internationl approach with crypto trading and conclusion

 143. Given that the crypto-assets can be created and traded anywhere in the world, the regulatory response to certain risks will only have ...

 143. Given that the crypto-assets can be created and traded anywhere in the world, the regulatory response to certain risks will only have limited success if other jurisdictions adopt a different approach. 144. David Raw, Deputy Director of Banking and Credit at HM Treasury, explained that international bodies are currently undertaking work to assess the risks associated with crypto-assets as well: [T]here is an international element to this. 

[…] Some of the international bodies in this space, like the FSB [Financial Stability Board] and the Financial Action Taskforce, have been tasked with doing some work […] on what the risks are and internationally what action can be taken, because the risk of regulatory arbitrage here is quite high.181 145. David Geale, Director of Policy at the FCA, outlined the extent of the work between regulators in the international regulatory sphere, but indicated that that work is still at the early stages: In th[e] […] case [of crypto-assets], there is a lot of interest among bodies like IOSCO [International Organisation of Securities Commissions], the international securities agency, and at the level of the Financial Stability Board. There is quite a lot of work going on to ensure proper information sharing so that we know the approaches we are all taking and why. We also need to think about things like the taxonomy so we are talking about the same things at the same time, and to think about the risks that are emerging and the most appropriate ways to deal with those. Everybody is feeling their way into this regulation a bit at the moment. Various jurisdictions are taking various steps. We have not yet seen which is going to be the most effective.182 146. The global regulatory response to crypto-assets is in its infancy. Nonetheless, given the UK has yet to introduce any crypto-asset regulation, it is in a position to learn from those experience of countries that have done so. Regulation in the United States of America (US) 147. In the US, the regulation of crypto-asset activity differs from state to state. In its written evidence to the Committee, Crypto UK argued that the approach of the New York State Department of Financial Services (NYSDFS) was “not as successful [as other regulators].”183 The regulator introduced the “BitLicense” and regulations which required different types of crypto-asset market participants to be registered with the NYSDFS.184 Crypto UK argued that “regulatory arbitrage opportunities within the US [and] a strong anti-regulatory sentiment […] meant that a huge proportion of New York’s crypto business moved out of New York State […].”185 This was corroborated by the findings of Reuters that “the slow licensing process and strict requirements are driving some companies

away.”186 These companies instead looked to “other US states [that] are developing rules and awarding licenses at a faster clip, [for example] Washington State and North Carolina.”187 Crypto UK stated that “the effects of the BitLicense continue today, with New York State lagging behind in terms of volume of crypto[asset] businesses compared to other comparable US states.”188 148. As mentioned earlier in the report, the Securities and Exchange Commission (SEC) has already issued guidance on the regulation of initial coin offerings (ICOs). In February 2018, Reuters reported that US lawmakers are “moving to consider new rules that could impose stricter federal oversight on the emerging asset class […].”189 However, “digital assets currently fall into a jurisdictional grey area between the SEC, the Commodity Futures Trading Commission (CFTC), the Treasury Department, the Federal Reserve and individual states.”190 149. Ryan Zagone, Director of Regulatory Relations at Ripple, outlined the different interpretations and approaches of authorities within the US: There are many different categories that we see coming to the market, depending on how that technology is used. In the US, the IRS [Internal Revenue Service], our tax authority, has deemed them assets, just like property. The CFTC is saying some uses of these and some designs of these look like commodities. The Securities and Exchange Commission say some look like securities, looking at the ICOs. We are seeing, depending on how they are constructed and used, different categories. We expect that conversation to continue as technology evolves.191 Regulation in Asia 150. Mr Raw told the Committee that some regulators in Asia appear to have progressed further in their thinking, as “there is a lot more activity taking place in relation to cryptoassets in the Far East than there is here.”192 151. Japan’s Financial Services Agency (FSA) approved eleven companies as operators of crypto-asset exchanges on 29 September 2017 after it recognised Bitcoin as a legal tender in April 2017 and required crypto-asset exchange operators to register with the FSA.193 The Japanese FSA has “laid out various requirements, such as building a strong computer system, segregation of customer accounts and checking the identity of customers.”194 152. The Committee received written evidence from Crypto UK commending the approach of the Japanese FSA which it argued “has led to the development of a group of mature crypto-[asset] exchanges within Japan.”195 The written evidence submitted  by Coinfloor also argued that Japan’s approach “crafted a framework which protects consumers, enables innovation and enables customers to adopt innovative products and services quickly.”196 153. China has taken a different approach to other regulators in the management of cryptoassets. In 2017, China “banned initial coin offerings, shut down local crypto-currency trading exchanges and limited bitcoin mining […].”197 On 15 January 2018, Bloomberg reported that China was “escalating its clampdown on cryptocurrency trading, targeting online platforms and mobile apps that offer exchange-like services [as] while authorities banned cryptocurrency exchanges last year, they’ve recently noted an uptick in activity on alternative venues.”198 In future, “the Government plans to block domestic access to homegrown and offshore platforms that enable centralised trading […] authorities will also target individuals and companies that provide market-making, settlement and clearing services for centralised trading.”199 Regulation in Europe 154. The Gibraltar Financial Services Commission (GFSC) has established a Distributed Ledger Technology Regulatory Framework (DLT framework). Since 1 January 2018, a firm carrying out by way of business, in or from Gibraltar, the use of distributed ledger technology (DLT) for storing, transmitting value belonging to others (DLT activities), needs to be authorised by the GFSC as a DLT Provider.200 The GFSC noted that “a flexible, adaptive approach is required in the case of novel business activities, products and business models.”201 The GFSC has thus designed regulatory principles rather than concrete rules for DLT businesses.202 These regulatory principles include: • Conducting business with honesty and integrity; • Communicating to customers in a way which is fair and not misleading; • Maintaining adequate financial and non-financial resources; • Ensuring that all systems and security access protocols are maintained to appropriate high standards; • Having systems in place to prevent, detect and disclose financial crime risks such as money laundering and terrorist financing; and • Developing contingency plans for the orderly and solvent wind down of its business.203 155. Obi Nwosu, Chief Executive Officer of Coinfloor, explained the reasons why Coinfloor had utilised the regulatory regime in Gibraltar to register a business:

