Long reads

The Westminster Series: Crypto regulation in the UK

Chris Holmes

Chris Holmes

Peer, House of Lords

There is an unrivalled opportunity for the UK to lead in crypto in terms of rules, regulations, words and welcome. Crypto is not a silver bullet nor indeed the solution to all our ills, but it holds a real and sustainable opportunity for us all in the UK and we must consider carefully what we require from Government to make this possibility a purposed reality.

My interest in the potential of crypto was spurred by my work on the related, often underpinning technology of blockchain and other distributed ledger technologies (DLT).  I have been conscious of the possibilities afforded by DLT for at least a decade now. 

Back in 2017 I gathered together a group of experts and published my report, Distributed Ledger Technologies for Public Good: leadership, collaboration and innovation, building on the excellent work of Sir Mark Walport, Distributed Ledger Technology: beyond block chain.  If the opportunities were there in 2017 and 2018 when I published a report update they are there in multiples today, and arguably with everything else we are facing as a country the opportunity if we get it right has become an even bigger prize.

It has been fascinating learning about how Auditchain have built an audit tool that uses this underpinning technology (an Ethereum layer 2 protocol) combined with a higher level semantic logic based on Xtensible Business Reporting Language “XBRL” to set the rules for the valid state of a reporting entity based on its reporting style and reporting scheme. 

Could this be the future of auditing? Instead of a system based on samples that often misses fraud and failure a technological solution such as the one described by Auditchain would have 100% transaction inclusion and a cryptographic audit trail. Would it – as they suggest - become cost prohibitive to commit fraud by the perpetrators and substantially raise the ability for auditors to detect fraud. Blockchain in the auditing puts an end to fraud?

It is clear that we require tailored regulation for crypto and we need it now.  If the UK can set out clarity in this area we will not only influence the environment in the UK we will give ourselves the best opportunity to influence global policy.  Similarly, such certainty would obviously be attractive to firms looking to locate in the UK.  Just as the rule of law worked and continues to work such certainty magic for so many businesses who choose to come to the UK and/or structure their dealings under this, so it could be for crypto businesses.   

The challenge in devising a regulatory approach to new technologies is finding the appropriate balance between encouraging innovation and providing regulatory clarity and ensuring that legislation mitigates possible risks raised by the relevant activities. Investors must be protected, competition must be promoted and encouraged.

The Financial Conduct Authority (FCA) is a regulator with a history and an approach to be proud of. We know how to positively face innovation if we so choose.  The FCA’s regulatory sandbox for fintechs was so successful it has been rightly replicated in over fifty jurisdictions around the world.  It is this same sense of reasoned, rational positivity and optimism that we must bring to our approach to crypto. 

Failure to address the subtleties in the way these systems can be deployed in any new regulation may create significant legal uncertainty and give rise to the potential for regulatory arbitrage. Crypto-assets, by their nature, require regulatory coherence with other leading jurisdictions to ensure cross-border interoperability, legal clarity, and certainty.

Raising consumer awareness of the risks associated with crypto-assets will be important in ensuring consumer protection. Important but crypto should not find itself on the end of disproportionate regulations merely on the basis of being, currently, new. 

It is right to bring to bear all the principles which should always underpin ‘right set regulation’. Anything beyond this is unlikely to afford any great consumer protection and will certainly stave off opportunity and international competitiveness and attractiveness. It must always be borne in mind, so many of the recent financial scandals, where so many have lost so much, have come from what must be seen as, well, pretty standard sections of our financial services sector.

To this positive end, the UK needs to act quickly to set high standards in crypto-asset and DLT regulation, while recognising that not all uses of DLT need to be regulated. There needs to be a really clear unified taxonomy that spans international jurisdictions - what is financial services, what is e-money, what falls outside the regulatory framework?

In respect of this regulatory perimeter, it seems sane that any extension should be based on the specific characteristics and taxonomies of relevant cryptocurrencies or ‘tokens’ and the identification of unregulated risks, all of which require clear legal definitions. And it is careful consideration of these token taxonomies which will be vital to the quality and specificity of the regulatory framework. For now, just this, to consider the purpose of the token, what rights it affords, crucially, can it be conceived clearly as exchange, utility or security.

A good start has been made in this area but the pace of change means the regulators need to move fast to keep up. We also need to ensure we are regulating the services not the underlying technology, with the emergence of DeFi and self-hosted wallets regulators need to be absolutely clear they are regulating the services, not the software. Again, the sand box has much to offer of help here.

A real source of stability in this space is in the fact that many of those involved are themselves ex-regulators with positive history and hinterland to bring to the debate. Thus, industry engagement must be maximised, as it is crucial to achieve a proportionate and risk-based approach. It is equally crucial for legislators and regulators to continue to become increasingly knowledgeable and involved with opportunities, use cases, benefits and indeed, risks. 

It is encouraging that over the decade of discussing fintech with fellow parliamentarians (the fintech parliamentary group I founded and co-chair was established in 2015) the sector is now so much better understood in Westminster. CBDCs and stable coins are currently at the fore of many of the discussions and debates currently being held in Parliament.

As was the case with fintech over a decade ago, the UK must engender an innovation-friendly business ecosystem by having a principles-based, outcome-focused approach to regulation, so that existing regulatory solutions and frameworks can be adapted quickly, if appropriate and required. It will be the combination of Government positive action on crypto regulation, Bank of England positive action on a potential ‘Brit Coin’, industry and policy makers coming together for the wider public good and national interest which will enable and empower future finance now. 

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