Digital Assets - Q1 2024

This edition of our Digital Assets newsletter focuses on developments from the UK and European regulatory environments. It features updates from relevant regulatory bodies alongside our assessment of steps that could be taken by management to better position their firm to comply with incoming requirements.

UK regulatory bodies continue to accelerate the pace at which rules and provisions centred on Digital Assets and the firms that interact with them are developed and implemented. This hastening process is exemplified in UK Finance’s February piece that focused on their members’ response to jointly proposed stablecoin regulations from the Bank of England (BoE) and the Financial Conduct Authority (FCA). The article captures the sentiment of these responses, which were largely supportive of the proposed approach to the integration of Pound-backed stablecoins into the UK’s payments ecosystem. However, members raised important concerns regarding the alignment of the BoE and FCA’s approaches, and sought clarification on overseas stablecoin issuance, the treatment of security tokens, and the flexibility of requirements relating to asset-backing.

Days later, in European affairs, the Deutsche Bundesbank published an interview with Executive Board member Burkhard Balz and Digital Euro Director General Alexandra Hachmeister. This piece reaffirmed the German Central Bank’s unequivocal support for the timely implementation of a Digital Euro, referring to the geo-strategic benefits of the solution, as well as its adaptability, cost-effectiveness, and likely ability to generate investment and boost competition in European markets.

Despite their distinct subject matters and authors, reading these informative pieces in tandem provides insight into the differing stages of maturity in the UK and European regulatory environments. This is also reflected in the below regulatory updates; while Europe consults on the implementation of granular elements of the well-established Markets in Crypto Assets Regulation (MiCA), the UK is still defining and corroborating the broad strokes of a regulatory framework for Digital Assets.

Bank of England (BoE) and His Majesty’s Treasury (HMT):

In our Q1 2023 and Q2 2023 editions, we discussed the BoE’s joint consultation with HMT into the Digital Pound, a proposed Central Bank Digital Currency (CBDC) that would be issued by the BoE to facilitate retail payments and function as a “risk-free, highly trusted and accessible” digital replication of cash. In late January, the BoE and HMT published a detailed Consultation Response that attempts to summarise and address “over 50,000 responses from members of the public, businesses, civil society and academia”. The Response’s second Section provides a transparent overview of the methodology used to process these significant levels of public interest, reiterating that innovation, safety, and trust are key objectives for the regulators during this exploratory phase. The following two sections of the Response focus on the most regularly cited concerns of contributors, including:

The rights, privacy, and protections of Digital Pound users
The role of the UK Parliament in the legislative process
Safeguarding of access to cash
The “clear and fair” regulation of private sector Digital Pound wallet providers (PIPs)
Financial inclusion and digital literacy
Experimentation and research into more expansive Digital Pound use cases

The Consultation Response concludes by describing some high-level timelines for the project, confirming that a final decision on whether the Digital Pound will be pursued should be made towards the end of the design phase, “around the middle of the decade at the earliest”.

What management should consider

The Regulators’ Consultation Response is framed as the continuation of a conversation regarding the future of the UK’s monetary system. Assurances are made that stakeholders will be consulted at each stage of the process, including after the introduction of primary Government legislation. As such, management should consider reviewing the Response as though it is an indicative checkpoint within a larger process, paying particular attention to Section ‘5 Next steps’, which focuses on private sector collaboration and could represent a significant opportunity for innovative Firms in the sector.

His Majesty’s Revenue & Customs (HMRC):

At the start of March, HMRC published a Consultation Paper (CP) regarding the UK’s implementation of the OECD’s Cryptoasset Reporting Framework (CARF) and the Common Reporting Standard (CRS). These international standards are intended to address tax non-compliance via cryptoassets consistently across jurisdictions. Sections 1 and 2 provide information on the CARF and the CRS respectively, while Section 3 describes how UK domestic reporting could be extended to become in line with these international standards.

Characteristics unique to cryptoassets, such as the ability to transfer and hold funds without interacting with traditional financial intermediaries, have posed significant challenges for tax transparency frameworks like the CRS. This has resulted in alterations to the Standards as well as the creation and international implementation of the CARF. The CARF aims to guarantee secure and standardised tax reporting in the context of cryptoassets by setting requirements for ‘Reporting Cryptoasset Service Providers’ (RCASPs) to conduct due diligence and collect data on users and transactions. There is an expectation that this data will then be reported to relevant tax authorities so that instances of tax non-compliance can be identified and addressed.

In Section 4, HMRC summarises a series of consultation questions and invites responses from businesses, legal firms, academic institutions, and other stakeholders before the deadline on 29 May 2024.

What management should consider

Several of HMRC’s consultation questions emphasise the potential need for additional guidance and clarifications. Affected firms should therefore consider producing a response that specifically highlights areas where management has concern around the level of CRS/CARF information currently available to UK Firms. Proposed UK RCASPs should closely examine the requirements around data collection and due diligence, as these may require significant operational changes and ensuring compliance could incur significant costs.

European Securities and Markets Authority (ESMA):

In our Q4 2023 edition, we provided an overview of the extensive consultation process surrounding Europe’s incoming Markets in Crypto Assets Regulation (MiCA). As per the ESMA’s Consultation Package plan, the third package is intended to cover the following themes:

Cryptoassets as financial instruments
Investor/stakeholder protection
Measures around market abuse
Operational resilience and security protocol considerations.

In a development that signalled the start of this final consultation package on 29 January 2024, the ESMA published two additional CPs.

The first was focused on the application of reverse solicitation in the context of MiCA. Reverse solicitation is a concept described in the Markets in Financial Instruments Directive II (MiFID II) that allows firms in a third country to provide investment services to EU clients without prior authorisation - if these services are requested at the client’s ‘exclusive initiative’. European regulators intend to apply reverse solicitation to cryptoasset services and this CP surveys stakeholders’ opinions on the proposed approach.

The ESMA’s second CP was centred on the conditions and criteria for the qualification of cryptoassets as financial instruments within MiCA. Here, the ESMA sought to provide clarity on the classification of cryptoassets as financial instruments primarily by drawing equivalencies to MiFID and setting out specific qualifying criteria for cryptoassets under MiCA in Section 5 of the CP.

Responses from cryptoasset issuers, service providers, and financial entities dealing with cryptoassets are encouraged by the ESMA. Both CPs are open to responses until the 29^th of April 2024.

What management should consider

MiFID compliant Firms, and cryptoasset-related Firms with any form of European presence, including the performance of transactions from a third country, should continue to pay close attention to the MiCA consultation process. Management might choose to take a judgement-based approach to responses, identifying specific consultation areas that are material to the Firm and should be examined more deeply based on the potential implication of changes to the Firm’s operation.