Crypto assets are a rapidly evolving and highly innovative sector of the financial industry, offering new opportunities and challenges for businesses, consumers and regulators.
Crypto assets are digital representations of value or contractual rights that use cryptography and distributed ledger technology (DLT) to enable peer-to-peer transactions without intermediaries. Crypto assets can take various forms, such as cryptocurrencies, stablecoins, utility tokens, security tokens and e-money tokens.
The UK is aiming to regain its place at the vanguard of jurisdictions with a comprehensive and proportionate regulatory framework for crypto assets, aiming to foster innovation, competition and consumer protection. The UK’s approach is based on the principle of “same risk, same regulatory outcome”, meaning that crypto asset activities should meet the same regulatory standards as similar traditional financial services activities. The UK’s regulatory regime for crypto assets is currently undergoing significant changes, as the government and the regulators are implementing new legislation, guidance and rules to address the emerging risks and opportunities posed by crypto assets.
Current economic conditions
The crypto assets sector has experienced phenomenal growth in the past few years, globally and in the UK. According to a recent report, the global crypto assets market capitalisation reached $2.6 trillion in May 2021, up from $193 billion in January 2020. The number of crypto assets users also increased from 35 million in 2018 to 221 million in June 2021. The UK is one of the leading markets for crypto assets, with an estimated 10% of UK adults owning some form of crypto assets, according to a survey by the FCA.
The sector has also faced significant volatility and uncertainty, as the prices of crypto assets fluctuate rapidly and unpredictably, influenced by various factors, such as supply and demand, technological innovation, regulatory developments, cyberattacks and market sentiment.
The sector also poses significant risks and challenges for clients and the accounting, insolvency/restructuring and legal professions, such as:
Consumer protection and financial crime risks
Crypto assets may expose consumers and investors to various risks, such as fraud, theft, hacking, scams, market manipulation and loss of access to funds. Crypto assets may also be used for illicit purposes, such as money laundering, terrorist financing, tax evasion and sanctions evasion. These risks may undermine the trust and confidence in the sector and harm the legitimate interests of clients and the public.
Legal and regulatory uncertainty
The legal and regulatory status of crypto assets varies across jurisdictions and depends on the specific features and functions of each crypto asset. Some crypto assets may fall within the existing regulatory frameworks, while others may be unregulated or subject to new rules. This creates complexity and ambiguity for clients and lawyers who need to navigate the different and evolving regulatory regimes and comply with the relevant obligations and requirements.
Technical and operational risks
Crypto assets rely on complex and novel technologies, such as cryptography and DLT, which may pose technical and operational challenges for clients and the legal profession. For instance, crypto asset transactions may be irreversible, immutable and anonymous, which may limit the ability to recover funds or identify the parties involved in a dispute. Crypto assets may also be vulnerable to cyberattacks, system failures, or human errors, which may compromise the security and integrity of the crypto assets and the underlying platforms.
Level of activity, trends and developments
Despite the risks and challenges, the sector also offers significant opportunities and benefits for clients and professional advisers, such as:
Competition and choice
Crypto assets may increase the competition and choice in the financial market, by challenging the dominance of incumbent players and offering alternative or complementary solutions to the existing ones. Crypto assets may also provide consumers and investors with more options and flexibility to diversify their portfolios and manage their risks.
Inclusion and empowerment
Crypto assets may increase the financial inclusion and empowerment of individuals and businesses, by providing access to alternative sources of funding, payment and investment, especially for the unbanked or underbanked populations. Crypto assets may also foster the participation and collaboration of diverse and distributed stakeholders, by creating peer-to-peer networks and communities that are governed by consensus and incentives.
Innovation and efficiency
Crypto assets enable new and innovative ways of creating, transferring and storing value, without relying on intermediaries or central authorities. Crypto assets may also enhance the efficiency, transparency and resilience of the financial system, by reducing transaction costs, processing times and operational risks. Crypto assets may also enable new business models, products and services, such as decentralised applications, smart contracts and decentralised finance (DeFi).
The sector is constantly evolving and expanding, as new crypto assets are created and new platforms are launched and use cases are explored and the universe of firms involved in the crypto asset sector expands (including traditional businesses which would not regard themselves as being in the “crypto asset business” and fintech firms which are in the value chain).
