This blog post was first published by Compliance Monitor on March 14, 2022.

Regulation of cryptoassets has long been near the top of the UK’s regulatory agenda.  Despite only being a few weeks in, 2022 has already seen what are, perhaps, the most drastic proposals for regulation yet: a three-fold process, under which first, the UK Treasury wants to bring cryptoassets within the remit of the Financial Conduct Authority’s (“FCA”) rules governing financial promotions; second, restrictions are applied to the types of consumers that can be targeted for investment; and third, tightening up how promotions are allowed to work in practice.  This new regime is outlined in a Consultation Paper (the “Paper”) published by the FCA on 18 January 2021.

But is the crackdown all it’s cracked up to be?  Despite the FCA’s stated position that it wants to help the nascent industry flourish and avoid unnecessarily restrictive regulation, there is a real risk that the new rules could suffocate the market while simultaneously failing to address the underlying issues which go hand in hand with an unregulated asset class.

Part one: expanding the Financial Promotion Order

The first step in the crackdown is the Treasury’s intention to introduce new legislation that would bring qualifying cryptoassets within the scope of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (“FPO”). This will result in the promotion of cryptoassets being regulated by the FCA.  The move has been precipitated by a concern that has loomed over regulators for some time: that any individual, no matter their familiarity with high-risk financial products, can put their money into the market.  A report published in October 2018 by the UK Cryptoasset Taskforce highlighted the harm caused to consumers who purchase highly volatile and potentially unsuitable cryptoassets without fully understanding the financial implications.  Regulators have puzzled over how to address the disconnect between the true risk tolerance of investors – how much money they can afford to lose – and the inherent risks involved in holding cryptoassets.

Bringing cryptoassets under the banner of the FPO is intended to close that gap, so investors are better protected.  Crucially, it means that promotions of cryptoassets can only be communicated or approved by an FCA authorised firm under section 21 of the Financial Services and Markets Act 2000 (“FSMA”).   A breach of this requirement amounts to a criminal offence.  Promotions which fall under the FPO would are required to be “clear, fair and not misleading”. 

Given that most firms dealing in cryptoassets do not, at present, have FCA authorisation, this presents a challenge, and there is a lack of clarity in the Paper as to how it will work in practice.  The Paper does suggest that new legislation could be passed to allow authorised firms to approve promotions for unauthorised persons.  In reality, this will be difficult. Not many authorised firms will have the requisite knowledge in cryptoassets to sign off on promotions and those that do may be reluctant to use their authorisation to approve the promotion of a high-risk product marketed by a separate firm.

Part two: restrict investment

Secondly, and as part of a broader effort to simplify and streamline its rules on restrictions on financial promotions, the FCA intends to create a new, three-tiered system to categorise types of investments.  Once cryptoassets are brought within the FPO, the Paper indicates that they will fall into the middle category, which is to be known as “Restricted Mass Market Investments” (“RMMIs”). 

Under the new proposals, RMMIs can still be mass-marketed to consumers as long as certain conditions are satisfied (discussed below).  However, the direct offer – that is, where a financial promotion specifies how a consumer should respond – of RMMIs is limited to individuals who are classed as high net worth individuals, sophisticated investors, or restricted investors.  Such direct offers will also need to comply with the FCA’s rules on appropriateness which, broadly, require a firm to consider the investor’s knowledge and experience in the relevant field to assess whether a product is appropriate for that person.

This is, of course, a drastic departure from the status quo and has the potential to dramatically reduce the number of people able to invest in cryptoassets, with the obvious knock-on effect that the market risks being starved of capital.

Part three: fair promotion

The third and final part of the proposals, however, looks more promising in its ability to strike a balance between consumer protection and allowing the industry to thrive.  By bringing cryptoassets within the scope of the FPO and subsequently classifying them as RMMIs, they would be subject to a variety of new rules which the FCA proposes to introduce to regulate financial promotions.  As well as needing to be approved by an authorised firm, described in more detail above, the proposals would require that, in mass-marketing cryptoassets, firms are prevented from offering incentives to invest (for example, with “refer a friend” schemes or the offer of new joiner bonuses), and ensure that the promotion contains clear messaging about the financial risks involved.  The FCA suggests replacing the bland “Capital at risk” warning, which it claims is often not taken seriously by consumers, with clearer language warning that an individual may lose all of the money invested.

Meanwhile, where financial promotions are directly offered to a consumer, the firm will have to introduce “positive frictions”, such as 24-hour cooling off periods for first-time investors and links to pop-up risk warnings, before an investment can be made.

When combined, these rules will likely go some way in ensuring that consumers are made aware of the risks involved before investing in cryptoassets. 

A possible patchwork of regulations

It is crucial to point out though, that these changes have no impact on the regulatory status of the cryptoassets and the underlying investment activity. Cryptoassets will remain unregulated and trading in them will still be an unregulated activity.  Aside from a subset of firms – those which exchange cryptoassets for money, or other cryptoassets – needing to comply with current anti-money laundering regulations, there is no broader regulatory oversight of the industry.  A lack of transparency in the market means that allegations of conflicts of interest abound; there are no rules prohibiting market abuse; and consumers are not covered by the FCA’s compensation regime.  The Paper does not seek to address any of these broader issues.

This throws into sharp relief a long-standing concern: that the FCA reacts to significant changes in the sector slowly and in a piecemeal fashion, thereby creating an incoherent patchwork of old and new regulations that is simply not fit for purpose.  By attempting to shoehorn cryptoassets into an existing regulatory framework – rather than creating a new regime specifically for this asset class – there is a risk of over-regulation in some areas, and under-regulation in others.  It seems counterintuitive to place such stringent restrictions on how products are promoted, and by extension who can participate in a market, while fundamentally failing to address the underlying dangers inherent in trading in an unregulated market.

Tinkering around the edges?

The FCA is at pains throughout the Paper to emphasise that it does not want to stifle innovation and competition within the market by imposing rules that are unduly restrictive. However, there is a real risk that that will be the inevitable outcome of the new proposed RMMI classification. Rather than erecting such barriers to entry and potentially starving the industry of capital, and thus a future, in the process of doing so, the FCA’s time may be better spent by taking a closer look at how it can regulate cryptoassets themselves to create a transparent and well-functioning market.