UK Crypto Regulation: From Caution to Confidence

The UK’s approach to digital asset regulation has been characterized by pragmatism and evolution. While initially taking a cautious stance, the Financial Conduct Authority (FCA), the primary financial regulator in the UK, has acknowledged the potential of this technology and gradually adopted a more nuanced approach.

Initially, the FCA’s regulatory remit over cryptoassets was limited to ensuring compliance with anti-money laundering (AML) and counter-terrorism financing (CFT) requirements. However, this meant the FCA lacked the necessary powers to fully oversee and regulate the broader crypto market.

Bolstering the FCA to oversee crypto

A significant step forward came with the Financial Services and Markets Act 2023 (FSMA 2023), which brought “cryptoassets” under the existing financial services regulatory framework. This legislation introduced provisions to regulate the management or arrangement of deals in crypto, financial promotions, and the regulation of Digital Settlement Assets (DSAs).

This empowers the FCA to oversee cryptoasset firms offering services like trading and custody, meaning firms marketing cryptoassets to UK consumers, regardless of their location, will need to comply with the FCA’s regulations, including adhering to disclosure requirements and ensuring promotions are clear, and not misleading.

The new regulatory framework encompasses stablecoins, which are cryptoassets pegged to a stable reference asset like fiat currency (currency not backed by a commodity such as gold, but rather designated by the issuing government as legal tender). FSMA 2023 also introduces additional regulatory measures for DSAs, aiming to mitigate potential risks associated with their use in financial markets.

The UK government is taking a phased approach to its rollout of cryptoasset regulation, the first phase being rules relating to stablecoins. The deadline for inputs to published blueprints for the first phase of the cryptocurrency regulatory framework from the FCA and Bank of England (BoE) was February 6, 2024, following which the FCA will write up new stablecoin rules. These are expected to be ready in ‘early 2024’, depending on parliamentary bandwidth.

Tokenised deposits are likely to be the way that a much greater number of financial institutions get involved in the digital asset space than stablecoins. Tokenized deposits are a new form of digital money that represents traditional bank deposits on a blockchain. They are issued by licensed and regulated depository institutions, such as commercial banks, and are backed by the same safety and soundness measures as conventional deposits. The institutions that issue these are already highly regulated and so the tokens may gain traction more quickly than stablecoins.

The second phase will include rules for covering crypto exchanges, lenders, and other service providers, which are expected to be before parliament for final approvals in mid to late 2024.

Balancing UK crypto regulation and innovation

The FCA has already established a regulatory sandbox to allow startups and innovators to experiment with new crypto technologies in a safe environment, providing access to financial data in order to validate their proof of concepts. The second digital sandbox is expected to be released by the end of Q1 2024 and is intended to allow financial firms some leeway under supervision so that they can experiment in areas where they may hit regulatory barriers.

This is a new and innovative way to regulate for the FCA. Rather than being reactive and waiting for activity before regulating, it can follow an iterative process that is expected to be more of a proactive learning curve. This is essential as the evolving nature of blockchain technology and the emergence of new types of digital assets present continual regulatory challenges. Keeping pace with technological innovation while ensuring effective regulation requires flexibility and adaptability.

Additionally, the Law Commission of England and Wales, an independent body that recommends reforms to the law, has played a crucial role in shaping the UK’s approach to digital assets. In 2023, it proposed the recognition of digital assets as a distinct third category of property, which provides greater clarity and legal certainty for individuals and businesses dealing with digital assets.

It also recommended the establishment of a digital assets panel of experts to advise courts on complex legal issues arising in the context of digital assets.

These developments demonstrate the UK’s commitment to fostering a regulatory environment that encourages responsible innovation in the crypto space while safeguarding consumer protection and financial stability. Finding the right balance between innovation and regulation will be crucial for the UK to establish itself as a global leader in the digital asset space.