How the regulatory climate in the UK, US and EU affects where cryptoasset firms operate

May 2024  |  SPECIAL REPORT: FINANCIAL SERVICES

Financier Worldwide Magazine

May 2024 Issue

For a cryptoasset firm, getting the location right can be crucial. For some, the choice is clear-cut, such as when the firm addresses issues in a specific community or when founders opt to incorporate in their home jurisdiction.

However, many firms seek an international footprint, prioritising tax and regulatory considerations in their selection of an operational base. The nature of the cryptoasset business can also influence this decision. For instance, miners typically prefer to reside in the US due to low electricity costs. Issuers often favour the Cayman Islands or British Virgin Islands for their tax advantages and recognition of corporate entities like decentralised autonomous organisations.

Conversely, exchanges or cryptoasset service providers tend to target jurisdictions where they can tap into substantial markets or user bases. For these firms, a local presence becomes important for liaising with financial service providers, such as payment companies, to access their markets. Thus, the financial services regulatory climate of these jurisdictions is a significant factor.

This article examines the regulatory frameworks of three prominent jurisdictions to determine whether their approaches foster or hinder the growth of cryptoasset firms.

The UK

Until recently, cryptoassets in the UK were not subject to any bespoke governance framework. The UK regulatory approach embodied technology neutrality – firms would examine the function and essential characteristics of a cryptoasset to determine if it met financial instrument definitions that trigger regulation.

Cryptoassets are not recognised as a ‘currency’ or ‘money’ for public policy reasons, so generally fall outside of regulations relating to deposit taking, lending and payment services (unless they meet the definition of e-money). That leaves many cryptoassets outside of regulatory oversight.

However, the landscape has shifted in recent years with the introduction of regulations that specifically govern cryptoassets, including those that fall outside the scope of traditional financial frameworks. Since early 2020, UK firms involved in exchanging cryptoassets or offering cryptoasset custody services have been obligated to adhere to anti-money laundering (AML) regulations.

They also must register with the Financial Conduct Authority. The registration process proved to be more onerous than anticipated, and only a small number of firms successfully registered. Many others exited the UK after the regulator advised firms to withdraw their applications.

As of October 2023, cryptoassets have been classified as ‘controlled investments’ under the financial promotions regime. Consequently, UK firms promoting cryptoassets must obtain approval from a regulated firm for marketing materials.

Firms registered for AML purposes can promote their own cryptoassets, but cannot approve promotions of other entities. These restrictions also mandate that firms disclose specific information to consumers and adhere to waiting periods before allowing new customers to invest in cryptoassets.

The implementation of the AML regime and difficulties in securing registration caused many UK cryptoasset firms to move to other jurisdictions, while still providing services to UK customers. However, with the revised financial promotions regime, these firms cannot offer services to UK customers without an authorised firm approving their marketing materials.

While some firms do that, this comes at a cost, and the authorised firm has the final say on the language of the promotion. The UK is consulting on more comprehensive cryptoasset regulations that would necessitate licensing for certain crypto-sector entities.

However, no definitive timeline has been set for the enactment of such legislation. The government has expressed no plans for a simplified or interim permissions process for existing firms. This has raised concerns about the process, especially in light of the challenges faced during the AML registration process. Some firms fear that seeking approval may be similarly burdensome and may drive firms away from the UK once again.

In light of these uncertainties, firms interested in entering the UK cryptoasset services market may prefer to delay their establishment until regulators clarify details relating to the authorisation process and ongoing compliance.

The EU

The European Union (EU)-wide approach to regulating cryptoassets has predominantly been the same as the UK’s until recent years. In fact, the UK’s AML framework reflects the transposition of an EU directive, which set out baseline rules for combatting money laundering across all EU member states.

However, the UK’s implementation of these rules is more stringent than the directive itself – some firms need to register in the UK even though they are exempt from similar requirements in EU countries.

Recently, the EU has taken a significant step with the Markets in Crypto-Assets Regulation (MiCA), set to take effect on 30 December 2024.

The MiCA pioneers a regulatory framework for cryptoasset markets as one of the first comprehensive pieces of legislation specifically regulating the cryptoasset sector within major economies. The regulation will subject cryptoasset service providers to a licensing mandate requiring compliance with governance, fit and proper criteria, and prudential standards.

