Market manipulation 107. In its written evidence to the Committee, the FCA highlighted the risk of price manipulation in the crypto-asset ...
Market manipulation 107. In its written evidence to the Committee, the FCA highlighted the risk of price manipulation in the crypto-asset market: Because of the […] dynamics of crypto-asset markets, where trading volume and capitalisation is considerably lower than established financial markets, there is a greater potential for malicious actors to coordinate price manipulation—such as ‘pump and dump’ schemes.
This presents a risk for any potential buyers—retail or institutional—who may interpret sudden price appreciation as a sign of a high quality crypto-asset with strong potential, only to lose their money as these price rises are reversed.147 The FCA also noted the risks of other forms of market abuse: The relatively immature market infrastructure underpinning the cryptoasset market could lend itself to more complex forms of market manipulation such as insider trading or spoofing orders—the latter enabled by the lack of reporting standards and the overreliance on non-professional websites for price or market information.148 The FCA indicated that these risks are exacerbated by the difficulties of policing cryptoasset markets, even if they had the powers to do so: [T]here would be practical difficulties policing market abuse in many crypto-assets, even with the requisite powers, since much of the exchange trading is concentrated in non-EU jurisdictions, and identifying the underlying owners of crypto-assets, who may hold ‘inside information’ or those malicious actors spreading false information may be hampered by the virtual and, in part, anonymised nature of these assets.149 108. An example of market manipulation of the price of Bitcoin was highlighted in a paper by academics at the University of Texas, published on 25 June 2018.150 The paper investigated whether Tether, a digital currency pegged to the US dollar, influences the price of Bitcoin and found that: Purchases [of Bitcoin] with Tether are timed following market downturns and result in sizable increases in Bitcoin prices. Less than 1 per cent of hours with such heavy Tether transactions are associated with 50 per cent of the meteoric rise in Bitcoin and 64 per cent of other top cryptocurrencies
. […] These patterns cannot be explained by investor demand proxies but are most consistent with supply-based hypothesis where Tether is used to provide price support and manipulate cryptocurrency prices.151 109. In its written evidence to the Committee, Crypto UK noted that the current lack of regulation of crypto-asset exchanges “create[s] an environment where there is a risk to consumer manipulation.”152 Thus Crypto UK argued that pro-actively introducing regulation of crypto-asset exchanges means that “[the] Government can pre-emptively protect consumers against market abuse and exploitation.”153 110. One of the FCA’s three objectives is to “protect and enhance the integrity of the UK financial system.”154 The FCA argued that “the markets need to be supported by resilient infrastructure, with appropriate access and transparency to meet the needs of the consumers, corporates and other wholesale clients that use them.”155
The FCA therefore seeks to ensure that senior management are accountable for the capital market activities, there is a positive culture of proactively identifying and managing conflicts of interest, and firms’ business models, activities, controls and behaviour maintain trust in the integrity of markets and do not create or allow market abuse, systemic risk or financial crime.156 111. 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.
Risks to financial stability 112. In March 2018, the Bank of England’s Financial Policy Committee “judged that existing crypto-assets did not currently pose a material risk to UK financial stability.”157 Martin Etheridge, Head of Note Operations at the Bank of England, elaborated on the Bank of England’s position: From the Bank’s perspective, the primary lens through which we look at this is one of financial stability. […]
[Crypto-assets] are not currently functioning in payments and settlement, so that is not a particular worry. In terms of the linkages with systemically important firms or systemically important markets, right now, those linkages are pretty negligible. The market itself is small in comparison to other large financial markets. In terms of the activities of UK firms, that is also pretty small.158 The Bank of England also emphasised this in its written evidence, noting that “since the peak on 6 January 2018, the crypto-asset market has lost 65 per cent of its value in just 12 weeks […]. Despite this fall, there has been no disruption to the financial system.”159 113. Mr Etheridge said that this view is shared by regulators globally:
[This] is also a position shared by our counterparts overseas as part of the Financial Stability Board, which has reported to the G20 that it does not currently believe there are material threats to global financial stability.160 114. The Bank of England is taking precautionary measures to ensure crypto-assets do not become a risk to financial stability and Mr Etheridge informed the Committee that the Bank of England is “stepping up […] monitoring activity […] [and] will be monitoring the extent to which there is additional take-up for these asset classes.”161 115. Furthermore, Sam Woods, the Deputy Governor for Prudential Regulation and Chief Executive Officer of the Prudential Regulation Authority (PRA), wrote to the CEOs of banks, insurance companies and designated investment firms on 28 June 2018, noting the risks crypto-assets pose and the regulator’s expectations: Crypto-assets have exhibited high price volatility and relative illiquidity […] raise concerns related to misconduct and market integrity [and] may appear vulnerable to fraud and manipulation, as well as money laundering and terrorist financing risks. […] I remind you of your firm’s responsibilities […] to (i) act in a prudent manner; (ii) have effective risk strategies and risk management systems; and (iii) deal with regulators in an open and cooperative way […]162
