Conclusions and recommendations
The crypto-asset landscape
1.Functioning currencies are generally understood to serve as a store of value, a medium of exchange and a unit of account. As yet, there are no so-called “cryptocurrencies” that serve all these functions. Well-functioning cryptocurrencies currently exist only as a theoretical concept, and the term “crypto-assets” is more helpful and meaningful in describing Bitcoin, and the many hundreds of other ‘altcoins’ that have emerged over the past decade. (Paragraph 13)
Blockchain and crypto-assets: advantages and limitations
2.Crypto-assets and blockchain were originally designed as an alternative system of making payments in exchange for goods and services. But even the most widely-used crypto asset—Bitcoin—is not widely accepted by merchants. Moreover, the blockchain that underpins Bitcoin transactions cannot process anything like the volumes of transactions that would be required for it to become a mass-market payments system. Even at current levels, the energy costs of verifying transactions appear disproportionate to the potential benefits of a decentralised payments system. (Paragraph 47)
3.The slow, costly and energy-intensive verification process for transactions is not unique to Bitcoin, but a fundamental feature of crypto-assets based on public, decentralised blockchains. This may ultimately limit the extent to which crypto-assets and blockchain can replace conventional money and payments systems. (Paragraph 48)
4.The arguments put forward that crypto-assets could further financial inclusion are unconvincing. Efforts to further financial inclusion are best focused on reducing the number of people without access to bank accounts, rather than increasing the numbers with access to crypto-assets. (Paragraph 49)
5.There are a number of examples of blockchain being deployed in the financial services industry and supply chain management. The Committee is supportive of good innovation, but notes that blockchain should not be pursued for its own sake. Rather, Government and industry should identify what problems exist and consider whether blockchain offers the most appropriate solution. The Committee recognises that blockchain technology may have the potential to solve problems caused by a lack of trust in data integrity and may be a more efficient method of managing certain types of data in the long term, offering higher levels of security than centralised databases. (Paragraph 50)
6.However, at present—although small scale uses for blockchain may exist—the Committee has not been presented with any evidence to suggest that universal applications of the technology are currently reliably operational. (Paragraph 51)
The risks of crypto-assets and the regulatory response
7.Crypto-assets have no inherent value. In the absence of any market fundamentals, their prices fluctuate according to sentiment. This causes far higher volatility than other asset classes, exposing investors to larger potential gains, but correspondingly greater risk of loss. The use of blockchain as a payments system exacerbates these risks, since the exchange rate (vis-à-vis other crypto-assets, or conventional currency) can fluctuate significantly during the time it takes to settle a transaction. (Paragraph 64)
8.On account of their volatility alone, crypto-assets are especially risky, particularly for inexperienced retail investors. (Paragraph 65)
9.Investors typically access and invest in crypto-assets through exchanges. A number of these have been hacked, with customers losing significant amounts of money as a result. (Paragraph 75)
10.There is no collective deposit insurance scheme to compensate investors in the event of a hack, nor do individual exchanges generally have arrangements in place to do so. The risk of hacking associated with crypto-assets may not be something investors in conventional assets have experience of, and therefore they may not be well placed to judge this risk. It constitutes further evidence that crypto-assets are particularly ill-suited to retail investors. (Paragraph 76)
11.There have also been instances of investors losing access to their crypto-assets when they have lost their passwords to their accounts with exchanges or crypto-asset platforms. Exchanges and crypto-asset platforms have subsequently been unable to recover their customers’ details, so customers are locked out of their accounts permanently. This often unexpected outcome for investors is a stark contrast against how customers of banks, and other regulated financial services firms, are treated when they have forgotten their details. (Paragraph 77)
12.The FCA’s stark consumer warning on ICOs is evidence that they present significant risks to investors. But apart from drawing attention to the risks, there is little the FCA can do to protect individuals from being defrauded or losing their money. This is because most ICOs do not promise financial returns, but instead offer future access to a service or utility, meaning they fall outside the regulatory perimeter. (Paragraph 87)
13.While there may be no explicit promise of financial returns, investors in ICOs clearly expect them: they are not buying tokens to gain access to as-yet unbuilt theme parks, or to obtain dental services in years to come, but in the hope of selling them at a profit. The development of ICOs has exposed a regulatory loophole that is being exploited to the detriment of ordinary investors. The Regulated Activities Order should be updated to bring ICOs within the FCA’s perimeter as a matter of urgency, and bring investor protections into line with those in the United States. (Paragraph 88)
14.Crypto assets and ICOs are extremely risky, and the Committee agrees with the FCA that investors should be prepared to lose all their money. (Paragraph 89)
15.Owing to their anonymity and absence of regulation, crypto-assets can facilitate the sale and purchase of illicit goods and services, and can be used to launder the proceeds of serious crime and terrorism. (Paragraph 103)
16.The absence of regulation of crypto-asset exchanges—through which individuals convert crypto-assets into conventional currency—is particularly problematic. (Paragraph 104)
