The UK Treasury’s consultation on further crypto asset regulation signals a heavy compliance burden for crypto businesses and some vertically integrated firms may be required to restructure to gain authorisation.

Crypto businesses operating in the UK must be registered with the Financial Conduct Authority (FCA) and compliant with the Money Laundering Regulation (MLR 2017). Around 85% of crypto-asset firms that tried to register with FCA were unable to demonstrate they met the minimum standards required the MLR regime. The regulatory approach outlined in yesterday’s Treasury paper will impose much tougher and wider requirements.

“These proposals mark a step-change in the direction of UK regulatory policy relating to cryptoassets and it is now clear that a regulatory wave will hit the sector. A number of these proposals are well trailed, but others perhaps less so and it is evident that the shadow cast by high profile failures through 2022 has influenced the extent and pace of implementation of these measures,” said Albert Weatherill, a financial services partner at Norton Rose Fulbright in London.

Crypto businesses and their lobbyists have advocated for a light-touch regulatory regime like a self-regulatory organisation. Lobby group CryptoUK wanted the government to appoint a “crypto tsar” to coordinate cross-departmental efforts and said the industry itself would need to make sure any rules were fit-for-purpose. That is not how the process has panned out.

“Few that don’t do Trad Fi compliance will really understand the intensity of these requirements. It covers millions of paragraphs of regulatory rules. The consultation does a great job of outlining lots of points of principle which will kick off an International equivalence race. If you know what the existing rules are—MiFID II, PRIIPS, MAR, etc—you will see them baked in here. This is going to be extremely tough for exchanges,” said PJ Di Giammarino, chief executive at think tank JWG.

TradFi rules

These proposals do not constitute an entirely new regime in the same way that the European Commission has approached Markets in Crypto Assets (MiCA) regulation, Weatherill said. HM Treasury instead plans to work with existing rules and extend its the framework to this asset class.

The Treasury intends to create several new regulated or designated activities tailored to the crypto-asset market where these activities “seek to mirror, or closely resemble, regulated activities performed in traditional financial services,” the consultation said.

The proposed scope of crypto-asset activities to be regulated include issuance, payments, exchanges, investment and risk management, lending, borrowing and leverage, safeguarding and/or custody and validation (mining) and governance. Firms will face more anti-money laundering and terrorist financing compliance obligations too.

Crypto-asset activity provided in or to the UK must be authorised. That means overseas firms must be UK authorised if they sell services to UK customers or conduct business here. The Treasury is considering “equivalence type arrangements” whereby firms authorised in a jurisdiction with crypto rules deemed equivalent might provide services in the UK without a physical presence.

The consultation addresses crypto firms’ “agglomerate” structures — providing many services and activities in one firm. The government expects, as a minimum, that these entities follow rules covering all of these activities — not just those relevant for operating a trading venue. These are also known as vertically integrated firms and the conflict of interest and risk management risks they pose were highlighted in the FTX fraud.

“Further consideration will be given to the risks of such combined activities in the crypto-asset sector, and whether and how existing controls on combinations of activity [segregation] in traditional finance could be applicable,” the consultation said.

It is not the government’s intention for Financial Services Compensation Scheme (FSCS) protections to apply to investor losses arising from crypto-asset exposures. It is the FCA and Prudential Regulation Authority’s responsibility to set the limits of FSCS protection in respect of regulated activities carried out by authorised firms, the consultation said.

“Ultimately, only time will tell whether the measures balance the drive for innovation and the oft-trumpeted growth agenda against the clear need to mitigate risks of consumer harm and financial stability, but it is readily apparent that those players who can best adapt to this new landscape will have an inevitable competitive advantage in the ‘flight to quality’ that is expected to play out through the course of this year,” Weatherill said.

High bar

Most crypto firms’ MLR applications were of a poor standard, with only 5% being progressed on the first attempt. Some 73% of the applications have been withdrawn or failed, which was the biggest withdrawal or failure rate the FCA had seen when taking on a new remit, the FCA said.

The FCA told the House of Commons’ Treasury Committee that while vetting crypto firms it found key personnel lacked the appropriate knowledge, skills and experience to carry out their roles and control risks effectively. In a small number of cases, the FCA identified likely financial crime or direct links to organised crime and referred the firms to law enforcement agencies.

“We are in the middle of an inquiry into crypto regulation and these statistics have not disabused us of the impression that parts of this industry are a ‘Wild West’,” said Harriett Baldwin MP (Con) and chair of the Treasury Committee.

Last week, the FCA published feedback on good and poor-quality applications for firms seeking to register under MLRs. It covered the basics, suggesting applicants were not well prepared.

“We expect applicants to demonstrate an understanding of the UK AML registration regime as set out in the MLRs,” it said.

Long road ahead

The consultation closes on April 30, but the Financial Services and Markets Bill needs to obtain royal assent before any rule making begins. Once the bill becomes law UK regulators will need to consult on rules before publishing policy statements and guidance. This process will stretch into next year, possibly beyond.

“The consultation brings home how far we still have to travel before crypto is regulated. Even when the Regulated Activities Order (RAO) is changed as proposed to bring into scope regulated crypto activity, the FCA will still need to consult on and amend their rules, for example those relating to governance (the Senior Management Arrangements, Systems and Controls sourcebook) and financial crime rules to bring into play the new crypto-asset activities. This will take considerable time,” said Rebecca Thorpe, chief executive at Bovill, a regulatory consultancy in London.

This article was Produced by Thomson Reuters Accelus Regulatory Intelligence on 02 February 2023