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Welcome to LEGAL LONG, a briefing on a relevant issue in the financial services industry.

If you would like to discuss any of the points we raise below, please contact me or one of our other lawyers.  
 

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Claire Cummings

020 7585 1406

claire.cummings@cummingslaw.com
www.cummingslaw.com


 
FCA and BofE evidence to Treasury Committee digital currencies inquiry 
 

Introduction

On 22 May 2018, the House of Commons Treasury Committee updated its webpage on its digital currencies inquiry to link to the written evidence it has received, which includes responses from the FCA and the Bank of England (BoE) in which they outline their work in this area.

Summary of FCA written response

The FCA noted that crypto-assets emerged with the Bitcoin network coming in 2009.  Bitcoin was originally designed as a peer-to-peer electronic cash system allowing individuals to transact directly without a financial institution. Bitcoin allowed individuals to use a decentralised network of computers using cryptography to secure transfers instead of using a centralised third-party to transact, such as a bank.

The FCA’s response discussed the role of digital currencies in the UK, including the opportunities and risks digital currencies may bring to consumers, businesses and the Government.  The FCA noted that the crypto-asset market is developing at pace with over 1500 different coins and tokens valued at around $311 billion, with each of these displays a wide variety of different characteristics. The relatively low barriers to entry and potential to attract high-levels of speculative investment have fuelled the launch of hundreds of different projects and ideas. The FCA stated that it anticipated that as these progress, they will supersede the existing technical bottlenecks; either by launching entirely new crypto-assets or by developing secondary services on top of existing crypto-asset networks and is likely to result in reduced transaction times and fees in the foreseeable future.

The FCA regulatory perimeter

The FCA’s response outlined how different forms of crypto-assets may or may not fall within its regulatory perimeter.  For example, crypto-assets themselves (i.e. those designed primarily as a means of payment/exchange) are generally not within the scope of FCA regulation.  Similarly, transferring, buying and selling of crypto-assets, including the commercial operation of crypto-asset exchanges, will also typically fall outside the FCA’s regulatory perimeter.

The FCA’s response also discussed crypto-asset exchanges and wallet providers in relation to AML regulations.  The current AML regulations do not apply to crypt-asset exchanges (however, the main crypto-asset exchanges do under take some due diligence on their customers).  However, the EU’s 5th Money Laundering Directive will be passed later this year and will apply AML requirements for crypto-asset exchanges and custodian wallet providers.

The FCA’s response included a table which explained in detail how the different forms of crypto-assets and products which may reference or relate to underlying crypto-assets, generally sit within the FCA’s regulatory perimeter.  For example, crypto-assets used as a medium of exchange and utility tokens are outside of the FCA’s perimeter whereas derivative instruments referencing crypto-assets and regulated payments services which use crypto assets are within the FCA’s perimeter.  However, the FCA confirmed that whether a crypto-asset (including crypto tokens issued as part of an initial coin offering (ICO)) falls within the perimeter will be fact specific.

Benefits of crypto-assets for regulated financial activities

The FCA explained that about a third of the 60 firms that have participated in its regulatory sandbox have used a crypto-asset or distributed ledger technology (DLT), making it the most popular technology employed in the sandbox.  The FCA identified three broad ways crypto-assets and the underlying technology could enhance the delivery of existing financial activities, namely: (i) improving operational resilience by reducing single points of failure; (ii) using distributed digital transaction records to improve transparency; and (iii) cost and time reductions arising from the removal of intermediaries required for processing a transaction.

The FCA found that the main uses of crypto-assets are: (i) in relation to international money remittance; (ii) issuance and settling of financial instruments; (iii) listing of private companies' shares; and (iv) charitable donations and e-money. 

Risks deriving from crypto-assets


Through its work with firms and monitoring the market developments, the FCA has identified several risks of harm deriving from crypto-assets which include: (i) price volatility; (ii) market manipulation; and (iii) increased regulation regarding crypto-asset derivatives; and (iv) money laundering. The FCA also outlines its work, as part of its RegTech initiative, to develop a prototype for regulatory reporting of mortgage transaction data. The FCA is unclear whether DLT will be adopted broadly across securities markets or remain limited to niche uses.

Conclusion of FCA written statement

The FCA confirmed it will continue to monitor the appropriateness of the existing regulatory framework for crypto-assets and distributed leger technology as a priority, informed by feedback from stakeholders and experience with innovative firms. The FCA is also working on several internal projects, alongside engagement with the Bank of England and HM Treasury as part of the domestic Crypto-assets Taskforce.  The FCA has been working closely with other international and supranational regulatory bodies, standard setters and monitoring agencies to share information to identify harm and take action where appropriate to ensure that the FCA is consistent with the international regulatory community and that consumers are adequately protected against harms that stretch across nation states.

Summary of Bank of England written response

The BofE’s mission is to maintain monetary and financial stability and therefore, its work on crypto-assets and distributed ledger technology (DLT) is concerned with how these technologies could impact monetary or financial stability.  The BofE statement drew a clear distinction between: (i) Crypto-assets themselves (for example, Bitcoin, Litecoin or Ether/Ethereum), which are often referred to as ‘coins’ or ‘tokens’; (ii) the underlying technology powering the majority of existing crypto-assets, in the form of public or ‘permissionless’ distributed ledgers; and (iii) the significantly adapted versions of DLT that are being developed for use in financial services on private or ‘permissioned’ distributed ledgers.  Each of these has a different set of potential risks and benefits.

