Cryptoassets Taskforce report on the UK's approach to cryptoassets and DLT in financial services
Policy and regulatory implications
02 November 2018
The UK Cryptoassets Taskforce Report examines the policy and regulatory implications of cryptoassets and distributed ledger technology (DLT) and sets out risks and opportunities they present. The Taskforce itself was set up in March 2018 and comprises HM Treasury, the Financial Conduct Authority and the Bank of England. The Report concludes that while DLT is at an early stage of development, it has the potential to deliver significant benefits in financial services and other sectors, and the Taskforce will continue to support its development, while trying to mitigate risks to consumers and market integrity and cryptoassets' use for illicit activity.
Enhanced resilience and efficiency gains in financial services
"DLT has the potential to enhance system resilience; improve the efficiency of end-to-end settlement processes and reporting, auditing and oversight; and enables greater automation".
The Taskforce identifies enhanced resilience as a key potential benefit that DLT platforms can offer to the financial industry. Maintaining copies of data that are recorded and accessed by multiple participants reduces the impact of data loss by one participant. Moreover, network consensus may foster cyber resilience, as an attacker would have to take control of multiple participants to control the network.
Moreover, DLT could lead to more efficient end-to-end settlement process, as participants access the same, distributed and yet synchronised data which eliminates the need to costly and slow reconciliation processes between platforms.
It can also render reporting and oversight within and between financial institutions, or between financial institutions and regulators, more efficient. For example, regulators could be granted access to retrieve data stored on DLT ledgers, allowing them to access one accurate and verifiable ledger in real-time.
Challenges associated with the use of DLT
"DLT is still a relatively young technology and there are several challenges which must be overcome before it can be deployed at scale in financial services"
Despite a broad range of use cases, the Report notes that DLT is still a maturing technology which has to overcome several challenges before being employed at scale in financial services. These challenges include trade-offs in the design of DLT platforms and other barriers to the wider adoption of DLT.
Design choices made by DLT developers often lead to important trade-offs that must be made between some of the features of DLT platforms. Some of the key trade-offs are between performance (for example, transaction capacity and scalability), resilience and privacy. For example, developers could limit the distribution of data to resolve privacy concerns. However, this may in turn reduce the potential resilience of the platform, as there is no longer a common shared ledger held by each participant. Technical advancements are needed to prevent these trade-offs from occurring or minimise their impact.
A potential barrier to the wider adoption of DLT lies in the interoperability of systems. In particular, coordinated technology standards would need to be developed and adhered to in order to realise the benefits DLT can offer across different platforms. The International Organisation for Standardisation (ISO) has started to develop a set of standards which should be adopted in different jurisdictions to deal with the interoperability issue.
A wide adoption of DLT may also lead to competition concerns. If a closed or permissioned DLT network developed to become essential infrastructure (for example in clearing and settlement), competition concerns might arise around access – DLT accessibility might become a market entry barrier.
Further, the application of DLT might also pose challenges with respect to data protection (in particular, the General Data Protection Regulation (GDPR)): GDPR establishes a right to have one's information erased, which might cause tension with core features of some DLT networks which offer immutable data storage and involve greater levels of transparency than the GDPR permits. However, some DLT platforms have already claimed to provide a more efficient way of complying with GDPR requirements by, for example, only sharing selective data.
Impacts of cryptoassets
"The Taskforce has concluded that if benefits develop in the future, they are most likely to materialise through the use of ICOs as a capital raising tool...However, without appropriate protections, [benefits arising from ICOs are] potentially to the detriment of consumers"
The Report concludes that cryptoassets can lead to more efficient and cheaper transactions when used as a means of exchange (for example, in micro-payments, simultaneous exchange and international transfers), given that fewer intermediaries are involved.
Further, when used for investment, proponents suggest that cryptoassets can widen access to new and different types of investment opportunities. However, the Taskforce states that this broad access is likely to expose consumers to inappropriate levels of risk and to exacerbate risks associated with the use of cryptoassets for illicit activities. The Taskforce's stakeholder engagement considers the risks to outweigh the potential benefits in this instance.
The Taskforce considers that the most important benefit of cryptoassets lies in ICOs as a capital raising tool, as they have the potential to support innovation (by funding new, innovative business models, products and services) and competition, to improve efficiency by linking cryptoassets issuers with investors, to fill the financing gap for high-risk, high-reward investments, and to unlock new sources of capital.