We have set up Coinfloor Exchange Gibraltar. The reason why is that we were incredibly impressed with Gibraltar’s forward-thinking approach to regulation. We have been working with them for over a year. They have taken a policy around AML and CTF (counter- terrorist financing). They have also looked at policies around custodianship of cryptocurrency, treating customers fairly, and they have taken a broader look at the market. This is what I was recommending that the UK should look at as well, as an example.204 156. The position of the French regulators is similar to the FCA. The Autorité des Marchés Financiers (AMF, Authority for Financial Markets) and the Autorité de Contrôle Prudentiel et de Résolution (ACPR, Prudential Regulation and Resolution Authority) clarified that “the purchase [and] sale of and investment in Bitcoin currently takes place outside any regulated market”205 and are therefore unregulated. In a similar position to the FCA, the AMF and ACPR have issued warnings to consumers that the value of Bitcoin can “unexpectedly collapse [and] investors are therefore exposed to very high risks of a [price] correction and do not benefit from any guarantee or protection of invested capital.”206 157. 

Conversely, the financial services regulator in Germany, BaFin (Federal Financial Supervisory Authority), has classified crypto-assets as “units of account from a supervisory point of view and therefore as financial instruments.”207 Given this classification, in Germany commercial trading in crypto-assets requires authorisation.208 In March 2018, BaFin also published a document on the regulatory classification of crypto-assets and ICOs in the area of securities supervision which stated that Ba Fin “determines on a caseby-case basis whether a token constitutes a [security] […] or a capital investment […].”209 In line with other regulators, BaFin has also cautioned potential investors on the range of risks associated with ICOs.210 158. The Committee recognises the importance of international cooperation on the regulation of crypto-assets and associated activities. The Committee encourages UK regulators to continue engaging with international bodies to ensure best practice from other regulators is learned and applied to the UK context The crypto-asset landscape 1. Functioning currencies are generally understood to serve as a store of value, a medium of exchange and a unit of account. As yet, there are no so-called “cryptocurrencies” that serve all these functions. Well-functioning cryptocurrencies currently exist only as a theoretical concept, and the term “crypto-assets” is more helpful and meaningful in describing Bitcoin, and the many hundreds of other ‘altcoins’ that have emerged over the past decade. (Paragraph 13) Blockchain and crypto-assets: advantages and limitations 2. Crypto-assets and blockchain were originally designed as an alternative system of making payments in exchange for goods and services. But even the most widelyused crypto asset—Bitcoin—is not widely accepted by merchants. Moreover, the blockchain that underpins Bitcoin transactions cannot process anything like the volumes of transactions that would be required for it to become a mass-market payments system. Even at current levels, the energy costs of verifying transactions appear disproportionate to the potential benefits of a decentralised payments system. (Paragraph 47) 3. The slow, costly and energy-intensive verification process for transactions is not unique to Bitcoin, but a fundamental feature of crypto-assets based on public, decentralised blockchains. This may ultimately limit the extent to which cryptoassets and blockchain can replace conventional money and payments systems. (Paragraph 48) 4. The arguments put forward that crypto-assets could further financial inclusion are unconvincing. Efforts to further financial inclusion are best focused on reducing the number of people without access to bank accounts, rather than increasing the numbers with access to crypto-assets. (Paragraph 49) 5. There are a number of examples of blockchain being deployed in the financial services industry and supply chain management. The Committee is supportive of good innovation, but notes that blockchain should not be pursued for its own sake. Rather, Government and industry should identify what problems exist and consider whether blockchain offers the most appropriate solution. The Committee recognises that blockchain technology may have the potential to solve problems caused by a lack of trust in data integrity and may be a more efficient method of managing certain types of data in the long term, offering higher levels of security than centralised databases. (Paragraph 50) 6. However, at present—although small scale uses for blockchain may exist—the Committee has not been presented with any evidence to suggest that universal applications of the technology are currently reliably operational.

