intended cryptoasset activities align with the money laundering regulations and demonstrate how they (and their personnel) will comply with the regulations. Firms should provide a thorough description of the organisation structure, key personnel, their roles and expertise, and provide their CVs, qualifications and description of their responsibilities. The FCA will not approve an application where a firm relies solely on group policies and procedures and where the firm does not demonstrate its compliance with the money laundering regulations.
• Outsourcing: Firms must provide complete information in relation to its outsourcing arrangements and service level agreements.
• Training: Firms must be able to evidence staff training materials that are tailored to their business models and associated AML risks, as well as their annual training plans.
• Suspicious activity reporting: Firms' Suspicious Activity Reporting (SAR) policies must cover all aspects of its business, including cryptoasset-related activities. Staff should be trained to identify and address suspicious activity and there must be a clear route of escalation internally to a MLRO or nominated officer, as well as to the National Crime Agency (NCA).

If you're considering applying for a registration under the MLRs, please do reach out - it's a pretty complex process, and the FCA do have a high bar when it comes to approving applications.

Law Commission publications on digital assets: Draft legislation and call for evidence on private international law

As mentioned, the Law Commission has recently published two noteworthy papers. The first was a consultation paper on draft legislation designed to confirm the existence of a 'third category' of personal property under English law, and the second was the long awaited call for evidence on private international law issues in relation to digital assets.

Consultation on the Property (Digital Assets etc) Act 2024

The consultation published by the Law Commission relates to the legislative proposal for the Property (Digital Assets etc) Act 2024. The substantive text in the draft legislation is very short (one sentence, in fact), stating that "A thing (including a thing that is digital or electronic in nature) is capable of being the object of personal property rights even though it is neither (a) a thing in possession, nor (b) a thing in action". This is designed to remove any lingering doubt that the English courts will only recognise two pre-existing categories of personal property (things in possession or action), as espoused in Colonial Bank v Whinney.

The draft legislation follows one of the two recommendations for statutory reform as set out in the Law Commission's earlier report on digital assets, published in June 2023. The wording is deliberately designed to foster flexibility as to what constitutes a third category thing, as it refrains from setting out a specific definition, thereby allowing the courts to develop criteria for defining third category things (and related principles) without creating 'hard boundaries' within primarily legislation. The criteria applied by the courts as regards what constitutes a third category thing is likely to follow the indicia set out in the Law Commission's earlier report.

The draft legislation is best seen as an 'unblocker' that confirms the existing case law in this area and provides grounding for the further development of common law principles (e.g. in relation to transfers and security interests in relation to third category things). The legislation should also prove useful beyond digital assets, as similar issues have arisen (for example) in relation to voluntary carbon credits and other intangibles in recent years.

Responses to the draft legislation are requested by 22 March 2024. We do not expect objections or changes given the nature of the proposals.

Call for Evidence

The Law Commission's call for evidence (and summary) relates to private international law issues in a digital assets context. These are issues that arise where the laws of more than one jurisdiction could apply to a given situation - for example, how to determine which jurisdiction's laws should be applied to resolve a dispute, or which country's courts should have jurisdiction to hear a claim.

Private international law issues arise in conventional situations that involve parties or assets based in more than one jurisdiction. However, the principles for resolving these issues are made more complex when digital assets are at hand, because of the cross-border nature of distributed ledger technology. For example, English conflicts of laws rules traditionally dictate that questions relating to the rights or entitlement to property should be governed by the law of the place in which the property or claim to property is situated (the lex situs) - this can be difficult to state with certainty in a digital assets context, given the systems on which digital assets are recorded are geographically dispersed. These questions can be difficult to grapple with and have significant legal and commercial implications.

The call for evidence aims to gather views on two issues. First, to better understand which issues relating to digital assets can be addressed satisfactorily by existing private international law rules and, second, to identify which issues are prevalent in market and legal practice. This will inform the Law Commission's priorities for future work in this area. Similar work has been undertaken transnationally in recent years, including the publication of UNIDROIT's principles of the private law treatment of digital assets.