Once MiCA-authorised, EU-based cryptoasset providers will be able to offer services throughout the European Economic Area by establishing a branch or through cross-border service provision. To extend services to other member states, firms must first notify the relevant authority in their home state.

Anticipating MiCA, some member states, such as France, have pre-emptively established optional licensing frameworks. Requirements in these regimes align with regulatory expectations and anticipate MiCA requirements, which should streamline the transition to MiCA compliance after it takes effect. As a result, firms eager to establish EU operations before MiCA’s introduction are gravitating toward these jurisdictions.

After authorities implement MiCA, non-EU cryptoasset service providers looking to enter the EU market without authorisation may encounter challenges. European Securities and Markets Authority guidance confirms that third-country firms will be prevented from providing cryptoasset services in the EU unless the client exclusively initiates the service.

The goal is to protect EU-regulated firms from competition with entities facing less stringent regulations. Consequently, cryptoasset firms outside the EU have an incentive to establish a branch or subsidiary in Europe to engage in the market under MiCA’s regulatory umbrella.

The US

The US regulatory landscape for cryptoassets is complex and sometimes fragmented due to multiple regulatory bodies with overlapping jurisdiction. This can create challenges for cryptoasset businesses attempting to comply with rules and regulations. The US has largely applied existing financial regulations to cryptoasset activities.

However, unlike many jurisdictions without specific cryptoasset regimes, the US has taken a ‘regulation by enforcement’ approach, and regulatory clarity often comes from enforcement actions, court rulings and piecemeal guidance.

The different regulators each have their own jurisdiction and interpretation of how existing laws apply to cryptoassets. These include the Securities and Exchange Commission (SEC), which primarily has focused on the classification of tokens as securities. Using the Howey Test – a legal precedent for determining what constitutes a security – the SEC has determined many cryptoassets to meet the definition of securities, even when they have not in other jurisdictions.

The SEC has taken enforcement actions against several cryptoasset projects that it deems to be unregistered securities. It continues to scrutinise cryptoasset projects and has signalled an interest in increasing regulation and oversight.

Also regulating cryptoassets, the Commodity Futures Trading Commission treats cryptoassets like bitcoin as commodities and thus has jurisdiction over futures and other derivatives tied to cryptoassets. It also investigates fraud and manipulation in the cryptoasset markets. The Financial Crimes Enforcement Network oversees the compliance of cryptoasset exchanges and other financial entities with the Bank Secrecy Act, which requires entities engaged in money transmission involving cryptoassets to implement AML programmes and report suspicious activities.

On top of federal regulation, each state can have its own regulations and licensing requirements for cryptoasset businesses. New York’s BitLicense, for example, imposes a separate regulatory framework for cryptoasset companies operating in the state.

Cryptoasset firms in the US have faced legal challenges, with some facing high-profile and costly court battles with regulators on the applicability of the rules to cryptoassets. The lack of clear regulation and prevalence of litigation in the US makes it a high-risk jurisdiction for cryptoasset firms. The US has witnessed several cryptoasset companies, especially exchanges, expanding operations overseas to avoid the challenging regulatory environment in the US. However, the size of the market makes it appealing, nonetheless.

Conclusion

Cryptoasset firms and industry bodies no longer want to operate outside the regulatory perimeter. They are calling on governments to introduce a regulatory environment tailored to their business. Many investors seek regulatory clarity prior to participating in fundraisings and eventually public offerings.

These will be key factors for firms to consider in deciding where to operate. Cryptoasset firms should also look beyond the language of a regulation to the behaviour and processes. Do regulators use enforcement action as a legislative tool? Do they truly understand the nuances of cryptoasset business?

Cryptoasset firms weigh many factors in decisions on location, including tax and market size, but they and their investors increasingly prefer areas where they can conduct business without the threat of shifting regulatory focus and regulatory crackdowns.

 

Rebecca James is a managing associate, Dan Jones is a partner and Guy Stevenson is a senior associate at Orrick. Ms James can be contacted on +44 (0)20 7862 4762 or by email: rebecca.james@orrick.com. Mr Jones can be contacted on +44 (0)20 7862 4807 or by email: d.jones@orrick.com. Mr Stevenson can be contacted on +44 (0)20 7862 4734 or by email: gstevenson@orrick.com.

© Financier Worldwide

BY

Rebecca James, Dan Jones and Guy Stevenson

Orrick

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