FCA considers banning sale of all derivatives referencing exchange tokens such as Bitcoin

Maria Nikolova

The regulator is set to consult on a prohibition of the sale of all derivatives (like CFDs) referencing exchange tokens such as Bitcoin.

The long-awaited report by the Cryptoassets Taskforce, consisting of HM Treasury, the Financial Conduct Authority and the Bank of England, is finally out. In short, there will be a raft of regulatory changes for firms whose activities have anything to do with cryptos, with the Financial Conduct Authority (FCA) considering drastic measures with regard to CFDs on cryptocurrencies.

The report notes there is not a single widely agreed definition of a cryptoasset. Broadly, a cryptoasset is a cryptographically secured digital representation of value or contractual rights that uses some type of DLT and can be transferred, stored or traded electronically. Examples of cryptoassets include Bitcoin and Litecoin (and other ‘cryptocurrencies’), and those issued through the Initial Coin Offering (ICO) process, often referred to as ‘tokens’.

The report pays particular attention to the scope of present regulations and whether cryptoasset-related activities fall within this scope.

When cryptoassets are used as a means of exchange, the activities are not necessarily within the regulatory perimeter. Payment services regulation under the PSR only covers activities involving fiat funds. Cryptoassets used as a means of exchange therefore do not fall within the perimeter. However, some cryptoassets used as a means of exchange may meet the definition of e-money.

When cryptoassets are used to facilitate regulated payment services, these activities are regulated.

When these assets are used for investment directly in cryptoassets, then the answer is not clear, as it depends on type of cryptoasset and type of investor. Direct investment in cryptoassets does not fall within the perimeter unless the cryptoasset is a security token or the investment is made by a regulated investment vehicle.

When cryptoassets are used for indirect investment through financial instruments that reference cryptoassets, then these activities are regulated. Financial instruments that reference cryptoassets likely fall within the perimeter. These instruments may also be financial instruments under MiFID II.

When cryptos are used as a capital raising tool or as part of a process designed to support a particular project, such as the creation of decentralised networks, and in the case security tokens are involved then, yes, the activities are regulated. Security tokens amount to a specified investment as set out in the RAO. For example, they are (or have characteristics which mean they are like) securities such as shares, bonds, or units in a collective investment scheme. They may also be transferable securities or financial instruments under MiFID II.

The report also stresses that Financial Promotions rules placed on regulated firms state that financial promotions must be fair, clear, and not misleading; give a balanced impression of the product or service; and not disguise and diminish important warning statements.

In addition to the Financial Promotions rules placed on regulated firms, there are also broader legislative restrictions in respect of financial promotions. Section 21 of the Financial Services and Markets Act 2000 (FSMA) provides that a person must not, in the course of business, communicate an invitation or inducement to engage in investment activity unless the promotion has been made or approved by an authorised person or it is exempt. Issuing a financial promotion in breach of Section 21 of FSMA is a criminal offence.

The Taskforce has identified a raft of risks associated with cryptoassets, including:

  • risks of financial crime, including opportunities for cryptoassets to be used for illicit activity and cyber threats;
  • risks to consumers, who may buy unsuitable products, face large losses, be exposed to fraudulent activity, struggle to access market services, and be exposed to the failings of service providers;
  • risks to market integrity, which may lead to consumer losses or damage confidence in the market;
  • potential implications for financial stability, which may arise if the market grows and cryptoassets are more widely used.

Advertising of cryptoassets, which is often targeted at retail investors, is not typically fair or clear and can be misleading. Adverts often overstate benefits and rarely warn of volatility risks, the fact consumers can both grow and lose their investment, and the lack of regulation. There are also examples of regulated firms marketing cryptoasset products without clarifying that this part of their business is not regulated.

Furthermore, it can be particularly difficult for consumers to assess the risks of a particular token being issued, as the ‘white paper’ documents that typically accompany ICOs are not standardised and often feature exaggerated or misleading information. Given the lack of clear information, consumers may not understand that many of these projects are high-risk and at an early stage, and therefore may not suit their risk tolerance, financial sophistication or wealth.

The Taskforce notes that, although regulated, financial instruments that reference cryptoassets also produce some specific risks to consumers. Leveraged derivatives, such as CFDs and futures, can cause losses that go beyond the initial investment. The risk of trading losses can be exacerbated by product fees such as financing costs and spreads, as well as by a lack of transparency in the price formation of the underlying cryptoasset.

The FCA has taken action where it has seen evidence of harm relating to the sale, marketing and distribution of particular derivative products. For example, the FCA supported ESMA’s restrictions on the sale to retail consumers of contracts for difference (CFDs) referencing cryptoassets. This measure took effect on August 1, 2018 and will be renewed from November 1, 2018. The intervention is temporary, but subject to renewal while the FCA (in parallel with other EU national competent authorities) implements its own permanent domestic interventions.

Given concerns identified around consumer protection and market integrity in these markets, the FCA will consult on a prohibition of the sale to retail consumers of all derivatives referencing exchange tokens such as Bitcoin, including CFDs, futures, options and transferable securities, the Report says.

The proposed prohibition would not cover derivatives referencing cryptoassets that qualify as securities, however CFDs on securities would remain subject to ESMA’s temporary restrictions and any future FCA proposals to implement permanent measures in relation to CFDs.

Let’s clarify that the Report defines “Exchange tokens” as ‘cryptocurrencies’ such as Bitcoin, Litecoin and equivalents. They utilise a DLT platform and are not issued or backed by a central bank or other central body. They do not provide the types of rights or access provided by security or utility tokens, but are used as a means of exchange or for investment.

The FCA will not authorise or approve the listing of a transferable security or a fund that references exchange tokens (for example, exchange-traded funds) unless it has confidence in the integrity of the underlying market and that other regulatory criteria for funds authorisation are met. Before listing any securities with cryptoassets as the underlying asset, the FCA will need to be satisfied that granting the listing would not be detrimental to investors’ interests. To date, the FCA has not approved the listing of any exchange-traded products with exchange tokens as the underlying asset.

Furthermore, the Taskforce wants to ensure that firms do not issue cryptoassets that have comparable features to specified investments (such as shares or units in a collective investment scheme) but are structured in such a way that they avoid regulation. Activities related to such cryptoassets should be regulated in order to protect investors, eliminate fraudulent activity and ensure market integrity. Should the issuance of cryptoassets through ICOs or another distribution mechanism prove to have benefits in the future (for example, as a means of capital raising), consistent application of regulation will also enable legitimate activity to thrive in the UK.

The UK government is poised to issue a consultation in early 2019 to further explore with the industry whether there are examples of such cryptoassets on the UK market and, if so, whether an extension of the regulatory perimeter is required. Subject to the outcomes of this consultation, the government stands ready to legislate to redefine and expand the perimeter if necessary. This will ensure that FCA regulation can be applied to all cryptoassets that have comparable features to specified investments, regardless of the way they are structured.

The Taskforce also considers that a consistent international approach to respond to exchange tokens is essential, to ensure global regulatory coherence and avoid arbitrage in a market that is not confined to national boundaries and involves highly mobile actors. An internationally coordinated approach and action by other jurisdictions will also help to mitigate risks to UK consumers – many of whom invest in cryptoassets through firms based outside the UK.

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