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Mishcon Academy: Digital Sessions – Cryptoassets: New FCA promotion rules

Posted on 04 March 2022

The Mishcon Academy Digital Sessions.  Conversations on the legal topics affecting businesses and individuals today.
Guy Wilkes

In this episode, promotion of cryptoassets in the UK is to become regulated.  What are the proposals and how will they impact firms in the sector?  What can firms do to prepare? 

Hello and welcome to the Mishcon Academy Digital Sessions podcast.  I’m Guy Wilkes, a Partner in our Financial Services Regulatory and Investigations team and I’m joined by my Partner, Charlotte Wilson, who heads our Financial Services Regulatory Advice team and together we head up Mishcon’s FinTech group. 

Good day Charlotte.  These are significant proposals.  Can you tell us a bit more about the background to the proposed changes?

Charlotte Wilson

Thanks Guy, of course.  So, at the beginning of this year, in January, the Treasury issued its response to last year’s consultation on cryptoasset promotions and among other things, the Treasury consultation proposed bringing certain unregulated cryptoasset such as utility and exchange tokens, within the scope of the UK financial promotion regime.  The Government has set out a proposed definition of qualifying cryptoasset which will be added to the list of controlled investments in the financial promotion order.  The Government is also making changes to introduce a new statutory gateway for firms approving financial promotions for unauthorised firms, this is known as the Section 21 Gateway.  This proposal involves imposing a new requirement on authorised firms, requiring that they will only be able to approve financial promotions if they have been assessed by the FCA as suitable to do so.  Following the Treasury publication the FCA then issued its own consultation paper consulting on the rules to implement the new legislation.  The FCA consultation closes on the 23 March and the FCA intends to publish a policy statement of final rules this summer.  At the moment, they are proposing to give firms three months from publishing the final rules to comply with the new requirements and for the requirements relating to cryptoasset promotions, those changes will apply from the date that qualifying cryptoassets are bought within the financial promotion regime. 

Guy Wilkes

Okay, so, qualifying cryptoassets is a term we’re all going to have to become familiar with.  How has the Treasury defined qualifying cryptoasset?

Charlotte Wilson

Qualifying cryptoasset has been defined as any cryptographically secured digital representation of value or contractual rights, which is both fungible and transferrable.  So, whilst the final drafting is under development, the key elements here include transferability and fungibility.  So, in relation to transferability, this is intended to exclude tokens such as travel passes or lunch passes and supermarket loyalty schemes that are cryptographically secure and also distinguishes between those tokens that are used specifically and only for payment to a vendor, so those won’t be in scope, and tokens which can also be traded between users for speculation or other purposes, which would be in scope.  I think that the key issue here though will be around fungibility so, if something is fungible, that means it is replaceable by another identical item or something that is interchangeable so, for example, a £10 note.  The FCA considers that fungibility is a core characteristic of a range of financial services products and it’s intended that the definition of qualifying cryptoasset by including this concept of fungibility, will exclude non-fungible tokens so, those are often referred to as NFTs and they are typically a tokenised representation of a unique digital item such as a photo, a video or some artwork.  It’s this, this element of the definition which I suspect, and Guy we’ve spoken about this previously, will be the most open to interpretation and also provide probably quite a lot of scope for regulatory arbitrage.  It’s worth bearing in mind that the definition itself is technology neutral and so I not tied to distributed ledger technology and so will be able to evolve as technology evolves.  I think one of the most important things to point out though is that although qualifying cryptoassets will be regarded as investments for the purposes of the financial promotions order, they are not necessarily regulated investments for other purposes and so, for example, cryptoasset firms will not necessarily be required to be authorised by the FCA.  Guy, can you tell us a bit more about what the consultation covers?