Some of the current trends and developments in the sector include:
Central bank digital currencies (CBDCs)
CBDCs are a form of digital money issued by central banks, which may use DLT or other technologies to enable the digital representation and transfer of central bank liabilities. CBDCs are intended to complement or replace the existing forms of money, such as cash and bank deposits and to enhance the efficiency, security and inclusiveness of the monetary system. CBDCs have attracted significant attention and interest from central banks and policymakers globally, as they may have profound implications for the monetary policy, financial stability and payment system. According to a 2021 survey, 86% of central banks are actively researching CBDCs, 60% are experimenting with CBDCs and 14% are deploying pilot projects. Some of the countries that have launched or are planning to launch CBDCs include China, Bahamas and Sweden.
Non-fungible tokens (NFTs)
NFTs are a type of crypto assets that represent unique and indivisible digital assets, such as art, music, games, collectibles or identity. NFTs use DLT to verify the ownership, provenance and authenticity of the digital assets, and to enable their creation, transfer and monetisation. NFTs have emerged as a new and exciting phenomenon in the market, as they enable the digitalisation and democratisation of the creative economy, and create new opportunities and challenges for artists, creators and consumers. According to a report, the total sales volume of NFTs reached $10.7 billion in the third quarter of 2021, up from $1.3 billion in the second quarter of 2021. Some of the popular platforms and projects for NFTs include OpenSea, CryptoPunks, Axie Infinity and NBA Top Shot.
Stablecoins
These are a type of crypto assets that aim to maintain a stable value by being pegged or backed by another asset, such as fiat currency, commodity or another crypto asset. Stablecoins are designed to address the volatility and scalability issues of other crypto assets, such as Bitcoin and Ethereum and to facilitate the use of crypto assets for everyday transactions and payments. Stablecoins have gained popularity and adoption in recent years, as they offer the benefits of both crypto assets and fiat currencies, such as speed, security, transparency and stability. According to an annual report, the global stablecoin market capitalisation reached $130 billion in October 2021, up from $37 billion in January 2021. Some of the prominent stablecoins in the market include Tether, USD Coin, Binance USD and Dai.
New legislation
The UK government and regulators have recognised the need to update and adapt the existing regulatory framework for crypto assets, to reflect the changing nature and scale of the sector and to align with the international standards and best practices. The UK has adopted a phased and proportionate approach to regulating crypto assets, focusing on the areas of highest risk and priority, while leaving room for future developments and innovations. Shoosmiths’ Key crypto case tracker highlights some of the new legislation that will have an effect on clients, which include:
The Financial Services and Markets Act 2000 (Regulated Activities) (Amendment) Order 2021
This order expanded the scope of the UK regulatory perimeter to include certain types of crypto assets, such as security tokens and e-money tokens, as well as certain activities involving crypto assets, such as issuing, dealing, arranging, advising and managing. This means that firms that carry out these activities in relation to these crypto assets in the UK need to be authorised by the FCA and comply with the relevant rules and requirements, such as the conduct of business, capital adequacy and financial crime prevention.
The Economic Crime and Corporate Transparency Bill 2022
This bill strengthens the UK’s fight against economic crime and terrorist financing. It includes amendments to the Proceeds of Crime Act 2002 (POCA) to support the recovery of crypto assets. The bill creates new powers to seize and forfeit crypto assets in civil and criminal proceedings and to impose reporting obligations on cryptoasset businesses. The bill also enables law enforcement agencies to investigate, seize and recover the proceeds of crime within the crypto asset ecosystem more effectively.
The Cryptoasset Promotion (Regulation) Order 2021
This order extended the financial promotion regime to cover certain types of crypto assets, such as unregulated tokens, stablecoins and NFTs. This means that firms that wish to promote these crypto assets in the UK to retail consumers must, by law, be authorised or registered by the FCA or have their marketing approved by an authorised firm. The order also introduced a time-limited exemption for FCA-authorised crypto asset firms to issue their own promotions, subject to certain conditions and safeguards.
