Meet The Members Europe – Regulation of digital currencies in the UK

What is a digital currency? On the one hand, a great deal of the money in our economy is digital. Numbers on balance sheets and bank ledgers move around the world with no actual physical paper exchanging hands. However, the value of the currencies is protected to a significant degree by the assets of the governments which back them. It is confidence in the underlying strength of certain economies, which have made currencies such as the US dollar and the Euro among the preferred currencies in international trade.

Some cryptocurrencies called stablecoins have tried to pursue price stability by maintaining reserve assets (including property or gold) as collateral, but further regulation will be required before there is a high level of confidence that the relevant collateral is sufficient to protect investor interests in the majority of cases.

Bitcoin is the most widely used digital currency, but its value is highly volatile. The coin’s value increased by more than 10x between March 2020 and April 2021 during the height of the Covid-19 pandemic but then halved again between April and June 2021. ‘Stability’ is supposed to be maintained due to the difficulty of finding or ‘mining’ additional coins.

New bitcoins are generated through the successful calculation of the next sequence in a complex algorithm. Huge amounts of computing power are deployed to try and generate the next sequence in the algorithm and ‘mine’ the next coin. Environmental campaigners point out that in a world where we are trying to reduce carbon emissions, generating electricity in an endeavour which gives rise to no ‘real’ economic activity is not a sustainable financial model.

“Cryptocurrency evangelists propose a world where a decentralised finance system liberates money from political control by governments or specific individuals.”

So, why are advocates so keen on cryptocurrencies?

Cryptocurrency evangelists propose a world where a decentralised finance system liberates money from political control by governments or specific individuals. Furthermore, if governments do not control the movement of money, businesses and individuals may be able to avoid the tax half of the axiom that “the only things in life which are certain are death and taxes”.

The holy grail of a decentralised finance system relies in part on the replacement of the traditional banking system with distributed ledgers, where each transaction has a unique encryption code and all stakeholders have copies of the ledgers, making it extremely difficult to generate a false ledger which agrees with every other corresponding ledger.

It sounds interesting but imagine the vast computing power required for every financial transaction to be held on millions of separate ledgers with each line encrypted. On the assumption that such computing power is not readily available in the medium term, the counter-suggestion is that ‘trusted organisations’ would hold the master ledgers. Problem: investors, consumers and all users of a financial system or organisation would need a high level of trust in the security of those ledgers and the trustworthiness of the ‘trusted organisations’ – and this is where the perceived requirement for governments to regulate those trusted organisations and the security of their systems comes back into focus.

Regulation vs Innovation

Governments around the world are rushing to try and regulate emerging financial markets, without appearing closed to the economic advantages of innovation. The UK’s focus in common with other major economies is to strengthen its position as a leader in FinTech, recognising that sound regulation will be required (a) to secure trust from institutional investors and consumers, and (b) to address the potential for unregulated financial instruments to facilitate crime and money laundering. On the regulatory side of the equation, January 2020 saw crypto-asset exchanges and wallet providers in the UK become subject to a statutory obligation to conduct anti-money laundering checks on all users of their services.

“The holy grail of a decentralised finance system relies in part on the replacement of the traditional banking system with distributed ledgers.”

In April 2022, the UK Treasury committed itself to introduce a new regulatory regime for crypto-assets. That consultation paper (the Paper) was published on 1 February 2023. It focuses on a proposed framework for crypto-assets used within financial services, with the aim being to regulate the businesses that conduct crypto-asset-related activities rather than the underlying assets themselves.

The intention is to create several new regulated or designated activities tailored to the crypto-asset market where these activities resemble regulated activities performed in traditional UK financial services. These would include:

• Operating a crypto-asset trading venue (such as FTX)

• Dealing in crypto-assets as principal or agent

• Facilitating crypto-asset deals

• Operating a crypto-asset lending platform

• Using crypto-assets to facilitate payments for goods and services.

Firms which intend to undertake one of these new activities (including firms already authorised to provide more traditional financial services) would be required to apply for FCA Regulation under the Financial Services and Markets Act 2000. We are told that the grant of new or additional authorisation will depend on the organisation being able to demonstrate the acceptable level of operational resilience and data reporting requirements felt to be required to support the liabilities that businesses would owe to their customers. The regulations will be extraterritorial, thereby helping to avoid a situation where businesses seek to move offshore to evade UK regulations.

The Paper also proposes requirements for a market abuse regime, a principal aim of which will be for regulated businesses to anticipate and mitigate against “pump and dump” schemes, whereby a new coin emerges with no real substance, stays in the market for a limited period and enables a minority of investors to make huge amounts of money before the coin then collapses and becomes valueless.

 The Paper also asks interested stakeholders to provide evidence about the operation of a decentralised financial system and the sustainable regulation of crypto-assets. The consultation will close on 30th April 2023. Further regulations are anticipated at the end of that consultation period. Watch this space.