Cryptocurrency: is UK regulation on the horizon?

Cryptocurrency has been hailed by its proponents as the future of finance. However, the volatile nature of cryptocurrencies as demonstrated by the fluctuations in the value of Bitcoin, and suggestions that they are used for illegal activities, has drawn the attention of regulators and governments both in the UK and abroad.

What is it and how does it work?

Each cryptocurrency will operate in slightly different ways. However, fundamentally, it is virtual money, which is not issued or backed by a central bank or government.

Cryptocurrencies use decentralised technology to allow users to make payments and store money anonymously. The currencies run on blockchain technology, a distributed public ledger, which contains a record of all transactions held by its users.

As the currencies utilise cryptography to secure them, transactions cannot be falsified. Cryptocurrencies tend to have low fees and are widely available without the need for using a traditional bank. They are, however, known to be very volatile.

It is estimated that there are now more than 1,000 cryptocurrencies available on the internet. They are commonly associated with investment, however some retailers have accepted payments in them as an alternative to standard currencies.

Alongside the longer established cryptocurrencies such as Bitcoin, Ethereum, Ripple and Litecoin, another important part of cryptocurrencies are Initial Coin Offerings or ICOs through which new currencies are launched.

ICOs are a form of crowd-funding mechanism and have some parallels with traditional Initial Public Offerings (IPOs). It is a way to raise money for a company or project, often at a very early stage of development. There are examples of ICOs raising millions of dollars, despite there being no substantive business behind them.

Regulation

The anonymous nature of the cryptocurrencies has raised regulators’ concerns due to its potential abuse for illegal activities, such as money laundering and tax evasion. Moreover, due to the decentralised nature of the blockchain technology underpinning the currencies, there are issues as to under which jurisdiction cryptocurrencies operate.

In addition, as cryptocurrencies become more widespread and more accessible to a greater number of investors, the issue of consumer protection has come onto the agenda. Aside from the regulatory efforts, there are examples of companies seeking to protect consumers, for example Facebook has banned all adverts for Bitcoin and ICOs due to fears of many being scams and Lloyds Bank has banned all of its credit card users buying cryptocurrencies using its cards.

Overseas regulation

Overseas regulators have started to take active steps in respect of cryptocurrencies.

In the US, where Bitcoin is traded as a commodity, the Commodities Futures Trading Commission issued subpoenas to a major Bitcoin exchange and Tether (another cryptocurrency) due to transparency issues regarding their actual financial positions.

US regulators have also taken steps in relation to ICOs, by issuing court orders. In January 2018, the US Securities and Exchange Commission (SEC) blocked a US$600 million ICO by Arise Bank in Texas. The SEC stated that the ICO was fraudulent. The SEC also issued cease and desist orders against the UK based Bitconnect, due to a lack of business transparency and because it was widely viewed as a Ponzi-scheme.

In South Korea, regulations have been issued to ban anonymous cryptocurrency trading and Japan has taken steps towards national regulation. Further, coordinated regulation for cryptocurrencies is on the agenda for the G20 summit in Argentina later this year.

UK regulation

Cryptocurrencies remain unregulated in the UK and regulators appear to have been less active than those overseas so far.

The Financial Conduct Authority (FCA) issued a Consumer Warning on ICOs on 12 September 2017, describing them as “very-high risk, speculative investments” and stated that the majority of ICOs will be unregulated. However, the FCA will consider ICOs on a case by case basis as to whether regulated activities are involved.

The FCA also issued a Consumer Warning in relation to Contracts for Differences (CFDs) or financial spread bets on the value of cryptocurrencies on 14 November 2017. The FCA also described CFDs as “extremely high-risk”. Contrary to ICOs, the FCA does regulate CFDs. Therefore, firms offering CFDs must be authorised by the FCA. However, the FCA warned that only experienced and sophisticated investors should consider investing.

In February 2018, the formation of the UK’s first trade body of crypto companies – CryptoUK - was announced with the stated aim of introducing self-regulation to the sector by introducing a code of conduct. It is not yet clear what the FCA’s response to self-regulation will be, however the body will be able to lobby on the industry’s behalf. Its remit will not, however, extend to ICOs.

The Treasury has announced plans to regulate traders of cryptocurrencies, forcing them to disclose their identities and report suspicious activities. Also, there have been discussions at an EU level regarding amending the Anti-Money Laundering and Terrorist Financing regulations to extend these to virtual currencies in Spring 2018. The EU's banking, securities and pensions watchdogs all warned in February that cryptocurrency investors could lose all their money as Bitcoin enters a "pricing bubble".

On 22 February 2018, the Treasury Select Committee announced an inquiry into digital currencies and distributed ledger technology (blockchain technology). This is said to arise in particular due to concerns over cryptocurrencies increasing “market volatility, money laundering and cybercrime”. This may lead to future regulation.

Comment

The regulatory response to cryptocurrencies has not been uniform. However, their growing popularity and evidence of illegal activities has resulted in recent regulatory activity, including in the UK.

There are recent examples, notably in the US, of lawsuits being brought against companies where there have been ICOs which allegedly involve violations of securities laws, including litigation on the key issue of whether cryptocurrencies are in fact securities and thus need to be registered with the SEC. There is a risk that there could be investor claims in respect of cryptocurrencies and/or ICOs. These claims could potentially be caught under D&O, E&O, cyber liability and crime covers.

Notwithstanding the risks, it has been recognised by governments, regulators and financial institutions that the blockchain technology underpinning cryptocurrencies could have wider application in the financial sector. Indeed one potential use is for insurance claims processing.

Cryptocurrencies and blockchain, in particular, could have a significant impact on the future claims environment and it will be important to be aware of how national and international regulators respond to these and other developing technologies.

Read other items in the Professions and Financial Lines Brief - March 2018