Guy Wilkes

Yes, so the FCA consultation builds upon the proposed statutory framework set by the Treasury and it proposes changes and additions to rules in the FCA handbook and although today we are focussing on cryptoassets, the FCA proposes changes to the regulatory regime for the promotion of all assets which the FCA describes as high risk and the changes are pretty wide ranging and involve firstly, a reclassification of investments into three risk categories.  Secondly, the introduction of a range of measures intended to address FCA concerns that too many consumers are just clicking through and accessing high risk investments without necessarily understanding the risks involved and these measures include strengthening risk warnings, banning inducements to invest so, free gifts and the like, and a range of measures which the FCA describes as positive frictions.  These include such things as cooling off periods for new investors.  There will also be what the FCA describes as improvements to client categorisation and appropriateness tests.  And finally, for the first time, crypto promotions will need to be approved by an FCA authorised firm and furthermore, the FCA has tightened up requirements about how this is to take place, not just for cryptoassets but for all promotions that need to be approved by such firms. 

Charlotte Wilson

So you said that the way investments are classified will change.  How will this work in practice so, particularly for cryptoassets? 

Guy Wilkes

Well, investments will be in one of three categories and the first is what are called readily realisable securities and these are investments which are listed on an exchange such as listed stocks, ETFs and the FCA regards these are lowest risk and most suitable for retail investors.  The second category is restricted mass market investments and these can be mass marketed but are subject to more restrictive rules such as around risk warnings and suitability.  And finally, for the highest risk investments called non-mass market investments, these are investments which the FCA does not regard as suitable for mainstream retail investors. 

Charlotte Wilson

Right, so where do cryptoassets fit in? 

Guy Wilkes

Well, qualifying cryptoassets will all be classified as restricted mass market investments and subject to similar rules as unlisted securities and P2P agreements – peer-to-peer agreements.  Perhaps, controversially, there’s intended to be no distinction between different types of qualifying cryptoasset.  So, for example, a utility token purchased by a consumer for non-investment purposes, for example for £10, is in principle characterised in the same way as a consumer making a speculative investment in £50,000 worth of an obscure cryptocurrency. 

Charlotte Wilson

So, qualifying cryptoassets will be, I think you said restricted mass market investments.  What does that mean in practice?

Guy Wilkes, Partner
Mishcon de Reya

Well, it does mean, as the name suggests, that cryptoassets can be mass marketed to UK consumers subject to complying with FCA rules regarding content and obtaining approval from an FCA authorised firm.  However, where a promotion is what the FCA terms a direct offer financial promotion, more stringent requirements will apply.  Under the proposed FCA definition, a direct offer financial promotion is a promotion which specifies how consumers can respond to the promotion or includes a form to do so.  So, in the online context, this essentially means a website or an app which enables a consumer to apply to invest in a qualifying cryptoasset and before a potential crypto customer gets to a form which enables them to invest, the rules will require the firm to go through a number of steps to filter out what the FCA would regard as ineligible or unsuitable customers.  So, Charlotte, I know you’ve been looking at this, how will it work in practice?

Charlotte Wilson

Well, in the first instance, a financial promotion can only be made if one, it doesn’t contain any monetary or non-monetary incentive to invest, as you said earlier, and two, it includes the prescribed risk wording.  Now, the FCA has prescribed this risk wording and it says don’t invest unless you are prepared to lose all your money invested, this is a high risk investment, you could lose all the money you invest and are unlikely to be protected if something goes wrong.  Take two minutes to learn more.  There is pre-existing FCA guidance on how risk warnings should be displayed and the FCA intends to build on this guidance for digital promotions.  The FCA also expects that firms take the accessibility standards into account when displaying risk warnings to ensure that they are sufficiently legible, prominent and also contrast to the background.  In relation to the two minutes to learn more wording, the FCA is proposing prescribed risk information for different types of high risk investment.  This information would be presented in a pop-up box when a consumer clicks on the link in the risk warning.  Firms should continue to provide further risk information specific to their business model and the product or service promoted aside from that included in the pop-up, to ensure that the whole of the promotion is clear, fair and not misleading.  This information should be succinct and in plain English.  The proposed risk information wording is in line with the FCA’s proposed guidance for matters to be covered within appropriateness tests and in the case of restricted mass market investments which would include qualifying cryptoassets.  If firms display further risk information, they should also consider covering this within their appropriateness tests where relevant.  The FCA is also looking to oppose a ban on inducements, as you said.  Examples include, using inducements to invest such as refer a friend bonusses and new joiner bonusses to achieve rapid and exponential growth in fraudulent investment schemes that rely on the flow of money from new investors to fund existing investors’ returns. 

