When people talk about the frontiers of FinTech, they usually mean new technologies or processes; something that changes the way we do things and causes wonderment.
Usually, the last thing they think about is legal and regulatory issues. As 2021 dawns, this is going to change. Except perhaps the lack of wonderment about regulation.
New inventions have limited value unless they can be sold to the public. Over recent years, various regulators, legislators and governments have proposed ways to apply existing investment regulation and e-money frameworks to crypto. One starting point is that cryptoassets have the potential to bring significant benefits to market participants and consumers. Another emphasises the risks to consumers and market integrity associated with cryptoassets and focusing on their potential use for illicit activity.
With effect from early January, there are two significant changes to regulation of cryptoassets introduced by the UK Financial Conduct Authority (FCA). First, an anti-money laundering (AML) registration requirement for firms that exchange, or arrange, or make arrangements with a view to the exchange of, cryptoassets and firms that safeguard cryptoassets. Second, a prohibition on the sale to retail customers of derivatives and exchange traded notes where these reference unregulated cryptoassets.
Both requirements have potential for confusion built in. The FCA AML registration requires many of the same systems and controls that apply to FCA authorised firms, and so in practice feels like FCA authorisation. However, it does not give the right to carry on regulated investment business with customers. Importantly, it does not give firms the right to describe themselves as FCA authorised. Confusion is also shown by at least one major FCA regulated firm having told its customers that with effect from early January only professional investors will be able to purchase cryptoassets at all.
As part of the AML registration process, the FCA has noted that there is a risk of consumers using unregulated products believing, wrongly, that they are regulated. For example, it is possible to set up unregulated structures for paying interest on cryptoassets, similar to a bank account, and to provide unregulated services similar to traditional investment securities activity, whilst remaining outside the scope of FCA regulation.
A key FCA concern is to make sure that AML registered firms do not describe products and services in a way that suggests that they are regulated. Superficially, this would seem achievable simply by including a warning in the product terms. However, if the marketing of a product uses terminology which implies that it is regulated, there is a legitimate question regarding whether simply adding a statement to the product terms, which consumers may simply skim over, really solves the “confusion risk” problem.
Trying to achieve a solution by not using language associated with regulated investment activities is trickier than it looks. If something operates like a regulated activity, then the language used to describe that operation will naturally tend to look like language associated with the regulated activity.
Another option is to explain the new activity using language which is not generally associated with the relevant operation. The problem with this approach is that it inevitably involves using atypical language to describe something. Or perhaps even creating new words to describe the activity. If creating new words with new meanings, or giving existing words new meanings, then we could easily accidentally start sounding like Humpty Dumpty in Alice in Wonderland, who states: “When I use a word, it means just what I choose it to mean” and to whom Alice responds: “The question is whether you can make words mean so many different things.” That leaves us with Humpty Dumpty’s conclusion: “which is to be master—that’s all.”
Or to put it another way: it is unlikely that this approach is going to avoid customer confusion.
So, what is the solution? The first thing to recognise is that this is a problem that regulatory specialists are used to addressing. For example, traditionally a common area of confusion has been differentiating between electronic money institutions and deposit takers. Whilst in terms of the products they offer, both may superficially look like “banks”, and the media may refer to them that way, they have completely different regulatory requirements. In fact, by law a company cannot even use the word bank in its name without a prior regulatory approval.
We recommend a mix of approaches. Firstly, where language can easily be used which avoids suggesting something has regulated status, this should be done. For example, instead of describing a smart property token as a “derivative” of the external reference asset, it can be referred to as a “voucher” for that asset. This has the same general connotation without suggesting a regulated product.
If the clearest descriptive language is reminiscent of a regulated product, then be clear and upfront in stating that the product is regulated. This includes providing a clear warning regarding the nature of the product.
Finally, when in doubt, get an outside view. Lawyers act as professional wordsmiths, and so can often help provide clear and helpful product description language. Or, for the more cynical, it is harder for people to claim that language is unclear if it has been reviewed and approved by an external independent advisor.
One thing not to do is take a wait and see approach. Current indications are that there is increasing concern from the regulators regarding potential customer confusion. If marketing communications with clients use unclear language, firms will find it increasingly harder to show compliance later, as there will be an increasingly large body of potentially misleading product information in existence. Furthermore, when updating language, there can be difficulty in locating customers to get confirmation that they understand the nature of the product and are happy to continue using it. Even where customers can be located, there is a risk that they will withdraw from the product if they discover that is not regulated when they thought it was. A situation made worse if they feel that they were deliberately misled about the regulated status of the product.
All new frontiers involve risk. This is partly why they are exciting. However, taking on additional risks which can be avoided is not good business practice. And confusion risk can be avoided with the right planning and advice.
James Burnie and Edward Black, gunnercooke LLP
James Burnie (https://www.linkedin.com/in/james-burnie-889b09a5/) and Edward Black (https://www.linkedin.com/in/edward-black-a747215/) are FinTech and financial services regulatory partners at law firm gunnercooke llp, with particular focus on blockchain, crypto and DeFi. For more information on the gunnercooke blockchain practice please see https://gunnercooke.com/practicearea/blockchain-cryptoassets-smart-contracts-and-defi/