However, without appropriate protections, consumers might be exposed to excessive risks, since they might be lured into buying unsuitable products, face large losses, be exposed to fraudulent activity, struggle to access market services and be exposed to the failings of market providers.
Other risks include financial crime (as cryptoassets might be used for anti-money laundering, terrorist financing or cyber-attacks given its pseudo-anonymous nature), consumer losses or damage to confidence in the market due to a lack of market integrity (e.g. due to weak systems and controls and a lack of transparency) arising from market immaturity, and it might endanger financial stability given cryptoassets' price volatility.
The Taskforce's response
"Activities to [cryptoassets which have features comparable to specified investments but are structured in such a way that they avoid regulation] should be regulated in order to protect investors, eliminate fraudulent activity and ensure market integrity"
The Taskforce will take action to mitigate the risks that cryptoassets pose to consumers, eliminate fraudulent activity and ensure market integrity, by, for example, regulating the issuance of cryptoassets that have features comparable to specified investments (such as shares or units in a collective investment scheme) but are structured in such a way that they currently avoid regulation.
It will also to aim to prevent the use of cryptoassets for illicit activity by broadening the scope of anti-money laundering (AML) and counter-terrorist financing (CTF) regulation – thereby going beyond the requirements set out in the EU Fifth Anti-Money Laundering Directive (5MLD), which only brings fiat-to-cryptoasset exchange firms and custodian wallet providers within the scope of AML/CTF regulation – to cover all relevant cryptoasset firms. It will in particular consult on including exchange services between different cryptoassets, platforms that facilitate peer-to-peer exchange of cryptoassets, cryptoasset ATMs and non-custodian wallet providers that function similarly to custodian wallet providers.
Crucially for the derivatives industry, the Taskforce will also consult on regulating financial instruments that reference cryptoassets. The FCA has already taken action where harm has been done relating to sale, marketing and distribution of particular derivative products by imposing temporary interventions – but it will implement its own permanent domestic interventions in due course. For example, the FCA has supported ESMA's restrictions on sale to retail consumers of contracts for difference (CFDs) referencing cryptoassets. These restrictions include limiting leverage on such products to 2:1, reflecting the high price volatility of these instruments. The FCA will also consult on a prohibition of the sale to retail consumers of all derivatives referencing exchange tokens such as Bitcoin, including CFDs, futures and options. The potential prohibition would not however cover derivatives referencing cryptoassets that qualify as securities.
The Taskforce stated that it will encourage the responsible development of legitimate DLT and cryptoasset-related activity in the UK, highlighting the FCA's technologically neutral approach to regulation, and committed itself to continue to provide a platform for innovation to encourage the development of new technologies to support a dynamic financial system.
International coordination to shape future regulatory approaches
"The UK government, the FCA and the Bank of England recognise the importance of international coordination in shaping the future regulatory approaches and to this effect will continue to engage internationally through a range of fora"
The UK government is also acting to support DLT in and beyond financial services. For example, it has invested over £10m through Innovate UK and the research councils to support a diverse range of DLT projects. It also created a £20m GovTech Catalyst Fund to explore technology-based solutions for public sector challenges, potentially including the use of DLT.
The UK government, the FCA and the Bank of England recognise the importance of international coordination in shaping future regulatory approaches and will continue to engage internationally through a range of fora. The UK intends to continue to be a leading voice in discussions on cryptoassets at G20 and G7 level as well as with the Financial Action Task Force (FATF), who sets the global standards on AML/CTF. UK authorities will continue to engage in discussions at the European level and collaborate with other overseas regulators and related organisations. Existing collaboration between the FCA and other regulators has already led to publication in August 2018 of a consultation paper on creation of a Global Financial Innovation Network, with one of the proposed aims being to provide a forum for joint work and discussions on innovative technologies such as DLT and cryptoassets.
In conclusion, the UK authorities will continue to support development of DLT, monitor market developments and work with international counterparts to consider appropriate domestic and international responses to DLT and cryptoassets, while taking action to mitigate risks to consumers and market integrity and prevent cryptoassets' use for illicit activities.
Written by Yana Papst, Trainee Solicitor