Insights

Crypto-Assets in the UK - 2018 Roundup and 2019 Outlook

Firm Thought Leadership

2018 Roundup

Despite most crypto-assets having their all-time highs in January 2018, the year was largely bearish with crypto-assets falling through a number of price support levels during the course of 2018. Stablecoins, however, saw a surge in popularity during the year as investors sought to hedge against the price dips. Given a diminution of trust in Tether (USDT), a number of alternative projects sprung to the market (such as LBXPeg and USDCoin).

Notwithstanding crypto-assets' price drops, investor sentiment in initial token offerings remained high with Coin Schedule estimating that over USD 20 billion was raised during the course of the year - significantly higher than the estimated USD 6.5 billion raised in 2017. This increase is partly a product of institutional interest in the sector with Bloomberg reporting that hedge funds have surpassed high net-worth individuals as the biggest buyers of crypto-assets.
Following hedge funds, large financial institutions have started to enter the crypto-asset sector. Fidelity announced a crypto-trading platform, UBS is experimenting with a utility settlement token and the Global Payments Steering Group (comprised of BAML, RBC, Standard Chartered and others) is collaborating to establish a cross border DLT settlement to challenge SWIFT.
Although regulation remains outstanding in major jurisdictions, 2018 saw increased interest from Governments and at the December 2018 G20 summit, leaders signed a joint declaration to develop a regulatory framework for crypto-assets, albeit with no concrete timeline.
In the UK, September 2018 saw a report from the Commons' Treasury Select Committee suggesting that all crypto-assets should be regulated equivalently. This publication was followed (on 29 October 2018) by the Crypto Asset Taskforce Report (CAT Report) (which can be accessed here). The CAT Report differentiated between crypto-asset classes and recognised that they should be regulated accordingly (i.e. security tokens should be treated pursuant to securities law whilst consumer tokens should receive less regulatory oversight). This conclusion has been welcomed by industry and the CAT Report was widely regarded as a step in the right direction for the crypto-asset sector in the UK.
Supplementary to the CAT Report, HMRC (in December 2018) published its long awaited crypto-asset advice for individuals (available here). Helpfully, the HMRC publication adopts the taxonomy of the CAT Report which should assist with cohesion between regulation and tax. In brief, HMRC expects that the buying and selling of most crypto-assets will amount to an investment activity and capital gains tax will apply to any disposal.

2019 Outlook

Following from significant developments last year, we predict the following will be key trends of 2019:

Regulation and Standards
2018 saw a number of nimble jurisdictions (e.g. Malta, Gibraltar and Switzerland) implementing law and/ or regulation and issuing guidelines for crypto-assets. 2019 is likely to see larger jurisdictions following suit. France is currently developing ICO legislation, the US. is undertaking a bipartisan initiative and the UK Crypto Asset Taskforce is commencing regulatory consultations.

In the (current) absence of clear regulatory guidance, industry standards are being published by organisations such as Global Digital Finance. These provide 'best practice' guidelines for, amongst others, token sales and exchange platforms against which companies can benchmark.

Institutional Involvement
Following last year's announcements by Fidelity, Goldman Sachs and others, it is highly likely that other institutional players will back crypto-assets publicly, particularly as organisations are recognising crypto-assets as a potential investment opportunity.
Any such announcements are welcome as additional institutional involvement will bring a level of experience and maturity from which the sector can benefit.
A much-anticipated example is Bakkt (an Intercontinental Exchange company) which is due to launch a Bitcoin Daily Futures Contract, tradeable on ICE's platform, and warehousing for delivered Bitcoin on 24 January 2019. Once operational, this is likely to set the precedent for further regulated projects.

From ICO to STO
Although 2018 was a record year for ICOs, quality varied significantly, and many lacked an adequate underlying business product with little accountability for teams behind the ICOs. Consequently, many ICO projects failed or were found to be fraudulent - with deadcoins.com suggesting that over 900 ICO projects are no longer active.
Security token offerings (STOs) provide an alternative to this as they are offerings which will be compliant with securities law and regulation (with legal and financial support) and will include detailed information memoranda, as compared to the flimsy 'white papers' included with many ICOs. It is anticipated that security or asset tokens will tokenise large illiquid assets, such as real estate or media libraries, and provide rights in relation to businesses (akin to equity) or portfolios akin to unit trusts.
As security or asset tokens will be related to tangible and legitimate assets or enterprises (with the added benefit of liquidity), they are likely to be a popular alternative to traditional investment products.

Roadblocks

Despite a positive outlook for 2019, several sector hurdles remain. We anticipate that these will largely be addressed during the course of this year.