Guy Wilkes

Thanks.  So, what’s wrong with inducements generally?  Aren’t they a legitimate promotional tool?

Charlotte Wilson

Well they can be, Guy but as new investors are being referred by friends, family and other contacts, the FCA believes that this creates powerful social and emotional drivers to invest with consumers often failing to realise the risks until it’s too late and investors can wrongly assume the investment being promoted is credible just because it’s referred to them by someone they already know.  Even when these types of inducements are used by legitimate firms, the FCA is concerned that they unduly influence consumers’ investment decision and cause them to invest without really fully considering the risks involved. 

Guy Wilkes

Right.  I spoke earlier about new rules relating to direct offer financial promotions.  Charlotte, can you explain a bit more about what they are?

Charlotte Wilson

Of course.  So, a person will only be able to make direct offer financial promotions after meeting certain conditions, some of which you mentioned earlier so, firstly, there’s the 24-hour cooling off period for first time investors, second, a personalised risk warning pop-up, third, client categorisation and fourth, an appropriateness assessment.  The FCA has said that it wants to build positive frictions into the consumer journey to counter social and emotional pressures to invest and support more considered investment decisions.  As you said, the aim of these frictions would be to prevent consumers from simply clicking through and accessing high risk investments they don’t understand or which don’t match their risk appetite.  Because of this, a person will only be able to make a direct offer financial promotion following this new cooling off period and personalised risk warning pop-up.  In relation to the client categorisation piece, direct offer promotions of qualifying cryptoassets will only be made to specific categories of investors so, restricted investors, high net worth investors and certified sophisticated investors.  It will not be possible to market qualifying cryptoassets to self-certified sophisticated investors and I think that will come as a surprise to a lot of people.  The FCA wants to make changes to investor declarations to help consumers better categorise themselves and they’ll do this by implementing evidenced declaration, where consumers will be required to state why they meet the relevant criteria so, for example, stating their income to demonstrate why they are high net worth.  The FCA also wants to simplify the language of the declarations and add a none of the above option.  Finally, as I mentioned, the rules on the appropriateness assessment will also need to be complied with. 

Guy Wilkes

Okay, thanks.  I think in practice, we anticipate that most firms will be relying on the restricted investor category and this will require individuals to confirm that they will not in the next 12 months and have not in the preceding 12 months invested more than 10% of their net assets in cryptoassets or indeed any other restricted mass market investments.  But as you said, there’s also an appropriateness assessment to comply with.

Charlotte Wilson

Yeah, that’s right so, the FCA is looking to strengthen the existing appropriateness test so consumers only invest following what the FCA describes as a robust assessment of their knowledge and experience.  The FCA’s appropriateness requirements are now often met through an interactive set of questions put to the consumer online without any human involvement from the firm at all and the FCA is proposing to introduce guidance on the types of questions to be covered by the assessments and discourage binary choice between answers.  They are also proposing to introduce rules restricting the ability to reassess appropriateness where an investment has been assessed as being inappropriate.  Also, rules governing feedback and the nature of questions that may be asked on reassessment and finally, imposing record keeping requirements in relation to the consumer journey more generally.  Now Guy, we have spoken about the need for this requirement to ensure promotions are approved by an FCA regulatory firm.  How is that going to work in practice?