116. 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. Advertising and investor protections 117. Both ICO issuers and crypto-exchanges use advertisements, including on social media, that highlight the potential for quick returns on investments in crypto-assets. Because neither ICO issuers or crypto-exchanges are regulated, these advertisements are not subject to the FCA’s rules, nor does the regulator have any powers to withdraw a misleading advert. For example, Coinshop, a website that enables users to buy Bitcoin and Ethereum, advertised its services in Easy Jet’s inflight magazine in May 2018 stating that “in 2017 we’ve witnessed the Bitcoin rise from $1,000 to $19,000—a 1800 per cent increase. Millionaires, top level CEOs and wall-street strategists predict that the Bitcoin will increase to levels between a conservative $50,000/Coin to a high of $1,000,000/Coin by the end of 2020.”163 The advert does not mention that the price of Bitcoin fell from $19,000 at its peak in December 2017 to under $7,000 in April 2018.164 The advert also omits investment warnings that past performance is not a reliable indicator of future results, that investments may fall as well as rise, and that the amount realised may be less than the original sum invested. 118. David Geale, Director of Policy at the FCA, told the Committee how the FCA might approach these advertisements were they to fall within the regulator perimeter: If [crypto-assets] were to come into our regulatory remit, I imagine the protection we applied would be similar to that we apply elsewhere. We would look at things like the customers the firms are dealing with, who they are targeting through their marketing, the standards of their marketing, the standards of their disclosures through things like risk warnings, the balance and sufficiency of those, and so on. […] For crowdfunding, for example, we have taken steps to restrict the marketing to people who are inexperienced investors at the outset, to try to stop them putting all their life savings into it.165 119. Izabella Kaminska, Editor of the Financial Times Alphaville, told the Committee that regulating the advertising of crypto-assets, crypto-exchange services, and related products, would be an important step in furthering consumer protection: At the moment, there is a wild west situation with the adverts. They are deployed in a way that presents the impression that it is a one-sided market that will go up and that anyone can make a lot of money very easily. The advertising is prolific as well. It is not in any way catered towards a sophisticated clientele. You see it on the tube. Younger people are being exposed; older people are being exposed. Everybody is exposed at the moment, so that is certainly one area that the Committee should look to.
120. David Gerard, author of Attack of the 50 Foot Blockchain, shared this view and argued that “it would be appropriate to put in place strong consumer protection against misselling crypto-asset enterprises as investments to retail-level investors.”167 121. As well as considering the absence of regulation around crypto-assets for consumers prior to their purchase, the Committee has also considered the implications of the lack of regulation on consumer detriment once the assets themselves have been bought, and how consumers can pursue redress and compensation. 122. This chapter has raised a number of ways in which consumers may experience economic detriment and not be entitled to redress or compensation: • Being mis-sold a crypto-asset that subsequently loses much or all of its initial investment given the price volatility; • Having your crypto-assets stolen through a hack on a crypto-asset exchange; • Losing access to your crypto-assets when you forget the password to your account with exchanges or crypto-asset platforms; and • Investing in an ICO that is later found to have been a fraudulent or mis-sold investment opportunity. 123. Mr Geale emphasised that the usual consumer redress and compensation, that consumers have come to expect from FCA regulated financial services would not apply to unregulated financial activities and products such as crypto-assets: We have to separate the regulated space from the unregulated space. In the regulated space, if it is a regulated firm that has done something wrong, [the consumer] has a right to complain. They complain to the firm. Our rules require the firm to deal with that in a particular way. If they remain unsatisfied, they can go to the FOS [Financial Ombudsman Service]. If the firm has failed and has left a loss on the consumer that is not a trading loss—for example, if the firm has misappropriated client money—they may have a call on the Financial Services Compensation Scheme. In terms of people in the unregulated space, they do not have access to the ombudsman service and they do not have access to the compensation scheme. […] Unless there is some kind of fraud involved or something, their options are very limited.168 124. David Raw, Deputy Director of Banking and Credit at HM Treasury, noted that HM Treasury may consider changing the regulatory perimeter to ensure consumers do have access to mechanisms for redress and compensation: If we discover that there are huge risks to consumers outside the regulatory perimeter where people do not have recourse to the FOS or the FSCS, the answer may well be that the Treasury legislates or takes action to change where the regulatory perimeter is
125. 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 password
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