High Risk Investments: Crypto-assets and the FCA
During a period of what many are describing as an “economic crisis”, cryptocurrency, which is enabled by block-chain technology, appears to be booming. For example, recent mainstream appeal in Non-Fungible Tokens (a type of crypto-asset that is sold by the same block-chain technology that underpins cryptocurrency) saw sales soar by almost 2,500% in the past year alone.
Experts speculate that this surge in investment means that cryptocurrency could form an integral part of our existing “real” economy. However, there are grave concerns about the risks of this type of investment product.
As of 6 January 2021, the sale of certain high risk investment products such as crypto assets to retail clients was prohibited by the FCA. Retail clients are defined by the Conduct of Business Rule 3.4.1 as “A retail client who is not a professional client or an eligible counterparty”.
Block-chain technology exists on a peer-to-peer network enabling users to transfer electronic funds without the need for a central clearing authority, such as a bank. Amongst all of its potential uses that are currently being explored by financial institutions, block-chain has enabled the creation of cryptocurrency, which is an electronically stored medium of exchange that uses encryption techniques to verify the transfer of funds. The most commonly known type of cryptocurrency is Bitcoin, for which block-chain technology was originally invented.
There is no FCA Glossary definition of crypto-assets per se, but the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 provides the following definition:
“A cryptographically secured digital representation of value or contractual rights that uses a form of distributed ledger technology and can be transferred, stored or traded electronically”.
So what’s the issue?
The FCA highlighted some real Regulatory concerns about crypto-assets in its 2020/21 Business Plan. The FCA’s main objectives in relation to enabling effective consumer investment decisions are to:
- Ensure that investment products are appropriate for consumers’ needs, for example by protecting consumers against high risk products disguised as investments, which are not necessarily value for money.
- Ensure consumers are able to make effective decisions about their investments via high-quality advice and support to protect against scams and fraud; and
- Ensuring that firms and individuals operate under high regulatory standards and act in consumers’ interests at all times, for example by marketing investments in a fair, clear and not-misleading way.
The Regulatory concerns and product risks surrounding crypto-assets means that unless strict guidance was issued in relation to the sale of crypto-assets, the above objectives would not be met. For example:
- Money Laundering: Transactions using cryptocurrency often allow a degree of anonymity enabling some users to exploit this is as a means to transfer illicit funds without detection. Crypto businesses must comply with UK anti-money laundering regulations just as other financial institutions do in an effort to provide the market with much-needed credibility and safety as far as potential consumers are concerned.
- Fraudulent Activity: Action Fraud reported over £2 million worth of losses in one month alone in 2018 due to “get rich quick” investments in mining and trading in crypto-assets.
- Market Volatility: An inability to value crypto-assets reliably creates a high risk for the average retail consumer. For example, Bitcoin’s daily mean and maximum price changes are 5.5. and 7.5 times higher than compared to gold.
In a bid to protect consumers, the FCA confirmed that as of 6 January 2021, the sale, marketing and distribution of unregulated transferable crypto-assets was banned. As a result, the new Conduct of Business Rule 22.6.5 now provides that “(1) A firm or TP firm must not (a) sell a crypto-asset derivative or a crypto-asset exchange traded note to a retail client; or (b) distribute a crypto-asset derivative or a crypto-asset exchange traded note to a retail client; or (c) market a crypto-asset derivative or a crypto-asset exchange traded note if the marketing is addressed to or disseminated in such a way that it is likely to be received by a retail client. (2) Marketing includes, but is not limited to, communication and/or approving financial promotions.”
The FCA has provided guidance on the different categories of crypto-assets and which types fall within the regulatory perimeter. The FCA’s Policy Statement PS 19/22 advises on the following types of crypto-asset (tokens):
- Exchange Tokens: A good example of this is Bitcoin. Going back to the above explanation of block-chain technology, this type of cryptocurrency is not governed by a central authority and is designed to be used as a means of exchange. These types of token fall outside of the regulatory perimeter and therefore caught by the new COBs Rule 22.6.5.
- Utility Tokens: A good example of this is ERC20 Ethereum Standard. The Ethereum network raised money through Initial Coin Offerings, which required them to create their own tokens and sell them to the public in exchange for Ether, the cryptocurrency of the Ethereum block-chain. Utility tokens are decentralised digital assets designed to be spent within a certain block-chain system. In most instances, these types of token are likely to fall outside of the regulatory perimeter, with e-money being an exception.
- Security Tokens: These tokens have a specific characteristic whereby they confer rights similar to those attached to shares or debt instruments (as an example). This means that they meet the definition of a Specified Investment as set out in the Regulated Activities Order. Firms carrying out regulated activity in relation to these Specified Investments must be authorised to do so by the FCA.
How will the new rules be enforced?
The FCA will have the power to enforce disciplinary intervention against firms falling foul of the new Rules. Further, consumers may have access to a claim for damages under Section 138D of FSMA, which provides that “(2) A contravention by an authorised person of a Rule made by the FCA is actionable at the suit of a private person who suffers a loss as a result of the contravention, subject to the defences and other incidents applying to actions for breach of statutory duty”. Of course, any success in bringing such claims will depend on the merits of the case, given that it is “subject to the defences…”
What this means for consumers
Cryptocurrencies are highly volatile assets that usually lack guarantees because of their potential for quick returns. It must therefore be understood that these are high risk investments in which there is a realistic potential for an investor to lose all of their money. The FCA estimates that by issuing this ban, it will save UK consumers approximately £53 million in losses, making consumer protection paramount in its objectives.
Any firm offering to invest a retail consumer’s money in unregulated crypto-assets is likely to be a scam. The FCA has issued a stark warning that consumers who are involved with crypto-asset related investments are unlikely to have access to the Financial Ombudsman Service or the Financial Services Compensation Scheme if things go wrong.
Is the ban a set-back for the UK economy?
Critics argue that the ban is a setback for the UK in maintaining its dominant position as a global fintech hub, and flies in the face of the FCA’s own survey results where over 97% of the FCA’s consultation respondents disagreed with the proposal of the ban.
However, the UK’s careful approach in protecting its most vulnerable investors, the retail consumer is commendable as it minimises risk in times of economic uncertainty whilst the UK gets to grips with the impact of the COVID-19 pandemic.
Malaika Jawed, Associate, BLM
Disclaimer: This document does not present a complete or comprehensive statement of the law, nor does it constitute legal advice. It is intended only to highlight issues that may be of interest to clients of BLM. Specialist legal advice should always be sought in any particular case.