Five minutes on… the FCA’s approach to cryptoassets

In a new consultation, the FCA has set out how it plans to treat certain cryptoasset types going forward. Matt Packer picks out some key points

Back in October, the government’s special Cryptoassets Taskforce published its final report on the potential impacts of blockchain-powered digital coins and tokens on the wider UK economy. Comprised of experts from HM Treasury, the Bank of England and the Financial Conduct Authority (FCA), the Taskforce was convened to scan the horizon for risks that could stem from the rapid evolution of financial products built on distributed ledger technology (DLT). The report concluded that DLT and its related token systems have the scope “to deliver significant benefits in both financial services and other sectors” – with all three authorities behind the Taskforce pledging their support to the field’s development. However, they also committed to exploring areas of concern, and considering how those points may be addressed through regulatory means. In late January, the FCA followed up on the Taskforce report by launching a consultation with stakeholders on draft guidance that – once finalised – will determine the specific cryptoasset activities that it regulates.

Great to see the FCA is maintaining the momentum of the Taskforce’s work. So, what’s the regulator’s top-line angle on these products?

Not something that can be boiled down into a couple of sound bites: the guidance is a detailed and wide-ranging document that examines cryptoassets in the context of different classifications and a host of potential use cases. That said, we can provide a snapshot of how the consultation paper touches upon certain areas of interest to treasury – particularly the use of crypto tokens to finance business ventures.

Sounds like a lot to chew on – this must indicate that the FCA is pondering specific new approaches for these technologies.

Not necessarily; in the paper’s opening pages, the FCA explains that it is a “technology-neutral regulator”. Therefore, the use of new technology alone does not alter its considerations of how a particular product fits within the regulatory perimeter. However, it points out: “while our tech-neutrality means we’re agnostic about the type of technology used, the choice of technology may influence the way in which regulation applies”. It further explains: “While the use of a certain technology won’t usually have an impact on the permissions the firm requires, it might have an impact on the unique risks associated with the carrying on of certain regulated activity.”

So this is more about viewing DLT-based financial products through the prism of how more traditional offerings work?

Exactly. To make that process more manageable, the FCA has drawn up three categories for blockchain-powered coins and tokens – only one of which is likely to occupy the regulator’s time going forward:

1. Exchange tokens Any ‘cryptocoins’ or ‘payment tokens’ that reside on a DLT platform and are not issued or backed by a central bank, or other central authority. These are used purely as a means of exchange or investment. As such, they would typically fall outside the FCA’s regulatory perimeter.
2. Utility tokens These serve the very narrow purpose of providing users with credits to redeem against access to specific products or services provided via a DLT platform. For that reason, they would also typically fall outside the FCA’s scope.
3. Security tokens From a regulatory standpoint, this is the most relevant category. In the FCA’s view, these tokens would amount to ‘Specified Investments’ under the UK Regulated Activities Order. They may confer upon the holder particular rights, and may be classed as transferable securities, or other financial instruments, under the EU’s Second Markets in Financial Instruments Directive (MiFID II). Those factors place tokens of this type within the FCA’s regulatory perimeter.

Drilling deeper into the question of how a market participant would know whether or not their token is a Specified Investment, the paper highlights a range of potential factors:

• The contractual rights and obligations the holder has by virtue of holding, or owning, that cryptoasset;
• Any contractual entitlement to profit share – for example, dividends, revenues or any other sort of payment or benefit;
• Any contractual entitlement to ownership in – or control of – the token issuer, or another relevant person (for example, voting rights);
• Language used in the relevant documentation (often called a token ‘whitepaper’) suggesting that the tokens are intended to function as an investment – although the substance of the token will determine whether an instrument is a Specified Investment, rather than the chosen label (for example, if a whitepaper declares an offering to be a utility token, but the contractual rights it confers would make it a Specified Investment, the FCA would treat it as a security token);
• Whether the token is transferable and tradeable on cryptoasset exchanges, or any other type of exchange venue or market; and
• A direct flow of payment from the issuer or other relevant party to token holders may indicate that the token is a security – although an indirect flow of payment (for example, through profits or payments derived exclusively from the secondary market) would not necessarily indicate the contrary.
  

