The UK authorities’ deluge of recent crypto-asset interventions has continued with the Bank of England making rumblings about the need for regulation, while also outlining what it regards as the main risks.
The Bank of England’s Financial Policy Committee (FPC) has published its views of the risks to the stability of the UK financial system from crypto-assets and decentralised finance (DeFi).
It warns that if the pace of growth seen in recent years continues, and as these assets do become more interconnected with the wider financial system, crypto-assets and DeFi will present financial stability risks. As a result, an enhanced regulatory and law enforcement framework will be necessary at both a domestic and global level.
According to the Bank of England, these frameworks should address developments in crypto-asset markets and activities, encouraging sustainable innovation, while maintaining broader trust and integrity in the financial system.
A vision for crypto
“The publication is the Bank of England’s most important statement to date on the nascent crypto-economy,” said Olu Omoyele, regulatory consultant at Midelatory Consulting.
According to Omoyele, the central bank had originally dismissed crypto as a passing fad, before more recently treating it like a threat. “The Bank of England now appears to be gearing up to engage with it as an important new segment of the economy, one with implications for financial markets, payments and UK financial stability.”
However, the slew of crypto-related announcements from regulators in the UK has got experts wondering: where are the concrete regulatory proposals?
"The problem we have is that the Bank of England and HMT are taking a long time to publish feedback,” said Nilixa Devlukia, director at Payments Solved. “A lot is happening in the world, but it is not clear what has delayed these publications. This used to be done a lot quicker."
According to Jannah Patchay, director at Markets Evolution, although it is heartening to see both the FPC and the Prudential Regulatory Authority (PRA) take active steps in recognising the growing adoption and potential for crypto-assets, there is a danger that prolonged waiting times for regulatory certainty will continue to erode the UK’s position as a leader in financial innovation.
It would be helpful to see a clear vision of the UK’s future in this space from policymakers, Patchay told VIXIO. “Will it be a world leader, a global hub for well-regulated crypto-assets firms, or a fast follower? As this will also signal the potential direction that the regulated environment might take.”
"Regulators and policymakers have been dramatically outpaced by the advance of blockchain technology and in particular the huge proliferation in digital assets and cash substitutes,” said Etay Katz, financial regulatory partner at Ashurst.
Promoting a safe and sound integration of traditional financial intermediaries is critical to avoid a systemic downfall with huge collateral damage, he continued. "We are now at a critical junction where the Bank of England alongside other prominent policymakers must accelerate the pace of regulatory accommodation and proactively enable innovation to enter mainstream financial and money markets.”
"Absent a decisive and coordinated approach to enabling innovation in the crypto markets, we are consciously inviting a downfall,” warned Katz, adding “this is avoidable through proactive and clear action by policymakers".
For Omoyele, however, the signs lean towards tougher rules. “The focus on the potential for financial stability risks, from stablecoins and DeFi in particular, as preconditions for potential regulatory policymaking is helpful from a proportionality point of view,” he said.
“Nonetheless, the crypto sector, as well as regulated banks wishing to enter it, should treat the publication as an early warning of an impending, and potentially restrictive, regulatory regime in the UK.”
As part of its study, the Bank of England has touched upon the matter of payments, outlining why crypto-asset use could disrupt payments in the UK negatively and predicting that stablecoins role in payments could become increasingly important.
It was further envisaged that public confidence in money and payments could be undermined if a systemic stablecoin used for payments fails to meet its obligations, suggesting that if it failed to honour its obligations or suffer an operational failure such as a breach of privacy, this could undermine public confidence in money and payments, and in the financial system more broadly.
The FPC’s update also welcomed a new "Dear CEO" letter, published by Prudential Regulation Authority (PRA) deputy governor Sam Woods.
Woods’ letter called for financial institutions, including banks, insurance companies and designated investment firms to consider their exposure to crypto-assets.
He emphasised the need to comply with existing regulatory obligations while expecting changes to supervisory oversight.
“While the regulatory framework provides a structure to consider such risks, the methodologies and calibrations will likely need to be adjusted, in some cases substantially, to ensure that firms are appropriately and prudently considering and capitalising the risks,” Woods said.
Woods first wrote to market participants about this issue in 2018 but said that increased use warranted a reminder and enhanced expectations of firms who wish to operate in, or be exposed to, the sector.
FCA risk warning
As part of a coordinated approach that has become common for regulators dealing with crypto, the Financial Conduct Authority (FCA) also published a new diktat in regards to the industry, reminding firms of their obligations when interacting with, or being exposed to, crypto-assets.
Although crypto-assets and their underlying technologies can offer benefits to financial services firms, such as reducing costs and increasing efficiencies, they also present risks to market integrity and consumers, particularly when used as a speculative investment, the watchdog has cautioned.
"It seems to be that we have had the Treasury’s consultation and Kalifa Review before that, and the direction of travel from the UK government has been to support crypto and fintech firms. Yet, in the last few days, the dial appears to have turned,” said Devlukia.
UK regulators have arguably come across as too defensive and focused only on the risks of crypto, rather than a more balanced, risks and opportunities approach, argued Omoyele. “This has been a little surprising given the UK’s otherwise pro-fintech stance.”
“Going forward, the UK’s regulators should adopt a more nuanced posture that recognises crypto as a new and important development, and its underlying blockchain architecture a potentially transformative general-purpose technology,” he suggested.
The challenge is that more and more people are dabbling, investing and looking at crypto, not necessarily as a means of payment but as investment, and there is no comprehensive regulatory framework, she added.
In the new guidance to market participants, the FCA has set out some areas of risk that firms need to consider, including being clear with clients.
This is to ensure that consumers understand the extent of business that is regulated and to clearly distinguish those elements which are unregulated business.
“At all times, firms remain responsible for identifying and managing potential risks related to crypto-assets,” the FCA said.
Moreover, compliance with financial crime and registration requirements, prudential considerations and risk assessments must also be considered by firms.
“Where firms’ clients and customers are using crypto assets or offering related services, firms are given the flexibility to adapt their actions to the perceived risks,” the FCA pointed out.
Firms should assess the risks posed by a customer whose wealth or funds are derived from the sale of crypto-assets, or other crypto-asset related activities, using the same criteria that would be applied to other sources of wealth or funds, the regulator noted, pointing out that one way that crypto-assets differ from other sources of wealth is that the evidence trail behind transactions may be weaker.
“This does not justify applying a different evidential test on the source of wealth and we expect firms to exercise particular care in these cases,” the regulator cautioned.
According to Omoyele, the FCA’s overly enforcement-led approach to platforms such as crypto exchanges and other service providers is counter-productive. “The FCA should instead focus on devising a dynamic, outcomes-focused, and principles-based regulatory regime that can adapt flexibly as the sector develops, one that promotes competition and is decidedly pro-innovation.”