17.The adoption of the Fifth Anti-Money Laundering (AML) Directive represents a step forward in this respect. Under the Fifth AML Directive, crypto-asset exchanges will have to comply with anti-money laundering and counter-terrorist financing rules. The Committee urges the Government to treat the transposition of the Directive as a priority, and to expedite the consultation process, which is currently not planned to finish until the end of 2019. If the UK leaves the EU without a transition period in March 2019, the Committee would nonetheless expect the Government to seek to replicate the relevant provisions of the AML Directive in UK law as quickly as possible. (Paragraph 105)
18.The Committee believes that the FCA should be the relevant regulator for supervising anti-money laundering. (Paragraph 106)
19.Crypto-asset markets are particularly vulnerable to manipulation, and they fall outside the scope of market abuse rules. In responding to this Report, the FCA should outline the approach it would take to market manipulation were these markets to fall within its remit. (Paragraph 111)
20.The Committee agrees with the Bank of England that, since they are not being widely used as a means of payment, and the linkages to systemically-important firms and markets are negligible, the risk to financial stability arising from crypto-assets is low. The Committee expects the Bank of England and the FCA to continue to monitor developments in crypto-asset markets, and financial institutions’ exposure to them. (Paragraph 116)
21.The FCA’s consumer warnings are a feeble corrective to advertisements—on social media, billboards, trains and taxis—that only emphasise the upside opportunities of crypto-asset investing. The advertisements for crypto-asset investing are clearly misleading to consumers and as crypto-asset activities fall outside the FCA’s regulatory perimeter, the FCA is restricted in actions it can take. The FCA needs more power to control how crypto-exchanges and ICO issuers market their services, by bringing the activities they perform into the regulatory perimeter. Such a step would also provide investors with wider protections against mistreatment, including loss of deposits through fraud and hacking, or losing access to funds due to the loss of passwords. (Paragraph 125)
22.Crypto-assets have been embedded in certain pockets of society and industry, and it is highly likely that they are here to stay. The UK Government and financial services regulators appear to be deciding whether they will allow the current “wild west” situation to continue, or whether they are going to introduce regulation. The current ambiguity surrounding the Government’s and the regulators’ positions is clearly not sustainable. (Paragraph 129)
23.The Committee is aware of the establishment of self-regulating bodies in the crypto-asset industry such as Crypto UK, which set out codes of conduct and best practice for the industry. However, as these standards are wholly voluntary, there are inevitably firms ignoring them. When industry is self-regulating, there is no authority to hold industry to account. Throughout the inquiry, the Committee has heard of the crypto-asset industry distributing misleading advertisements and laxing on their self-imposed ‘know your customer’ rules. Self-regulation within the crypto-asset industry is clearly insufficient. The introduction of formal regulation would make standards compulsory and relevant regulators can hold industry to account. (Paragraph 130)
24.Given the scale and variety of consumer detriment, the potential role of crypto-assets in money laundering and the inadequacy of self-regulation, the Committee strongly believes that regulation should be introduced. At a minimum, regulation should address consumer protection and anti-money laundering. (Paragraph 131)
25.In deciding the regulatory approach, the UK Government and regulators should evaluate the risks of crypto-assets, and assess whether their growth in the UK should be encouraged. (Paragraph 132)
26.If the Government decides that growth is to be encouraged, the Committee believes that the introduction of regulation could lead to positive outcomes for the crypto-asset market. The implementation of crypto-asset regulation in the UK may enable the market place to move to a more mature business model that improves consumer outcomes and enables it to grow sustainably. The entry of institutional investors into the market would increase liquidity, which in itself could reduce some of the inherent risks that exist at present. (Paragraph 133)
27.If the UK develops an appropriate and proportionate regulatory environment for crypto-assets and if future innovations in crypto-assets proved themselves as beneficial to society and industry, the UK could be well placed to become a global centre for this activity, providing that the crypto-asset market adhered to high standards and was not associated with criminality. (Paragraph 134)
Implementation of regulation
28.The Committee considers that introducing the regulation of crypto-assets and associated activities by extending the Regulated Activities Order would be the quickest method of providing the FCA with the necessary legal powers to execute its duties of protecting consumers and maintaining market integrity. Designing a new framework of regulation would inevitably take much longer and given the growing risks surrounding crypto-assets and subsequent consumer detriment, the introduction of regulation should be treated as a matter of urgency. (Paragraph 141)
29.The Committee recommends that the Government consider what “activity” related to crypto-assets should be specified in the RAO and the ramifications of this introduction. As discussed earlier, this should include at a minimum the issuance of ICOs and the provision of crypto exchange services. (Paragraph 142)
International approach to regulation
30.The global regulatory response to crypto-assets is in its infancy. Nonetheless, given the UK has yet to introduce any crypto-asset regulation, it is in a position to learn from those experience of countries that have done so. (Paragraph 146)
31.The Committee recognises the importance of international cooperation on the regulation of crypto-assets and associated activities. The Committee encourages UK regulators to continue engaging with international bodies to ensure best practice from other regulators is learned and applied to the UK context. (Paragraph 158)
Published: 19 September 2018