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Despite their inherent present volatility, cryptocurrencies have shown a unique ability to adapt and survive such setbacks, and it is likely that this will continue to be the case for years to come.
Far from its beginnings back in 2009, cryptocurrency and, in particular, Bitcoin, have become household terms. Despite such a lengthy lifespan however, many questions and confusion still exists with regards to these currencies and the legal framework in which they exist.
As cryptocurrency becomes more widely known and understood, it has been increasingly difficult for governments to ignore and so more and more focus is being given to the legal and regulatory issues which it brings. Combined with ongoing changes in how the underlying operating systems sitting behind different cryptocurrencies work, as well as how widely they are accepted as a means of payment and exchange, it means that the topic continues to feature heavily in the news and is a regular topic of discussion for investors, regulators, politicians, and legal professionals.
Here, we have set out some of the key developments in the world of cryptocurrency that have taken place over the course of the past nine months, and some ideas about what the coming years may look like.
As it presently stands, cryptoassets themselves remain largely unregulated in the UK. The only significant exception to this is the requirement for businesses who carry on cryptoasset activity to be compliant with anti-money laundering regulations and to be formally registered with the FCA in order to operate. Additionally, the acquisition and disposal of cryptoassets may give rise to tax liabilities, including Capital Gains Tax. Certain financial activities such as the management of derivatives limited to cryptocurrencies, as well as the management of Alternative Investment Funds dealing in cryptocurrencies may, however, fall within the remit of existing regulatory requirements and regimes.
Beyond this, there is relatively little by way of formal regulation of cryptocurrencies themselves, but as they continue to grow in use and popularity, the ongoing question for governments to consider is whether to begin to formally regulate these. For the UK, the answer looks to be an unequivocal yes.
In April 2022, then-chancellor Rishi Sunak announced the government’s intention to move towards greater legal recognition of certain forms of cryptocurrency known as stablecoins, in which the value is pegged to another currency or financial instrument (and so in theory more stable in day-to-day transactions). This would, the government stated, help pave the way for stablecoins to be used in the UK as a recognised form of payment, which was in turn planned as part of a series of measures intending to make the UK a “global hub” for cryptoasset technology and investment. Plans were even announced that the government would be working with the Royal Mint on a Non-Fungible Token (“NFT”) of its own, which was described as “emblem of the forward-looking approach the UK is determined to take.”
Even amidst changes in leadership later in the year, the government reaffirmed its pledge to embrace crypto technology by continuing to progress with the implementation of the Financial Services and Markets Bill, which aims to introduce the new regulatory framework for stablecoins. Political changes, therefore, seem to have done little to delay any progress in this area. Long before assuming the role of Prime Minister this year, Liz Truss confidently stated, in a tweet published back in January 2018, that cryptocurrencies should not only be welcomed, but should also be welcomed in a way which “doesn’t constrain their potential.”
Around the same time as these announcements, the Law Commission published a consultation paper in July 2022 setting out provisional proposals to amend the law to ensure that digital assets such as cryptocurrencies and NFTs are both legally recognised and protected. The current reform proposals involving categorising cryptoassets as a new form of personal property known as “data objects”, to allow for a more nuanced set of legal principles which can apply to digital assets separate to those existing forms which apply to physical items and any non-tangible rights (such as a right over land).
The consultation is presently inviting responses and this remains live until 4 November 2022, after which formal policy development will take place and a final report will be issued.
One of the key questions will be what steps are intended to offer consumers protection in using cryptoassets. The government’s Response to Consultation, published in April 2022, confirmed that stablecoins as a means of payment were intended to be brought into the UK’s existing regulatory perimeter, and that a regulatory mandate was to be developed for the relevant governing and regulatory bodies including the Bank of England and the Financial Conduct Authority (“the FCA”). The proposed system would grant the FCA powers over not only stablecoin issuers, but also wallet providers.
Assuming that stablecoins are brought into the remit of the FCA in the manner proposed, then it will likely follow that the issuers and wallet providers will be subject to similar regulatory requirements and approval mechanisms as those currently experienced by traditional financial institutions. This may serve to create a higher threshold of entry for business and firms wishing to issue and manage such cryptocurrencies and other cryptoassets, resulting – theoretically – in a higher level of standards for consumers. Additionally, consumers may receive the benefit of protection and support from the Financial Services Compensation Scheme, so as to provide a safety net against any improper conduct or the failure of any stablecoin issuers or wallet providers.