Crypto-assets are very unlikely to replace commonly used payment systems

In its response, the BoE outlined why it believes that crypto-assets are very unlikely to replace commonly used payment systems. The BoE also confirms its view that crypto-assets do not currently pose a material threat to financial stability since the current generation of crypto-assets are currently failing to perform the three key functions of money: (i) as a store of value, (ii) a means of payment, and (iii) a unit of account.  The BofE written statement stated that crypto-assets are too volatile to be a good store of value.  It also stated that crypto-assets do not function well as a means of payment as they are not widely accepted, face significant capacity constraints resulting in high cost transactions, slower confirmation times than cash or contactless card payments, and inherent cost due to energy usage.  As a result of these limitations as a store of value and means of payment, crypto-assets are not being used as a unit of account.

Furthermore, cyber risk is a further barrier to more widespread adoption of crypto-assets. With crypto-assets the
burden of security is on the holder. The private keys that enable users to spend crypto-asset balances are targets for hackers, and theft is irrecoverable. In cases of loss due to cyber-attack or fraud, there is no third party who will reimburse the victim.

The BofE has found that crypto-assets lack the key attributes of sovereign currencies such as sterling. They are failing to fulfil the roles of money and do not serve as substitutes for national currencies. Therefore, given the magnitude of the challenges that crypto-assets face, the Bank does not think that crypto-assets have any reasonable prospect of replacing traditional payment systems in the foreseeable future.

Crypto-assets do not currently pose a material threat to financial stability

In March 2018, the BofE’s Financial Policy Committee concluded that crypto-assets do not currently pose a material threat to financial stability in the UK because: (i) their use in payments is minimal in the United Kingdom; (ii) the total stock of crypto-assets is small relative to the global financial system; and (iii) systemically important UK financial institutions currently have negligible exposures to these assets and to the ecosystem around them.


The BofE did note that crypto-assets could pose a threat to financial stability if: (i) they became significantly larger as an asset class, and/or (ii) systemically important firms took significant and/or leveraged exposures to the asset class. The BofE does not expect this to happen in the near term however, the market, industry and technology around crypto-assets is evolving rapidly, and therefore risks may emerge unexpectedly.  Therefore, the BofE will continue to closely monitor developments in the field for signs that (i) crypto-assets are becoming more widely used in payments and/or settlement, and (ii) systemic firms are taking on significant and/or leveraged exposures to cryptocurrencies.  The BofE is also assessing how prudential regulations should apply if crypto-assets were held by banks and/or financial institutions, including whether additional requirements are merited to cover some of the associated risks, such as the extreme levels of volatility that they exhibit.

DLT could have material benefits when adapted for use in the financial system

The BofE stated that DLT could have the following material benefits when adapted for use in the financial system: (i) increasing the efficiency of managing data, by reducing data replication and associated reconciliation processes; (ii) improving resilience by eliminating central points of failure, as multiple parties share replicated data and functionality; (iii) enhancing transparency and auditability through the creation of instant, permanent and
immutable records of transactions; and (iv) expanding the use of straight-through processes, which largely eliminate manual processes, including with ‘smart contracts’ that make automatic updates or payments on receipt of new information.

The BofE also noted that there are significant challenges around the application of DLT, including: (i) scalability and reliability; (ii) privacy – the origins of DLT are based on sharing identical copies of the ledger across multiple participants, but this may involve the undesirable sharing of private data; (iii) security – assurance will be needed over the security of any system from cyber-attack; and (iv) governance – consideration will be needed around how a distributed system is controlled and governed.

Conclusion of BofE written statement

In conclusion, the BofE’s approach to DLT is consideration that solutions might offer certain benefits (e.g. increased resilience), but may also pose new risks or challenges (e.g. governance, privacy concerns).  It will continue to closely monitor developments for signs that crypto-assets are becoming more widely used in the payments and settlement areas, and whether systemic firms are taking on significant or leveraged exposures to crypto-currencies. The BofE is also assessing how prudential regulations should apply if crypto-assets were held by banks or financial institutions, including whether additional requirements are necessary to cover associated risks (such as the extreme levels of volatility). While the BoE remains open to the eventual development of a central bank digital currency, it states that it does not plan to issue one in the medium term.


Cummings

May 2018

 
This document is for general guidance only. It does not contain definitive advice.

 


We have taken great care to ensure the accuracy of this document. However, it is writen in general terms, is for general guidance and does not constitute advice in any form. You are strongly recommended to seek specific advice before taking any action based on the information it contains.

No responsibility can be taken for any loss arising from, action taken or refrained from on the basis of  this publication.

Nothing within this document may be copied, re-printed or similar without prior writen permission from Cummings Law Ltd.



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Cummings

Tel: + 44 20 7585 1406
Mob: + 44 7734 057 327

Cummings Law
42 Brook Street
London Greater London W1K 5DB
United Kingdom

www.cummingslaw.com

14 12 2018

 
 

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