Regulating the new kid on the block: the FCA's final guidance on cryptoassets and the regulatory perimeter

The FCA has finalised its perimeter guidance in relation to cryptoassets (Guidance), which sets out its approach to analysing whether particular cryptoassets are regulated. While its guidance is not binding on courts, firms that comply with it will be treated as having complied with the relevant rule or requirement.

What is the background to the Guidance?

The FCA consulted stakeholders on draft perimeter guidance in January 2019.

The Guidance forms part of the actions being taken by HM Treasury, the FCA and the Bank of England to further develop and implement the UK's policy and regulatory approach to cryptoassets and Distributed Ledger Technology (DLT) as set out in the final report of the Cryptoassets Taskforce (Taskforce) in October 2018.

HM Treasury is due to consult in 2019 on potentially expanding the FCA's regulatory perimeter.

The FCA has also recently consulted on a potential ban on the sale of products referencing some unregulated cryptoassets to retail consumers.

What is meant by the term "regulatory perimeter"?

The regulatory perimeter refers to the boundary that distinguishes regulated and unregulated financial services. Unless an exemption applies, firms that carry on regulated activities by way of business in the UK in connection with cryptoassets must ensure that they have the correct permissions from the FCA; conducting regulated activities without authorisation is a criminal offence and may give rise to financial penalties.

How does the FCA categorise cryptoassets?

The FCA uses the term "tokens" to refer to different types of cryptoassets and it originally adopted the three-fold categorisation used by the Taskforce: (a) exchange tokens; (b) utility tokens; and (c) security tokens.

The FCA has now revised the terminology it uses to reflect feedback it has received from industry and will now categorise tokens as follows:

Security tokens : these are tokens that provide rights and obligations similar to specified investments as found in the Regulated Activities Order ( RAO ). They may also be financial instruments under MiFID II; e-money tokens are not included in the category of security token – see below. Security tokens are within the regulatory perimeter .
E-money tokens: these are tokens that fall within the definition of e-money. They are subject to the Electronic Money Regulations (EMR), which means firms must ensure that they have the right permissions and comply with the relevant rules. Previously e-money tokens were classified as utility tokens. E-money tokens are within the regulatory perimeter.
Unregulated tokens: this category captures any token that does not mean the definition of e-money or provide the same rights and obligations as other specific investments under the RAO. The category includes tokens which are referred to as utility tokens and exchange tokens (Bitcoin and Ether being examples of the latter). Their characteristics can vary considerably. For example, they can be issued centrally or be decentralised, allow access to a current or prospective good or service in one or multiple networks and ecosystems or be used as a means of exchange. They can be fully transferable or have restricted transferability. These tokens are outside the regulatory perimeter.

We provide below some further commentary on those tokens subject to regulation ie security tokens and e-money tokens.

What factors indicate that a token is a specified investment?

Determining whether a token is a specified investment is not always straightforward. The full list of specified investments is found in Part III of the RAO and the FCA has provided detailed guidance in Chapter 2.6 of its Perimeter Guidance manual.

The Guidance contains a non-exhaustive list of factors to take into account including:

the contractual rights and obligations the token-holder has a result of holding or owning the cryptoasset
any contractual entitlements to profit-share (like dividends), revenues or other payment or benefit of any kind
any contractual entitlement to ownership in, or control of, the token issuer or other relevant person (like voting rights)
the language used in relevant documentation such as that found in token "whitepapers", which suggests that the tokens are intended to function as an investment. The FCA notes that clearly it is the substance of the token that determines whether it is a specified investment rather than the label used.
whether the token is transferable and tradeable on cryptoassets exchanges or any other type of exchange or market
a direct flow of payment from the issuer or other relevant party to token holders may be one of the indicators that the token is a security but an indirect flow of payment would not necessarily indicate the contrary
if the flow of payment is a contractual entitlement the FCA would consider it to be a strong indication that the token is a security, irrespective of whether the flow of payment is direct or indirect or whether other ownership rights exist.

What are the most relevant specified investments for tokens?

From the FCA's market observations, the following are the likely to be the most relevant: (a) shares; (b) debt instruments; (c) warrants; (d) certificates representing certain securities; (e) units in collective investment schemes; and (f) rights and interests in investments.

The Guidance illustrates each of the above with case studies, which firms should familiarise themselves with. For example, whether a token might amount to a share will depend on the rights which are conferred to the token holder. Tokens which give holders similar rights to shares, such as voting rights or access to a dividend or the distribution of capital upon liquidation are likely to be security tokens.

Firms also need to be aware that instruments that derive their value from referencing a token, like derivative instruments, are likely to within the regulatory perimeter.

In addition, firms should consider whether a token may also be a financial instrument under MiFID II, which requires them to take account of relevant EU materials such as the European Commission's Q&A on MiFID II and material from the European Securities and Markets Authority.

What are the characteristics of e-money tokens?

For a token to be an e-money token, it must meet the definition of e-money under the EMRs. E-money is electronically stored monetary value as represented by a claim on the electronic money issuer which is:

issued on receipt of funds for the purpose of making payment instructions
accepted by a person other than the electronic money issuer
not excluded by regulation 3 of the EMRs

The Guidance notes that within the FCA's regulatory sandbox – which allows businesses to test their innovative propositions in the market with real consumers – it has seen many firms which have facilitated DLT-based e-money to provide more efficient, automated and transparent services, including for international payments.

What is a stablecoin?

A stablecoin is a cryptocurrency that is pegged to another stable asset such as gold or a fiat currency like the USD and typically with a 1:1 backing. It is intended to maintain a consistent value with the fiat currency or other asset and is therefore in theory backed by the fiat currency/asset. Any token that is pegged to a currency, like USD or GBP, or to another asset, and is used for the payment of goods or services on a network might constitute e-money (provided that it also meets all of the elements of the definition of e-money above).

What other regulatory restrictions may apply to tokens?

Payments services : firms that enable customers to pay merchants in fiat currency or transfer fiat currency via cryptoassets may require permissions under the Payment Services Regulation.
Financial promotion: any communication which invites or induces a person to engage in an investment activity must be made by an authorised person or be approved by an authorised person or fall within an exemption. Authorised firms must communicate financial promotions in a way which is clear, fair and not misleading ensuring that it is clear which activities are and are not regulated.
AML/CTF: as part of its implementation of the Fifth Anti-Money Laundering Directive, HMT will be extending Anti-Money Laundering/Counter Terrorist Financing regulation to cryptoassets including exchange tokens.
Prospectus and transparency requirements: while a company issuing its own security tokens will not usually require to be authorised, it will need to take account of regulations applying to the issuance, which include the Prospectus Regulation and the Disclosure Guidance and Transparency Rules.