Guy Wilkes

Well, it’s been a longstanding requirement of the regulatory system, as set out in Section 21 of the Financial Services and Markets Act, that subject to certain exceptions, a financial promotion must be issued by or approved by an FCA authorised firm.  Now, in most circumstances, the promotor of investments will themselves be FCA authorised and therefore are in a position to ensure that their promotion is compliant with FCA rules, including for example that it is clear, fair and not misleading and contains the appropriate risk warnings.  For those who are issuing financial promotions who are not themselves authorised, it is necessary to secure the services of an FCA authorised firm to check the promotion is compliant and approve the ad or other promotion and these are known as Section 21 Approvers.  Now there are only a small number of FCA authorised firms that do provide this service.  It’s not without risks since if the promotion is not compliant, it’s the FCA authorised firm not the advertiser against which the FCA will take enforcement action.  Now under the current FCA proposals, the requirements for Section 21 Approvers are going to be significantly tightened up and so under the new regime, authorised firms will have to apply to the FCA to be an approver and be able to demonstrate that they’re competent.  Secondly, there’ll be an ongoing requirement for Section 21 approvers to take reasonable steps to monitor promotions during their lifetime and this is new and it’s a move away from what the FCA describes as a once and done approach and so this means ensuring that any changes to the wording of the promotion or indeed the business of the provider or the product do not affect the validity of that promotion and approvals will need to be timestamped so that consumers can see when the advertisement was approved.  Now the vast majority of cryptoasset firms are not regulated by the FCA and to be clear, a registration with the FCA for AML purposes or an e-money or a payments regulation authorisation does not count.  As such, the vast majority of cryptoasset firms will need to engage a third party supplier to approve and monitor promotions.  Now the FCA does recognise that because cryptoassets sit outside the financial promotion regime at the moment, there’s unlikely to be an existing population of Section 21 Approvers.  However, the FCA does estimate there are around 300 firms promoting cryptoassets and as such, there’s likely to be a sizeable and lucrative market for Section 21 Approvers, however, this does come at a cost.  The FCA estimates that currently costs to approve a financial promotion are around £5,000 to £15,000 per promotion.  However, because of the potential complexity of cryptoassets and the increased regulatory obligation to undertake ongoing monitoring, costs are likely to significantly increase.  Now, it has to be said that in some respects the proposed Section 21 Approval regime for cryptoassets is not logical and that’s because in order to be a Section 21 Approver, you need to be FCA authorised but because activities relating to crypto are not regulated, it follows that in order to qualify as a crypto promotion approver, you have to be authorised and actually do some other kind of completely unrelated activity, it’s not possible to obtain FCA authorisation simply to be a Section 21 Approver and there are no proposals to change that.  So, Charlotte, in summary, what does all this mean for cryptoasset providers?

Charlotte Wilson

The changes that we’ve described are a significant set change which have the potential to significantly increase the costs of doing business in the UK.  Aside from the practicalities of complying with a new regime, there are also some I think inherent issues with the regime itself.  So, firstly, there are issues around the definition of qualifying cryptoassets and in particular I think around the term fungibility.  So, I spoke earlier about fungibility means but I think the issues are going to be particularly relevant given the increased prevalence around the use of non-fungible tokens or NFTs.  So, NFTs have significantly evolved and the term is increasingly generic and I think there’s likely to be real questions around, you know, for example, whether NFTs are fungible, in particular where they’re issued for example in series.  Secondly, the regime as you’ve said, will apply to cryptoassets that are not intended for investment so, the definition is potentially too broad and captures, for example, utility tokens or fan tokens where actually, maybe that’s not appropriate.  And thirdly, there’s a real issue, I think, around the cost of compliance and the burden of complying just being too high, especially when you take into account the cost of some of these tokens so, for example, as you mentioned earlier, you know some utility tokens or fan tokens costing no more than £10.  Finally, I think there’s going to be a real issue around the availability of Section 21 Approvers so, as you mentioned, cryptoassets currently sit outside the financial promotions regime, certainly unregulated cryptoassets and there’s unlikely to be an existing population of Section 21 Approver firms and the population of authorised firms with sufficient competence and expertise to approve cryptoasset financial promotions is likely to be really limited at first. 

Guy Wilkes

Okay.  I think it’s also fair to say that the proposals may have some negative and unintended consequences and so one concern is that customers who are determined to invest in cryptoassets are maybe put off by the FCA’s positive frictions such as the 24-hour cooling off period, may look for and find unscrupulous and potentially fraudulent firms based overseas who don’t apply the FCA’s controls.

