Alan Hughes: Can ‘Ethereal’ Crypto Market Really Be Regulated?

HM Treasury published its consultation on the future regulatory regime for cryptoassets earlier this month. Given the recent collapse of FTX, this is well timed.

Although it is not easy to find reliable statistics on the level of crypto ownership in the UK, it is estimated that several million adults here own such assets, with higher ownership levels among younger adults.

By regulating it, you risk making it seem more “mainstream” than it should be

Why is this relevant to financial advisors? Well, while there appears to be little appetite for mainstream advisors to get involved in crypto, given the current level of investment, it appears that more mainstream investments are “competing” with crypto for investors’ money.

Senior figures at the Financial Conduct Authority have previously raised an important conundrum around crypto (as opposed to investment as opposed to other purposes) and regulation – by regulating it you risk making it appear more “mainstream” than it should be, given its underlying volatile and high-risk characteristics.

However, the downside is that by leaving it largely unregulated, you have little control over the crypto market and potentially expose more people to the risks associated with it.

If it can be made to work, why reinvent the wheel?

The government also seems keen to make the UK a preferred destination for crypto firms, as they see opportunities to do so (although, if we’re talking about crypto as an investment, I’ve never been quite sure what those opportunities is in the longer term).

And so the decision has been taken, it should be regulated and the treasury hearing describes how the government proposes to do it.

Some of the most interesting issues to emerge from the consultation are as follows:

• The intention is, where possible, to use the existing regulations to regulate activities around crypto. This makes sense. If it can be made to work, why reinvent the wheel?
• The underlying principle is “Same risk, same regulatory outcome”. Again, absolutely correct, but given the massive volatility of the crypto market, this may mean that the “target market” will be severely limited.
• 85 percent of crypto firms that attempted to “register” with the FCA to combat money laundering following new legislation in 2020 failed to meet the requirement, with the regulator being quite harsh on the quality of applications. Assuming the bar will be higher for full authorization (and the consultation indicates it will), how many firms will actually be able to clear this bar?
• One of the most interesting proposals is that those platforms, etc., offering crypto-trading facilities must publish detailed disclosure (including “features, prospects and risks”) about crypto-assets offered/issued, similar to what is required in a prospectus or information memorandum (for shares etc.). It will be fascinating to see what “detailed information” is revealed in relation to crypto. What about the underlying asset value of a new crypto asset?

Consider this question in light of the following from the consultation note:

“Despite parallels to existing investment advisory activities, there are important differences. The UK’s current investment advice regime requires regulated advisers to be experienced, competent and qualified and to assess the suitability of an investment before making a recommendation. However, the price and value of an unbacked crypto asset is driven by speculative investment decisions, rather than market fundamentals that can be assessed objectively.

“This is in contrast to traditional financial assets; even for high-risk investments such as illiquid securities, advisors at least have the experience and qualifications to perform due diligence on the corporate issuer (e.g., by assessing projected growth plans). It would be very difficult to require an investment adviser to meet these criteria for investment advice for cryptoassets.”

Robust regulation in the style proposed could severely limit the opportunities for market development

This explicitly acknowledges that the crypto market is entirely based on sentiment and offers no suggestion of what would constitute “competence” to advise on it.

In principle, any firm offering crypto services to UK consumers, whether from the UK or from abroad, will need to be approved by the FCA. Given the “ethereal” nature of this market, enforcement may prove difficult.

The development of the regulatory approach to crypto will be interesting to follow. In some ways, robust regulation of the style proposed could severely limit the opportunities for crypto market development – ​​for example, by making the risks much more apparent than they are now.

Will more or fewer people hold crypto once regulation is established and what impact will this have on the mainstream investment market, alongside the FCA’s other initiatives around simplified advice?

Alan Hughes is a partner at Foot Anstey law firm