The Consultation on the Regulation of Crypto assets and Stablecoins
This consultation set out ambitious plans to robustly regulate crypto asset activities, providing confidence and clarity to consumers and businesses alike. The consultation proposals included strengthening the rules for crypto trading platforms and custodians, introducing a crypto market abuse regime and establishing a world-first regime for crypto lending. The consultation also sought views on the regulatory treatment of stablecoins and CBDCs and the potential benefits and risks of DeFi and NFTs. The consultation closed on 26 April 2021 and the government published its initial response here.
The Financial Services and Markets Act 2023
The FCA has been given discretion to bring more crypto assets (and activities relating to them) within the existing regulatory perimeter and HM Treasury has been able to launch the first “digital sandbox” (which will permit firms to operate under existing rules and regulations to provide innovative crypto asset-related products and services even if the rules and regulations do not, on their face, cover those products and services).
HM Revenue and Customs (HMRC)
HMRC has published consultations on tax treatment of Decentralised Autonomous Organisations (DAOs) and “lending” and “staking” of cryptocurrencies and has launched a campaign to encourage voluntary disclosure of any unpaid tax on income or gains from crypto assets.
Potential hurdles or difficulties
This sector is not without its challenges and difficulties, as clients may face various legal, regulatory and practical hurdles and obstacles when engaging in crypto assets activities in the UK.
These include:
Legal disputes and enforcement
The sector may also give rise to various legal disputes and enforcement issues, as clients may encounter conflicts, breaches or liabilities when engaging in crypto assets activities in the UK. For instance, clients may face contractual disputes over the terms, performance, and enforcement of crypto assets transactions or agreements, especially when they involve smart contracts, which may be self-executing, immutable and irreversible. Clients may also face regulatory disputes over the compliance, supervision and sanctioning of crypto assets activities, especially when they involve cross-border or multi-jurisdictional aspects. Clients may also face civil or criminal disputes over the ownership, recovery or compensation of crypto assets, especially when they involve fraud, theft, hacking or loss of access. These legal disputes and enforcement issues may pose significant challenges and costs for clients and lawyers who need to resolve them in a timely and effective manner.
Regulatory complexity and fragmentation
The UK’s regulatory framework for crypto assets is complex and fragmented, as it involves multiple regulators, such as the FCA, the Bank of England, the HM Treasury, the HM Revenue and Customs and the Information Commissioner’s Office, each with their own remit, objectives and powers. Moreover, the UK’s regulatory framework is not fully harmonised with the EU’s regulatory framework, as the UK has diverged from some of the EU’s initiatives and proposals, such as the Markets in Crypto-assets Regulation (MiCA) and the Digital Operational Resilience Act (DORA). This creates uncertainty and inconsistency for clients and lawyers who need to deal with different and sometimes conflicting rules and requirements across jurisdictions and sectors.
Regulatory gaps and risks
The UK’s regulatory framework for crypto assets is not comprehensive and exhaustive, as it does not cover all types of crypto assets and their associated activities, leaving some of them unregulated or subject to new rules. For instance, some crypto assets, such as unregulated tokens, stablecoins and NFTs, may fall outside the scope of the existing regulatory regimes or may require new definitions and classifications. Similarly, some activities, such as DeFi, CBDCs and NFTs, may pose new and emerging risks and challenges for the regulators, such as governance, interoperability, scalability and consumer protection. These regulatory gaps and risks may create legal uncertainty and vulnerability for clients and lawyers who need to anticipate and adapt to the changing regulatory landscape and expectations.
Conclusion
Crypto assets are a dynamic and innovative sector of the financial industry, offering new opportunities and challenges for clients and the legal profession. The UK is seeking to develop a comprehensive and proportionate regulatory framework for crypto assets, aiming to foster innovation, competition and consumer protection. However, this sector is also subject to significant volatility and uncertainty, as the prices, technologies and regulations of crypto assets change rapidly and unpredictably, and the uncertainty will continue for some time given the possible change to the UK administration and any Parliament’s legislative agenda and priorities. Therefore, clients and lawyers need to be aware and prepared for the current and future developments and trends in the sector, and to overcome the potential hurdles and difficulties that they may face when engaging in crypto assets activities in the UK.