Regulation
As mentioned above, clear regulatory guidance from larger jurisdictions is conspicuously absent in the crypto-asset sector. Understandably, the major economies are less nimble with regulatory delivery; however, regulation is crucial for fully legitimising the sector and for unlocking the significant capital which is available in jurisdictions such as the US and the UK.
Furthermore, once regulation is in place, companies will be able to operate with more certainty and security.
In the UK, the Crypto Asset Taskforce will be undertaking a consultation process (commencing in January 2019). This will allow industry participants to input with a view to guiding the appropriate regulation. Following the consultation process, it is likely that the regulatory perimeter will be extended to bring security tokens within the scope of the Financial Services and Markets Act 2000 (Regulated Activity Order) 2001.
The EU is following suit, albeit at a slightly slower pace, with the European Banking Authority's (EBA) report (published 9 January 2019) outlining that crypto-assets do not constitute regulated services within the scope of EU banking law. Consequently, the EBA has recommended that the European Commission carry out further analysis to determine the appropriate EU regulatory response.

Tax Guidance
Following its publication for individuals in December 2018, HMRC is expected to publish crypto-asset tax guidance for corporations in Q1 2019.
This will be of substantial benefit to the sector as many companies are reluctant to engage in crypto-asset activity for fear of falling foul of subsequent tax rules. Furthermore, taxation will play an important role in determining the corporate viability of many crypto-asset products.

Banking Access for Crypto-Asset Companies
Despite many banks publicising crypto-asset and DLT projects, access to retail banking remains difficult for companies which are involved in the crypto-asset and DLT sectors. Even challenger banks remain reluctant to provide retail banking services.
Banks typically cite AML restrictions and financial crime concerns when refusing bank accounts. However, the CAT Report outlined that the use of crypto-assets for illicit activities remains low.
Internal compliance policies at banks requires change as easy access to banking is a necessity for businesses. Without the major retail and commercial banks opening their doors, it will be challenging for the sector to mature in the UK. Given that many such banks are still part owned by the Government, policy makers may have influence here too. After all, the Government is sponsoring the digital economy as a major growth area for jobs and tax revenues.

High Quality Information
Almost all ICOs have been accompanied by some form of 'white paper', which typically outline the commercial, technical and financial details of the project (or some combination). However, as ICOs have been subject to limited regulation, the quality of 'white papers' has varied considerably with many providing little more than a bullet point overview of the project. Furthermore, there has been limited recourse against ICO issuers for incorrect information in 'white papers'. This has ultimately resulted in losses to investors and is a consumer protection issue (a key concern for regulators).
Companies such as Novum Insights and Equity Development are combatting this issue by providing independent data and regulated information memorandums (respectively) in relation to crypto-asset projects.
Reliable information, such as mentioned above, will help to protect consumers, strengthen investor confidence and allow the sector to develop.

Regulated Corporate Finance Advice
Established investment banks and other regulated corporate financiers have been noticeably absent from the sector. Although new entrants are emerging, the majority are unregulated in the UK and cannot provide a full range of services.

This presents an issue for the sale of security tokens in STOs or otherwise, particularly if security tokens become regulated as specified investments, as an investment bank will likely be required to underwrite or provide intermediary services in respect of these offerings.

Security Token Exchanges
Security and asset tokens are considered by us to be beneficial as an asset class as they can provide liquidity to traditionally illiquid assets – for example, tokenising real estate developments or intellectual property estates. However, this liquidity is subject to the development of a regulated multilateral trading facility (MTF) (as exists for traditional financial instruments) for such assets.
At present, there are a limited number of companies which provide the software for multilateral trading facilities and it is likely that the capability to build a crypto-asset MTF doesn't yet exist. That being said, companies are working to develop the technology and proto-types are likely to be seen this year.
Once a regulated MTF is operational, the liquidity of security tokens will be realised.

Conclusion

Crypto-assets are already starting to look more bullish in the first few weeks of 2019. Larger deal sizes, security and asset tokens and stable coin projects are resulting in the emergence of crypto-asset capital markets which will accelerate the involvement of regulated chartered financial advisors, hedge funds and others, with internet and commercial banks eventually following suit.

Increased engagement by financial institutions and the prospect of sensible regulation in larger jurisdictions suggests a positive outlook for 2019.
For further information in relation to crypto-assets and regulation of the sector in the UK and internationally, please contact the authors.


To listen to Neil Foster's CryptoLaw Podcast interview, which includes a series of practical calls to action towards the regulatory landscape, including banking, taxation, and a comparison among crypto friendly jurisdictions, click here

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