Charlotte Wilson

So, Guy, you specialise in advising firms and individuals who are subject to FCA enforcement action.  What powers does the FCA have to take action against these firms that don’t comply>

Guy Wilkes

Well the most important thing to bear in mind is that breach of Section 21 of the Financial Services and Markets Act is a criminal offence so, firms that promote qualifying cryptoassets within the UK without the promotion being approved by an FCA authorised firm, are committing a criminal offence and firms could face an unlimited fine and individuals up to two years in prison. 

Charlotte Wilson

You said there that promotion within the UK is covered.  How does that apply then to overseas firms?

Guy Wilkes

Well the rules do apply to any promotion which is accessible in the UK so, a crypto firm based entirely overseas but which does have promotions which are accessible from the UK, such as on the internet, will be covered and so, for example, a firm which uses the internet, as I say to promote qualifying cryptoassets to UK customers, will still be subject to these rules even if there’s no other activity within the UK and the only way to take oneselves outside the rules is to restrict UK customers from investing.  Now that does present a practical problem for the FCA.  How does the FCA prosecute a company or individuals who are based overseas for breach of UK law?  Now there might be treaties in place which permit extradition or mutual cooperation arrangements but that does depend upon where the potential defendant is located.  However, even if the FCA is unable to take direct action, the FCA might be able to take other actions such as securing the closure of websites and issuing consumer warnings.  And furthermore, because breach of Section 21 is a criminal offence, overseas firms operating in the UK without the necessary Section 21 approvals, may find it difficult to secure banking and payment services to undertake business in the UK.  Now the second implication of breach of Section 21 is that it may give a consumer a right to rescind any agreement which they have entered into following an approved promotion and a right to recover any moneys which they paid although it does of course depend on the consumer being able to find the firm and enforce any judgement.  Now the good news for crypto firms which do obtain Section 21 approval is that the regulatory obligation to ensure compliance with FCA rules is on the approver not the promoter so, any FCA disciplinary action, for example for non-compliance, is for the approver and, as I said, not the promoter.  Having said that, breach of the rules might give a consumer a right of action to recover losses arising from an investment which was made following an advertisement which did breach the financial promotion rules.  So, Charlotte, given the changes that will take place, what can cryptoasset providers do to prepare?

Charlotte Wilson

So, I think there are broadly three things that these cryptoasset providers can do.  The first is respond to the consultation.  Now as I said earlier, the FCA consultation closes on the 23 March so there is still time to put in responses.  The second is to consider their business model so, take a look at your tokens and the proposed definition of qualifying cryptoassets and really have a think about whether there is any flexibility around how the tokens will operate and where there’s any way of looking at that as against the definitions fungibility and transferability.  Thirdly, cryptoasset providers can start looking into potential Section 21 approvers.  A starting point might be compliance consultants with an authorised firm or regulatory cover providers that are already operating in and therefore have experience in the crypto space.  I think those are my three top tips for now. 

Guy Wilkes

Okay, thanks for that, Charlotte.  So, let’s wrap up there.  I’d like to say thanks to Charlotte Wilson for joining me for this Mishcon Academy Digital Sessions podcast.  I’m Guy Wilkes and do look out for the next episode in the series. 

The Digital Sessions are a series of online events, videos and podcasts, all available at Mishcon.com and if you do have any questions you’d like answered or suggestions of what you’d like us to cover, do let us know at digitalsessions@mishcon.com

 

The Mishcon Academy Digital Sessions.  To access advice for businesses that is regularly updated, please visit mishcon.com.

On 18 January 2022, HM Treasury issued its response to last year's consultation on financial promotions. The resulting legislation will bring certain unregulated cryptoassets within the scope of the UK financial promotion framework, and introduce a more robust regime for authorised firms approving financial promotions. The Treasury response was closely followed, on 19th January 2022, with the FCA's consultation on rules and guidance, necessary for implementing this new regime.

In this podcast, Partners Guy Wilkes and Charlotte Wilson discuss these significant proposals. How will they impact firms in the sector? What can firms do to prepare?


Visit the Mishcon Academy for more learning, events, videos, podcasts and reports.

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