Responses to the call for evidence are requested by 16 May 2024.

If you would like to discuss either of these in more detail, please do reach out to my colleague Oliver Ward.

Singapore case on the lex situs of cryptoassets

Speaking of conflicts of laws and lex situs, readers may be interested in the recent Singaporean case of Cheong Jun Yoong v Three Arrows Capital Ltd [2024] SGHC 21. In this case, the High Court held that the situs or location of a cryptoasset should be the jurisdiction in which the person who holds the private key is resident, on the basis this was the place in which control over the cryptoasset is exercised. This was relevant to the facts at hand, relating to cryptoassets being held on trust by an insolvent company (and the claim that those assets were located in Singapore).

The case is a useful touchpoint for those considering lex situs issues, particularly in Singapore but also in other common law jurisdictions. It follows similar cases considered by the English courts, e.g. in Ion Sciences vs Persons Unknown and Others (unreported) (21 December 2020) and Tulip Trading Ltd (a Seychelles company) v Van Der Laan [2022] 2 All ER (Comm) 624.

UK plans for DLT in Financial Instruments

There have been a couple of recent suggestions regarding the use of DLT in financial instruments. Firstly, eagle-eyed readers of the UK's Spring Budget may have noticed that the Government stated it "will continue to examine, and will be engaging with firms on, the possible applications and benefits of applying Distributed Ledger Technology to a sovereign debt instrument". This response to calls from various market participants and industry bodies (notably UK Finance) for the Government to issue a digital gilt in order to boost market confidence in the digitalisation of the financial markets. Those calls follow the establishment of the UK Digital Securities Sandbox, which formally launched in January 2024.

Further, interest in exchanging tokenised money market funds as collateral has increased in recent months. The FCA's consultation paper CP 23/28 on changes to the UK Money Market Funds Regime contains two questions relating to the exchange of tokenised MMFs as collateral for non-cleared OTC derivatives, and the Investment Association recently published a briefing paper outlining the relevant issues. We expect more interest in this area, as firms consider whether or not to accede to platforms that facilitate these arrangements.

This month in MiCA

The Italian Ministry of Economy and Finance (MEF) has published a consultation for feedback on draft implementing legislation of MiCA. The consultation states that crypto service providers registered with the Organismo Agenti e Mediatori (OAM) under the current Italian regime have until 30 December 2024 to apply for a new MiCA licence in any EU jurisdiction. If they do so, they can continue their operations until 30 October 2025, or until their application is approved or denied, whichever comes first. Providers who do not apply for the new MiCA licence by December 30 2024 must cease their operations in Italy on that date. The Italian authority will then remove them from the register.

This follows other announcements that you may have seen in other EU jurisdictions. On 15 February 2024, the Dutch Authority for the Financial Markets (the AFM) confirmed that the formal MiCA licensing and notification window will open as of 22 April 2024. This is therefore relevant for both Dutch CASPs that intend to apply for a 'full' MiCA license, but also for already licensed 'traditional' financial firms that need to notify the AFM of their intention to provide crypto-asset services. On the same date, the AFM also published the relevant MiCA license application and notification forms.

The AFM is already calling upon market participants to reach out to them now, so before the formal window opens. In this context, the AFM also offers the possibility of a 'pre-scan'. This entails a more informal process, during which the AFM may conduct a high-level assessment of information submitted to them on selected topics to which they can provide initial feedback. It is expected that this will increase the efficiency of the formal application process. In Germany, meanwhile, the implementing act, which is currently in the draft stage, provides a grandfathering period of 12 months which ends on 31 December 2025.

Helpfully, as part of our MiCAdemy, we have a pan-European team discussing these regulatory changes, and what they mean for impacted firms on 15 March 2024. If you would like to register for this event, please click here.