At present, the move towards regulation is slow and it is likely to be some time before final legislation is passed and the regulators are sufficiently able to announce a series of policy statements and other such measures so as to allow crypto firms to prepare for a regulated market.
From the developments that have taken place this year however, it appears that the government intends for cryptocurrencies and digital assets to have a presence in the future economic landscape of the UK. Exactly how this landscape will look from a regulatory perspective is unclear for now, but the direction of travel is undeniably clear.
In September 2022, a new ‘first’ in the world of crypto occurred, with the reporting of the purportedly first known case of insider trading. As per a press release issued on 12 September by the US Department of Justice confirmed that an individual had pleaded guilty to “one count of conspiracy to commit wire fraud in connection with a scheme to commit insider trading in cryptocurrency assets”. In the case, an employee of a crypto exchange provided his brother with information regarding certain crypto assets which the exchange was planning to list, after which the brother made purchases and trades for those assets ahead of the public announcement.
It would be true to say that the issue here does not rest with the operation of any cryptocurrencies, NFTs or crypto transactions themselves (i.e., there was no attempt to interfere with the underlying operation of the coins and to interfere with any blockchains or transactions), but does strike at the heart of their role as an asset in their own right and the potential for human interference. Whilst it was, on the face of it, a fairly straightforward case of information being obtained through a “friendly contact”, the case will still give regulators issues to consider when considering the question of regulation and the classification of cryptocurrencies as assets.
The present lack of regulation in the UK has also given rise to numerous concerns about what – if any – protection is available to consumers and investors. As of the time of writing, the FCA continues to publicly regard cryptoassets as being “very high risk, speculative investments” and provides a clear warning that “if you buy these types of cryptoassets, you are unlikely to have access to the Financial Ombudsman Service (FOS) or the Financial Services Compensation Scheme (FSCS) if something goes wrong.”
Above all, the FCA’s most important warning is perhaps the simplest: “if you invest in cryptoassets, you should be prepared to lose all your money.”
Many advocates of cryptocurrencies emphasise the fact that they are intended to be used as an unregulated and de-centralised mode of currency, free from the risk of government control and can hedge against inflation and the potential misuse or interference by entities such as banks and other financial institutions. Whilst these benefits remain hotly debated, the fact remains that the risk of consumer harm is high and there is little protection afforded to consumers who may fall victim to one of the many crypto scams which are active. In March 2022, the FCA published a warning about the ongoing operation of illegal crypto ATMs in the UK, and in June they published updated warnings about online investment scams, whereby individuals are encouraged to invest in an opportunity which transpires to be a non-existent crypto asset, or whereby a customer’s account is immediately closed once the payment of the required sum is made to the scammer’s fraudulent investment software.
The UK’s national reporting centre for fraud and cybercrime – Action Fraud – has also previously issued a warning that scammers are increasingly fabricating recommendations from celebrities and high-profile individuals for particular cryptoassets and/or fraudulent investment opportunities.
It is hoped that by introducing a new, regulated framework for the operation of cryptoassets, the risk to the public may be reduced, if perhaps not eliminated. In the meantime however, the fact remains that there is little to readily protect consumers in respect of cryptoasset investments, whether it be from their inherent market volatility or from the potential for crime. Individuals should, therefore, continue to operate with caution when deciding whether to commit to a crypto investment.
Whilst Bitcoin is certainly the most widely known cryptocurrency for now, other coins are also paving the way for new changes and developments in the operation and use of cryptocurrencies and the underlying technology with significant impact.
In September, Ethereum progressed with the next phase of its planned merger with another decentralized ledger. The intention behind the change is to transition the underlying consensus mechanism used to verify cryptocurrency transactions from a ‘proof-of-work’ system to a ‘proof-of-stake’ system.
Under the existing proof of work system, which is one of the most common consensus mechanisms and which is used by cryptocurrencies such as Bitcoin, the validity of coin transactions recorded on a blockchain is determined by way of a series of complex computerised algorithms and codes. These in turn are used to create, in effect, a mathematical puzzle which users can solve to verify the transaction, the act of which is commonly known as “mining”. As different computers and users complete and verify the solution, the consensus serves to act as a verification of the accuracy of transactions recorded on the chain.
