UK: Regulating Cryptoassets May Be Harder Than FCA Expects

On 6 March 2020, Therese Chambers, Director of Retail and Regulatory Investigations at the Financial Conduct Authority ("FCA"), gave a speech at The Advancement of Digital Assets and Addressing Financial Crime Risk at New York University School of Law about tackling financial crime and imposing anti-money laundering ("AML") regulation on the emerging market for cryptoassets.¹

Using the FCA's umbrella term of "cryptoassets" – encompassing all assets underpinned by cryptography, the most well-known of which are digital currencies such as Bitcoin and Ether – Chambers sought to outline how the regulator intends to impose AML regulation on this previously untamed market. She began by setting out the challenges of this task posed by the principles and structure of the industry, she then moved on to describe the various ways in which the FCA hopes to regulate the exchanges which facilitate transactions, with particular emphasis on the new powers bestowed on the FCA by the UK's implementation of the Fifth Money Laundering Directive ("5MLD"). However, while Chambers painted a hopeful picture, presenting the new regime as a strong stance from the FCA, questions about the effectiveness of the measures nevertheless remain. Obstacles such as the global nature of the industry and the resistance to regulation may pose much more of a problem than the FCA anticipates.

Traditional anti-money laundering frameworks and their application to cryptoassets

Chambers outlined why, at first blush, it may appear that traditional forms of AML regulation cannot be applied to cryptoassets.  The UK's AML controls are designed to apply to the intermediaries who facilitate transactions between parties: primarily banks and other financial services institutions, as well as other professional services such as solicitors and accountants.

The problems around the regulation of cryptoassets stem from the fundamental principle which has driven its development: designed as a decentralised "peer to peer" technology, allowing the transfer of value directly from one party to another by a system secured by cryptography, such intermediaries simply do not play a part. Where a bank would perform essential checks such as customer due diligence, risk assessments and the continuous monitoring of trading activity to detect and report red flags, the opportunities for scrutiny in such a decentralised system are much harder to come by.

Centralised exchanges and 5MLD

However, Chambers went on to argue that, although the market was initially built to function via peer to peer trading, the current reality is vastly different. According to research conducted by the FCA, market participants see cryptoassets, and in particular digital currencies, as alternative investments – stores of value which will, in theory, appreciate over time – rather than using them as the peer to peer digital cash they were originally intended to be. It is estimated that up to 90% of activity in the market takes place via centralised exchanges; the market, therefore, is not dissimilar to traditional financial services (for example, forex trading).

Capitalising on this, the FCA's intention is that these exchanges will be required to fulfil the same AML role as intermediaries in the markets ordinarily would. This intention has been facilitated by 5MLD, which was transposed into UK law with effect from 10 January 2020. Under the new laws, the FCA is designated as the AML supervisor for five specific activities involving cryptoassets:

• Exchange of fiat currency for cryptoassets;
• Exchange of cryptoassets for different cryptoassets;
• Custodian wallet provision – business which operate custody services for cryptoassets with direct control over those assets;
• Initial Coin Offerings – the raising of capital via the issuance of cryptoassets; and
• Crypto ATMs – businesses which offer automated kiosks selling cryptoassets in exchange for fiat currency or other cryptoassets.

Any business undertaking these activities in the UK must be registered with the FCA and satisfy the regulator that it undertakes sufficient risk assessments, appropriate customer due diligence, comprehensive transaction monitoring and record keeping, and that it makes Suspicious Activity Reports when necessary. Along with these new measures, the FCA now has additional powers akin to those it already exercises over the institutions it regulates: the power to request information, impose voluntary and involuntary requirements (including, in the most egregious cases, stopping business where there is a serious risk of money laundering), and implementing a "fit and proper" test for key individuals.

Can it really be this easy?

Given these new powers, there can be no doubt of the FCA's intention to take money laundering in the industry seriously; they represent a huge step forward in this previously unregulated space. But how effective will these new powers actually be? While Chambers struck a firm and optimistic note throughout her speech, it is possible that the regulator is being slightly naïve when it comes to the ease with which the sector can be brought to heel.

Weak links in the global regulatory chain

There are two main hurdles which Chambers acknowledged during her speech that may pose problems, the first of which is the default global nature of the cryptoassets market. The decentralised systems which underpin the market are not confined to borders as regulators are; demonstrative of this issue, 5MLD applies only to businesses carrying on their activities in the UK. Exchanges undertaking the newly regulated activities can simply dodge UK regulation by being registered and basing their main operations in a different jurisdiction where regulations are less stringent or, perhaps, even non-existent.

While Chambers appeared to recognise that properly regulating the market will require extensive international co-operation to close loopholes and strengthen localised weak links, her speech lacked the detail of how such co-operation will happen. She mentioned working closely with the Financial Action Task Force, an international money laundering and terrorist financing watchdog, but provided no specifics on how different approaches in different jurisdictions could be reconciled. Where countries such as the UK and USA are keen to regulate the market and crack down on the flows of illicit funds, others are favouring a "light touch" approach, cautious not to be too heavy handed lest they risk stifling innovation. This is not a fight that the UK can win alone; the FCA may well be understating how difficult international co-operation in tackling this issue will be.

Enforcing compliance

The second major obstacle which Chambers mentioned in passing as she wrapped up her speech is one which is far more obvious: simple resistance to compliance with the new regulations. This is a system which was built on principles of libertarianism, designed to be free from the shackles of the established financial norms, and is unlikely to easily acquiesce to the new regulations being imposed. Although Chambers commented that the FCA is keen to work with exchanges to ensure that standards are met, this seems to be a rather blasé approach: again, underestimating how difficult it will be to bring this sector in line with all other regulated firms.

Too little, too late?

While Chambers' speech and the FCA's attempts to control money launderers using cryptoassets to clean dirty money are unquestionably laudable, question marks remain over whether the measures go far enough. Will the task of shoring up the weak links in international regulation and bringing the industry into line really be quite as straightforward as this speech might suggest? Regulators across the world have always been playing catch up in trying to regulate this market, but constant developments in technology have left meaningful progress just out of reach. The FCA's new powers may simply be too little, too late.

This article first appeared on Law360 on 26 March 2020.

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