  The FCA no doubt has developments such as initial coin offerings (ICOs) in mind, here.

  • Absolutely. The critical aspect of ICOs from a corporate perspective is that it is not just retail investors who have taken part in them. Often, companies have participated, too. Indeed, what distinguishes the ICOs field from the traditional investment landscape is that it’s an ecosystem of different tokens, projects and enterprises operating like a network, with numerous channels of exchange and support. The paper notes that, while ICOs raised $925m of capital around the world in November 2017, global takings for the same month of last year were down to just $65m. The FCA cites growing market awareness of ICO fraud as one likely factor behind this dramatic fall, but also points out: “The underlying volatility of cryptoassets used may also be an issue – as they are used, in many cases, for payments in ICOs.”
    

    OK – so what about the use cases mentioned above? Has the FCA set out details of how it aims to treat cryptoassets deployed in certain contexts that are likely to become more and more common?

    Yes, within that broad field of Specified Investments. Here, in three categories, are some of the potential use cases it has considered, and how it is likely to approach them:

    Shares

    Case study 1

    Firm AB issues tokens that provide the token holder with a share of the company’s profits to be paid annually. The tokens also provide the holder with voting rights. The tokens are structured so they can be easily transferred between two individuals and a change of ownership can be recorded. The tokens can also be traded on cryptoasset exchanges. Assessment This token confers rights similar to those given by shares and is likely to be considered a Specified Investment. The negotiability suggests that the token will also be considered a transferable security. This token will be considered a security token.

    Case study 2

    Firm CD, incorporated in the UK, has created a social trading platform, called the CD Platform, for users to easily exchange fiat currencies for exchange tokens. The firm issues ‘CD Tokens’, which are exchanged for fiat funds and these tokens are used to purchase other exchange tokens. Assessment This alone is not enough to categorise the CD Tokens as security tokens. However, that changes if the CD Tokens also confer upon the holder a right of ownership of the CD Platform, proportionate to the number of CD Tokens held – plus a right to enjoy the profits of CD Platform (if any), to be paid annually in the form of a dividend. Under those circumstances, the tokens are likely to be the same as – or similar to – shares. As such, they would be regarded as security tokens.

    Case study 3

    Firm EF issues a token that it describes in the relevant whitepaper as a ‘pure utility token’. The token allows the holder to access a product the firm is still developing. The token also allows the holder to share in profits in line with their holdings, once the product launches. The developers have been careful to make sure the token will not be able to be traded on the capital markets. Assessment Despite the token being described as a utility in the whitepaper, its lack of tradability and the fact that it offers access to a future product, this token would still likely be considered a Specified Investment. That is because it confers upon the holder attendant rights, such as the right to share in profits in line with their holdings. On that basis, EF’s offering is likely to be a security token.

    Debt instruments

    Case study 4

    To generate working capital, company GH issues tokens that grant holders the right to be repaid their investment in full by a certain date – and also entitle holders to regular payments of interest on the capital amount. The GH tokens are freely traded on cryptoasset markets. Assessment These tokens are likely to be considered instruments that create or acknowledge the debt owed by the issuer to the token holder, and are therefore likely to qualify as debt instruments. Because they are negotiable on the capital market, they are also likely to constitute transferable securities.

    Units in collective investment schemes

    Case study 5

    Firm IJ invests in fine art using the funds it receives and pools from investors and hires the art out for use at corporate events for a fee. It issues tokens to investors in proportion to their contributions. These tokens also entitle the investors to receive a share of the fees generated by the art rental, and the profits it makes whenever it decides to sell the art. The token holders have no day-to-day control over the art, nor the rental fees. The token holders’ contributions are pooled – as are the rental fees and profits from art sales – and the art is managed as a whole by IJ. Assessment Given those terms, the tokens that represent the participants’ shares in the investment are likely to constitute units in a collective investment scheme.

    Further reading

    Find the FCA’s full consultation paper here. The deadline for responses is 5 April.

    About the author

    Matt Packer is a freelance business, finance and leadership journalist