Following its commitment within the report issued on 30 October 2018 by the UK’s Cryptoassets Taskforce, on 23 January 2019 the FCA issued a Consultation Paper (“CP 19/3”) setting out draft regulatory guidance in respect of the UK regulatory perimeter applicable to cryptoasset tokens.
The Draft Guidance
CP 19/3 sets out the FCA’s view regarding whether cryptoasset tokens are likely to be:
- “specified Investments” under the UK Regulated Activities Order 2001 (the “RAO”);
- “financial Instruments” under the Markets in Financial Instruments Directive II; or
- “E-Money” under the E-Money Regulations.
Categorisation of Exchange Tokens
Exchange tokens (i.e Bitcoin, Litecoin etc.) are not issued or backed by any central authority and can be used directly as a means of exchange. Exchange tokens have been referred to in other frameworks as: ‘crypto coins’, ‘payment tokens’, ‘cryptocurrencies’, and are usually decentralised. These exchange tokens can be used independently of a platform and are not limited to use within a specific network or only for goods and services offered by a specific issuer.
Exchange tokens typically do not grant the holder any of the rights associated with the specified investments within the FCA’s perimeter. This is because they tend to be decentralised, with no central issuer obliged to honour those contractual rights.
As such, the FCA has confirmed in CP 19/3 that (i) exchange tokens fall outside the UK regulatory perimeter as neither a specified investment, financial instrument nor as E-Money; and (ii) if an exchange only facilitates transactions in exchange tokens between participants, this exchange does not carry out an FCA regulated activity.
Categorisation of Security Tokens
Security tokens typically include tokens that grant holders some, or all, of the rights conferred on shareholders or debt-holders, as well as those tokens that give rights to other tokens that are themselves.
As such, the FCA’s view is that security tokens can meet the definition of a specified investment, and possibly also a financial instrument
CP 19/3 sets out the FCA’s view of which are the most relevant of the classes of specified investments applicable to a security token (principally share, debt instrument and unit in a collective investment scheme), and supports this with case studies.
Case study for a security token to be viewed as a “share”
Firm AB issues tokens that provide the token holder with a share of the company’s profits to be paid annually. The tokens also provide the holder with voting rights. The tokens are structured so they can be easily transferred between two individuals and a change of ownership can be recorded. The tokens can also be traded on cryptoasset exchanges.
In the FCA’s view, this token confers rights similar to those given by shares and is likely to be considered a specified investment. The negotiability suggests that this token will also be considered a transferable security and so a financial instrument under MiFID II.
Case study for a security token to be viewed as a debt instrument
To generate working capital, company GH issues tokens that grant holders the right to be repaid their investment in full by a certain date and also entitle holders to regular payments of interest on the capital amount. The GH tokens are freely traded on cryptoasset markets.
In the FCA’s view, these tokens are likely to be considered instruments that create or acknowledge the debt owed by the issuer to the token holder and are therefore likely to qualify as debt instruments. Because they are negotiable on the capital market, they are also likely to constitute transferable securities under and so financial instruments MiFID II.
Case study for a security token to be viewed as a unit in a collective investment schemes
Firm IJ invests in fine art using the funds it receives and pools from investors and hires it out for use at corporate events for a fee. It issues tokens to investors in proportion to their contributions. These tokens also entitle the investors to receive a share of the fees generated by the art rental, and the profits it makes when it sells the art from time to time. The token holders have no day to- day control over the art or the rental fees. The token holders’ contributions are pooled, so are the rental fees and profits from art sales, and the art is managed as a whole by IJ.
In the FCA’s view, the tokens that represent the participants’ share in the investment are therefore likely to constitute units in a collective investment scheme.
Categorisation of Utility Tokens
Utility tokens provide consumers with access to a current or prospective service or product and often grant rights similar to pre-payment vouchers. In some instances, they might have similarities with, or be the same as, rewards-based crowdfunding. Here, participants contribute funds to a project in exchange, usually, for some reward, for example access to products or services at a discount.
In the FCA’s view, as utility tokens do not typically exhibit features that would characterise them as specified investments or financial instruments, they will not be captured in the UK regulatory regime, unless they meet the definition of “e-money”.
E-money is electronically stored monetary value as represented by a claim on the electronic money issuer which is:
- issued on receipt of funds for the purpose of making payment transactions;
- accepted by a person other than the electronic money issuer; and
- not excluded by regulation 3 of the E-Money Regulations.
In the FCA’s view, exchange tokens like Bitcoin, Ether and other equivalents are unlikely to represent e-money because, amongst other things, they are not usually centrally issued on the receipt of funds, nor do they represent a claim against an issuer.
The confirmation from the FCA that exchange tokens are currently outside of UK regulation, and that this will continue, should be welcomed by market participants. By contrast, the position of ESMA is more conservative, recommending that the position of exchange tokens as falling outside of the scope of EU regulation should be reviewed, with a view to possibly categorising them as financial instruments under MiFID II. It remains to be seen if this divergence increases post-Brexit.
The FCA’s pragmatism in its categorisation of security tokens is welcome, with an acceptance that security tokens do not automatically fall into a specified investment or financial instrument definition.
The FCA is asking for comments onCP19/3 by 5 April 2019.
1) Please see our November 2018 OnPoint in relation to this: "UK's Cryptoassets Task Force Delivers Latest Report – Consultations Pending But No Bans Yet"
2) FCA Consultation Paper CP19/3, January 2019