The proof of work system is generally considered a robust means to provide security for users, however it is also criticised for requiring significant amounts of computing power in order for the transactions to be verified. This raises concerns about the environmental impact of the technology, along with the potential for technological abuse. Additionally, as more and more users embrace the technology, the size and value of blockchains increase and so the necessary levels of mining and consensus required in order to verify transactions become significant. The risk therefore is that the system can become eventually unsustainable owing to the level of work required to promptly mine and verify the transactions.
In contrast, the proof of stake system introduces a mechanism whereby selected users contribute a “stake” of their own cryptocurrency to a blockchain and then are tasked with validating new transactions, for which they can earn rewards including new cryptocurrency. Once an individual has validated a new set of transactions, other validators can verify the accuracy of the prior verification. Whilst this solution may serve to reduce the risk of the system growing to such levels to prove unsustainable, it does suggest that those users who already own large amounts of a cryptocurrency have greater prospects of being the ones able to engage with the system, stake their own coins and begin the verification process. Equally, the new system was intended to significantly reduce the necessary energy required to sustain the system, with reports indicating the merge was expected to reduce the network’s energy use by 99.5%, and so aiming to alleviate the environmental concerns raised under the previous proof of work system.
Ethereum’s merge into a new model of working may prove to be the next step forward for the technology as a whole, and if so we may see further changes in how other cryptocurrencies operate and how consumers engage with these. A step away from the now-stereotypical idea of users “mining away” with walls of computer nodes may result in the technology taking a step towards being regarded as a more serious enterprise.
Whether other coins will follow Ethereum’s example will remain to be seen, but it is clear that the technology behind crypto remains something which is continuing to grow significantly.
Despite their critics, cryptocurrencies are clearly with us to stay for the foreseeable future in the UK, and the government appears clearly minded to both embrace and encourage the technology.
In 2023, we can expect to receive the outcome of the Law Commission’s consultation and policy development of crypto technology as a legal asset, along with further steps towards implementation of the Financial Services and Markets Bill. The implementation of this Bill may serve to be the first step towards a full regulatory framework for cryptocurrencies and provide the FCA with a significantly extended remit, which may in turn offer consumers greater security and protection. Such security may, in turn, serve to further increase public understanding, acceptance, and confidence regarding the use of cryptocurrencies as assets and, in turn, as a means of conducting day-to-day transactions similar to that being seen in other countries.
At the same time, we can expect to see continued changes and developments in how different cryptocurrencies operate and the systems used to support them. The Ethereum merge may prove to be a benchmark for future currencies, and an ongoing successful implementation could bring with it a new contender for Bitcoin’s crown as the most commonly-adopted cryptocurrency.
In terms of the public acceptance of cryptocurrency, it is likely we will continue to see efforts made to encourage this through further use of advertising campaigns presently involving celebrities and well-known figures such as Matt Damon and Mike Tyson. The public acquisition and disposal of cryptoassets by companies such as Tesla may also go some way to increasing a cryptocurrency’s own particular brand or reputation, further legitimising these as a genuine (if unpredictable) source of investment.
In the end, it may be the markets themselves which help determine the overall future of cryptocurrencies. A continued series of publicised “crashes” may serve to harden the views of many that Bitcoin and other such currencies are doomed to fail, leading to a reduction in their overall public acceptance, and so the legal and regulatory focus may in time become less significant. However, the resilience of cryptocurrency as a technology itself suggests that, regardless of what market fluctuations may take place in the coming years, there will still remain a firm place for cryptocurrencies in the UK’s economy.
At Freeths, we have experience in advising businesses adopting, trading and offering cryptocurrencies and crypto technology. We are able to advise on the current regulatory requirements which firms may need to consider before dealing with crypto, as well as providing risk management advice about crypto-related business ventures that may be being considered. Our team is also able to advise on tax planning and the tax implications that acquiring, holding and disposing of cryptoassets may bring.
To organise a free, no-obligation discussion with one of our specialist lawyers, please contact Adam Edwards, Daniel Seely or Daniel Meyer and we will be happy to talk you through your options.
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Author: Adam Edwards
Partner & Head of Financial Services
Author: Daniel Seely
Associate
Author: Daniel Meyer
Associate
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