The risks of crypto-assets and the regulatory response 7. Crypto-assets have no inherent value. In the absence of any market fundamentals, their prices fluctuate according to sentiment. This causes far higher volatility than other asset classes, exposing investors to larger potential gains, but correspondingly greater risk of loss. The use of blockchain as a payments system exacerbates these risks, since the exchange rate (vis-à-vis other crypto-assets, or conventional currency) can fluctuate significantly during the time it takes to settle a transaction. (Paragraph 64) 8. On account of their volatility alone, crypto-assets are especially risky, particularly for inexperienced retail investors. (Paragraph 65) 9. Investors typically access and invest in crypto-assets through exchanges. A number of these have been hacked, with customers losing significant amounts of money as a result. (Paragraph 75) 10. There is no collective deposit insurance scheme to compensate investors in the event of a hack, nor do individual exchanges generally have arrangements in place to do so. The risk of hacking associated with crypto-assets may not be something investors in conventional assets have experience of, and therefore they may not be well placed to judge this risk. It constitutes further evidence that crypto-assets are particularly ill-suited to retail investors. (Paragraph 76) 11. There have also been instances of investors losing access to their crypto-assets when they have lost their passwords to their accounts with exchanges or crypto-asset platforms. Exchanges and crypto-asset platforms have subsequently been unable to recover their customers’ details, so customers are locked out of their accounts permanently. This often unexpected outcome for investors is a stark contrast against how customers of banks, and other regulated financial services firms, are treated when they have forgotten their details. (Paragraph 77) 12. The FCA’s stark consumer warning on ICOs is evidence that they present significant risks to investors. But apart from drawing attention to the risks, there is little the FCA can do to protect individuals from being defrauded or losing their money. This is because most ICOs do not promise financial returns, but instead offer future access to a service or utility, meaning they fall outside the regulatory perimeter. (Paragraph 87) 13. While there may be no explicit promise of financial returns, investors in ICOs clearly expect them: they are not buying tokens to gain access to as-yet unbuilt theme parks, or to obtain dental services in years to come, but in the hope of selling them at a profit. The development of ICOs has exposed a regulatory loophole that is being exploited to the detriment of ordinary investors. The Regulated Activities Order should be updated to bring ICOs within the FCA’s perimeter as a matter of urgency, and bring investor protections into line with those in the United States. (Paragraph 88) 14. Crypto assets and ICOs are extremely risky, and the Committee agrees with the FCA that investors should be prepared to lose all their money.

