By Stuart Davis and Charlotte Collins

Following on from the Financial Conduct Authority’s (FCA’s) consumer warning on Initial Coin Offerings (ICOs) in September, the FCA has announced a deeper examination of this area in its Feedback Statement on Distributed Ledger Technology (DLT) and related press release. The FCA stated that it will consider whether regulatory action beyond the consumer warning is required.

The earlier Discussion Paper on DLT had asked for feedback on the legal and regulatory risks associated with ICOs (see Latham’s related Client Alert). According to the FCA, many respondents considered ICOs as having the potential to “dynamise innovation”, although others raised concerns about potential risks and possible investor harm.

FCA Views on the ICO Market

In the Feedback Statement, the FCA highlights that, in its view, a well-functioning ICO market can materially contribute to the development of DLT. However, the FCA stresses that promoters of ICOs must take the steps needed to enable fully informed decision-making by potential acquirers of their tokens. This concern stems from the fact that not all ICOs fall within the regulatory perimeter, and so the usual investor protection measures that would, for example, apply in the case of an initial public offering, will not necessarily apply.

Further, as ICOs are a relatively new phenomenon and do not fit neatly within the existing regulatory framework, identifying whether or not an ICO does sit within the regulatory perimeter can be challenging. This means that, even when the usual investor protection measures should be applied, there is a risk that participants may not appreciate that this is the case.

Annex 1 to the Feedback Statement sets out some high-level regulatory considerations for parties involved with ICOs, highlighting the regulatory rules that may apply. The FCA stresses that participants must take responsibility for assessing their own regulatory position. Considerations include, for example, whether parties are carrying on any regulated activities and therefore require authorisation, whether any financial promotions are being communicated, and whether a prospectus may be required.

The FCA plans to gather further evidence, to help it keep pace with developments relating to the ICO market. The FCA will then consider whether any specific regulatory interventions are required. In undertaking this work, the FCA will look to engage with both national and international regulators, and states that it will welcome further opportunities to engage with the technology and financial services communities. Therefore, interested parties should consider engaging with the FCA to help it better understand the market.

Support for Participants

The FCA also explains in the Feedback Statement how ICOs may make use of the Innovation Hub and Regulatory Sandbox to help navigate the regulatory framework. According to the FCA, a small number of ICOs have engaged with the FCA in this way, including one firm that has made use of the Sandbox. The FCA explains that firms may use the Sandbox, subject to meeting the eligibility criteria, particularly the consumer benefit criterion.

In the context of ICOs, the FCA clarifies that meeting this criterion means either:

  • The ICO must fall within the regulatory perimeter and be fully compliant with UK and other relevant regimes.
  • If outside the regulatory perimeter, the ICO must be designed, promoted, and governed in line with best practice, so that potential acquirers are properly informed about the proposition that is being marketed to them.

Therefore, parties considering seeking the support of the Sandbox should reflect on this criterion carefully before applying.

Anti-Money Laundering Concerns

This development comes as the European Parliament and the Council announced that they have reached agreement on proposals to amend the EU anti-money laundering framework (the so-called “MLD V” proposals). The proposals are designed to bring the current MLD IV framework, which has applied since June 2017, up to speed with recent market developments.

One part of the proposals involves applying anti-money laundering and counter terrorist financing rules to entities that are in charge of holding, storing, and transferring virtual currencies — such as Bitcoin — therefore potentially affecting ICO participants.

This will mean relevant entities having to conduct “know your customer” measures, and report suspicious activity to the appropriate Financial Intelligence Unit, in the same way that most financial institutions are already required to. Although the impact will not be immediate (the text needs to be formally endorsed by the European legislators, and after that there may be an implementation period of up to 18 months before the new rules apply), this shows an intention to bring virtual currencies within the scope of regulation in one very important area.