Crypto exchange regulation in the UK and mitigating risk

Crypto exchange regulation in the UK and mitigating risk

The UK is the biggest crypto market in Europe with US$170bn of cryptocurrency transactions in the year to June 2021, according to Chainalysis. Crypto trades are split roughly equally between centralised services such as crypto exchanges and decentralised finance (DeFi).

Bitcoin makes up 27% of crypto transactions in the UK by value, while Ethereum and wETH make up 40%. Bitcoin is still more commonly held among the public (see below), but the growth of the DeFi sector is driving Ethereum volumes. The remainder of crypto transactions are in various stablecoins and altcoins.

The UK ranks third in the world for grassroots DeFi adoption, with Chainalysis estimating that retail users sent roughly US$3.3bn in cryptocurrency value to DeFi during the year to June 2021.

UK regulator, the Financial Conduct Authority (FCA) estimates that 2.3 million British consumers own cryptocurrency, with an average holding of £300, based on a survey carried out in 2021. Two-thirds of crypto users in the UK hold Bitcoin, according to the same survey data, followed by Ethereum (35%), Litecoin (21%), XRP/Ripple (18%) and Bitcoin Cash (15%).

There are roughly 40 FCA-regulated crypto asset businesses in the UK, including five retail-focused crypto exchanges:

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Current crypto exchange regulatory landscape

The British government has said that it wants to make the UK a global hub for crypto businesses and in 2022 announced a package of measures to promote crypto technology and investment.

This included plans to regulate stablecoins, introduce a financial market infrastructure sandbox, set up a crypto asset engagement group to work with the industry and explore potential tax reforms. However, there is still some divergence between high-level policy goals and current regulation.

Indeed, the FCA has taken a cautious approach to trading in the retail market, banning any derivatives or exchange-traded notes that reference crypto assets. The rules came into force in January 2021 and the FCA estimates in its latest perimeter report that they will save consumers around £53m.

The FCA doesn’t recognise crypto exchanges separately from other crypto asset businesses. There are no specific cryptocurrency laws, but the regulator has taken an assertive stance on money laundering and terrorist financing. Since January 2020, any firms carrying out crypto asset activities in the UK need to register with the FCA and comply with its anti-money laundering (AML) rules.

Most crypto businesses have failed to meet this standard. More than 150 crypto firms have applied for registration with the FCA, but it has so far approved fewer than 40. The FCA said in its perimeter report that a “relatively large number of applications to us have been of poor quality and we have identified significant concerns during many of our assessments”.

As a result, many businesses remain unregistered. The FCA has identified more than 240 businesses that appear to be carrying out unregistered crypto asset activity.

Despite the FCA’s oversight of registered crypto businesses, it does not recognise most crypto assets as specified investments, which means that neither the Financial Ombudsman Service nor the Financial Services Compensation Scheme offer protection for crypto investments.

Key events shaping new crypto regulation

The US$40bn collapse of the TerraUSD stablecoin in May 2022 helped to justify some of the FCA’s hesitancy as regulators in more crypto-friendly jurisdictions are now taking a closer look at the sector.

      • US: Even before the Terra collapse, a boom in crypto activity and prices drew the attention of regulators around the world. In the US, new rules included in the Biden administration’s 2021 infrastructure bill require crypto exchanges to comply with AML laws. A proposed rule would also require them to report transactions over US$10,000.

      • Singapore: The city’s financial watchdog banned crypto advertising in January 2022 (a move the UK is also considering) and plans to implement tougher AML standards. After several high-profile scandals at Singapore-based firms, the regulator has said that it wants to shift the focus to digital asset innovation and away from crypto speculation.

      • Australia: Home to one of the most progressive crypto markets. It provides clear regulatory and tax guidelines and is planning a new licencing framework for exchanges that seeks to create a well-regulated environment for consumers to buy and sell crypto assets.

      • EU: Current crypto regulation is broadly similar to the UK but European lawmakers reached provisional agreement on a new bill in June 2022 that would enforce the so-called “travel rule” on crypto transactions. This would require crypto asset service providers, including exchanges, to obtain and submit information about both sides of every transaction.

It remains to be seen if the UK and EU will diverge in the wake of Brexit, particularly as the UK seeks to establish itself as a leading global hub.

Ways to mitigate risk

Crypto exchanges can limit their risks in a number of ways:

      • Registration: Providing crypto asset services without FCA registration (or temporary permission) is a criminal offence in the UK, even though the majority of crypto businesses continue to operate unregistered as noted above. As most crypto assets are not within the FCA’s regulatory perimeter, it lacks enforcement powers to crack down on such businesses, but it is monitoring them and does have significant powers over money laundering and terrorist financing activities.

      • Fair dealing: Regulated or not, all crypto exchanges should pay close attention to product suitability and provide consumers with information about the potential risks. They should also disclose whether their products and services are covered by any protections.

      • Prudential oversight: Licenced exchanges are subject to the same broad rules as other FCA-regulated businesses, such as the investment firm prudential regime, which requires firms to assess and mitigate potential harm to clients. They must also maintain sufficient financial resources to manage their risks and exposures to crypto assets, as well as arranging adequate protection for clients’ assets.

By adopting these measures, exchanges can protect their own businesses, as well as their customers.

To discover how Zai can help crypto exchanges succeed in a competitive market, get in touch.

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