Owing to their anonymity and absence of regulation, crypto-assets can facilitate the sale and purchase of illicit goods and services, and can be used to launder the proceeds of serious crime and terrorism. (Paragraph 103) 16. The absence of regulation of crypto-asset exchanges—through which individuals convert crypto-assets into conventional currency—is particularly problematic. (Paragraph 104) 17. The adoption of the Fifth Anti-Money Laundering (AML) Directive represents a step forward in this respect. Under the Fifth AML Directive, crypto-asset exchanges will have to comply with anti-money laundering and counter-terrorist financing rules. The Committee urges the Government to treat the transposition of the Directive as a priority, and to expedite the consultation process, which is currently not planned to finish until the end of 2019. If the UK leaves the EU without a transition period in March 2019, the Committee would nonetheless expect the Government to seek to replicate the relevant provisions of the AML Directive in UK law as quickly as possible. (Paragraph 105) 18. The Committee believes that the FCA should be the relevant regulator for supervising anti-money laundering. (Paragraph 106) 19. Crypto-asset markets are particularly vulnerable to manipulation, and they fall outside the scope of market abuse rules. In responding to this Report, the FCA should outline the approach it would take to market manipulation were these markets to fall within its remit. (Paragraph 111) 20. The Committee agrees with the Bank of England that, since they are not being widely used as a means of payment, and the linkages to systemically-important firms and markets are negligible, the risk to financial stability arising from crypto-assets is low. The Committee expects the Bank of England and the FCA to continue to monitor developments in crypto-asset markets, and financial institutions’ exposure to them. (Paragraph 116) 21. The FCA’s consumer warnings are a feeble corrective to advertisements—on social media, billboards, trains and taxis—that only emphasise the upside opportunities of crypto-asset investing. The advertisements for crypto-asset investing are clearly misleading to consumers and as crypto-asset activities fall outside the FCA’s regulatory perimeter, the FCA is restricted in actions it can take. The FCA needs more power to control how crypto-exchanges and ICO issuers market their services, by bringing the activities they perform into the regulatory perimeter. Such a step would also provide investors with wider protections against mistreatment, including loss of deposits through fraud and hacking, or losing access to funds due to the loss of passwords. (Paragraph 125) 22. Crypto-assets have been embedded in certain pockets of society and industry, and it is highly likely that they are here to stay. The UK Government and financial services regulators appear to be deciding whether they will allow the current “wild west” situation to continue, or whether they are going to introduce regulation. The current ambiguity surrounding the Government’s and the regulators’ positions is clearly not sustainable. (Paragraph 129)

3. The Committee is aware of the establishment of self-regulating bodies in the crypto-asset industry such as Crypto UK, which set out codes of conduct and best practice for the industry. However, as these standards are wholly voluntary, there are inevitably firms ignoring them. When industry is self-regulating, there is no authority to hold industry to account. Throughout the inquiry, the Committee has heard of the crypto-asset industry distributing misleading advertisements and laxing on their self-imposed ‘know your customer’ rules. Self-regulation within the crypto-asset industry is clearly insufficient. The introduction of formal regulation would make standards compulsory and relevant regulators can hold industry to account. (Paragraph 130) 24. Given the scale and variety of consumer detriment, the potential role of cryptoassets in money laundering and the inadequacy of self-regulation, the Committee strongly believes that regulation should be introduced. At a minimum, regulation should address consumer protection and anti-money laundering. (Paragraph 131) 25. In deciding the regulatory approach, the UK Government and regulators should evaluate the risks of crypto-assets, and assess whether their growth in the UK should be encouraged. (Paragraph 132) 26. If the Government decides that growth is to be encouraged, the Committee believes that the introduction of regulation could lead to positive outcomes for the cryptoasset market. The implementation of crypto-asset regulation in the UK may enable the market place to move to a more mature business model that improves consumer outcomes and enables it to grow sustainably. The entry of institutional investors into the market would increase liquidity, which in itself could reduce some of the inherent risks that exist at present. (Paragraph 133) 27. If the UK develops an appropriate and proportionate regulatory environment for crypto-assets and if future innovations in crypto-assets proved themselves as beneficial to society and industry, the UK could be well placed to become a global centre for this activity, providing that the crypto-asset market adhered to high standards and was not associated with criminality. (Paragraph 134) Implementation of regulation 28. The Committee considers that introducing the regulation of crypto-assets and associated activities by extending the Regulated Activities Order would be the quickest method of providing the FCA with the necessary legal powers to execute its duties of protecting consumers and maintaining market integrity. Designing a new framework of regulation would inevitably take much longer and given the growing risks surrounding crypto-assets and subsequent consumer detriment, the introduction of regulation should be treated as a matter of urgency. (Paragraph 141) 29. The Committee recommends that the Government consider what “activity” related to crypto-assets should be specified in the RAO and the ramifications of this introduction. As discussed earlier, this should include at a minimum the issuance of ICOs and the provision of crypto exchange services. (Paragraph 142)

International approach to regulation 30. The global regulatory response to crypto-assets is in its infancy. Nonetheless, given the UK has yet to introduce any crypto-asset regulation, it is in a position to learn from those experience of countries that have done so. (Paragraph 146) 31. The Committee recognises the importance of international cooperation on the regulation of crypto-assets and associated activities. The Committee encourages UK regulators to continue engaging with international bodies to ensure best practice from other regulators is learned and applied to the UK context.