The last 12 months has seen a number of advances in the UK blockchain market including maturing business cases, the evolution of regulation and legal certainty and advances in self-governance models. In noting the maturing market structures, it is important to understand that the blockchain market in the UK is not new and can, in part, be traced back to the Financial Conduct Authority’s (FCA) Project Innovate, an innovation hub supported by the regulator which went live in October 2014. Since then, the FCA has inaugurated a regulatory sandbox, in June 2016, where numerous blockchain projects have been able to test-run and develop their products and services under the regulator’s guidance and supervision. Following that model, the international regulatory sandbox – the Global Financial Innovation Network (GFIN) - was formally launched in January 2019 by an international group of financial regulators and related organisations, including the FCA.
In a significant step, in November 2019, the UK Jurisdiction Taskforce published a Legal Statement on the Status of Cryptoassets and Smart Contracts (Legal Statement) covering topics including recognition of digital assets as property under the law and enforceability of smart contracts. In the following months, there were a number of cases applying legal analysis around crypto-assets into English case law which constitute an important feature for certainty including, notably, the Commercial Court in December 2019 in AA v Persons Unknown  EWHC 3556 (Comm).
On other topics, the development of crypto-based payment services has also moved forward at pace, utilising the existing regulatory framework, including electronic money (e-money) approvals, to develop private sector payment solutions and now moving forward into public models including Central Bank Digital Currencies (CBDC). In March 2020, the Bank of England (BoE) published a discussion paper on CBDC and cited blockchain solutions as something to be considered in the development of CBDC in the UK. We expect the digitalisation of fiat currency, interaction between private and public projects in this space, the impact of open finance as an extension of open banking, and increased institutional interest and volume in security token issuances, to be some of the main themes of the coming 12 months.
There is a very broad range of business models applying blockchain technology in the UK today. A number of these are orientated around the financial services space, including:
In non-financial services, there are models in:
In the proof of concept space, one of the most exciting areas with enormous potential is a blockchain-based real estate ownership and trading solution. Asset-backed tokens are feasible via indirect structures (such as a token representing shares in a company holding real estate assets) but that brings the product into the financial services regulatory arena. Direct digitisation of real estate title interests, in the alternative, is subject to some limitations in the UK that need to be overcome to develop further. By way of a proof of concept, in partnership with Consensys, HMLR created a “Title Token” prototype and listed it on a digital asset marketplace to see how owners might tokenise their real estate holdings, manage property portfolios and trade their assets using a tokenised solution. Title tokens provide the prospect of low-barrier-to-entry property investment and trading opportunities and extracting greater liquidity from the real estate asset class.
The regulatory approach on blockchain and cryptocurrencies in the UK has developed sophistication and nuance as a result of regulatory consultation between industry and policymakers.
Blockchain, as a technological solution, remains outside the scope of FCA regulation. The FCA takes a “technology neutral” approach to regulating financial services meaning that it does not regulate specific technology types but the activities they facilitate and the firms carrying out these activities. The FCA is aware of some of the positive applications of blockchain and published Discussion Paper 17/3 in 2017 to start a dialogue with industry. On page 5, the FCA noted that “distributed ledger technology (DLT) is an example of rapidly developing technology which offers exciting potential to support the needs of consumers and the market”.
Conversely, the financial services regulatory regime has flexed to encompass certain cryptocurrency offerings and associated services where those offerings and services fit within existing conceptual boundaries of specified investments (such as securities) and/or regulated activities. Other cryptocurrencies that meet the definition of e-money, or constitute a payment instrument, may be in-scope of the -money and payment services regulatory frameworks which are also administered by the FCA.
In July 2019, the FCA published final guidance on cryptocurrency classification in Policy Statement 19/22 (FCA Guidance). On page 14, the FCA adopted the following taxonomy:
The FCA has proposed, in Consultation Paper 19/22, that regulated instruments such as derivatives or exchange-traded notes that reference certain crypto-assets be banned for retail consumers. The outcome of this consultation was expected in the second quarter of 2020 but has been delayed a result of the COVID-19 pandemic.
As at 10 January 2020, crypto-asset exchange service providers and custodian wallet providers are caught by the Fifth Anti-Money Laundering Directive (EU) 2018/843 (MLD 5) as implemented in the UK by the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs 2017). This was guided in its design by the Financial Action Task Force (FATF) recommendations in applying high international anti-money laundering (AML) and know your customer (KYC) standards to virtual asset service providers (VASPs).
MLD 5 has a broad application to service providers in the crypto-asset space, and the MLRs 2017 define a “crypto-asset” as meaning a cryptographically secured digital representation of value or contractual rights that uses a form of distributed ledger technology and can be transferred, stored or traded electronically. The definition of a crypto-asset may encompass some of the unregulated tokens referred to above, such as exchange tokens like Bitcoin.
Crypto-asset exchanges and wallet providers
A crypto-asset exchange provider is also defined broadly and applies to a whole range of businesses that exchange or arrange the exchange of crypto-assets. The definition extends to creators or issuers of any crypto-assets (eg, via initial coin offerings, security token offerings or initial exchange offerings) where they provide services for exchanging, arranging or making arrangements with a view to the exchange of the crypto-asset in question for money or other crypto-assets. The definition also covers operators of crypto-asset automated teller machines (ATMs).
A custodian wallet provider means any firm that safeguards or administers cryptocurrency on behalf of customers or private cryptographic keys on behalf of its customers. This may encompass both “hot” and “cold” wallet providers.
Crypto-asset exchange providers and custodian wallet providers that perform these activities by way of business in the UK must comply with the MLRs 2017. Compliance with the MLRs 2017 involves various obligations including registration with the FCA, submission of suspicious activity reports, undertaking customer due diligence or enhanced due diligence as appropriate. Firms subject to the MLRs 2017 under this regime, however, may not be subject to the FCA’s broader financial services regulatory regime or that applying to issues of e-money or payment service providers.
The UK has adopted MLD 5 which was guided in its legislative design by the recommendations of the FATF.
In the Bank of International Settlements Annual Economic Report, published on 17 June 2018, it was noted that there was not a “strong case for immediate issuance” of a CBDC. The BoE, however, published a Discussion Paper, in March 2020, on the form and purpose of any BoE issued CBDC and we consider that there is increasing interest in the opportunities for digital fiat currency in the UK, including the potential interaction between public and private offerings in this area.
The FCA, Payment Systems Regulator, the Prudential Regulation Authority and the BoE are the most relevant regulatory bodies in the UK.
In February 2018, Coinbase, eToro, CryptoCompare, CEX.IO, BlockEx, CoinShares and CommerceBlock established a self-regulatory body called CryptoUK to improve industry standards and engage policy makers, specifically in the UK, to support the crypto-asset industry. CryptoUK now has over 30 members and represents a broad range of businesses. It invites members to subscribe to its three principles and the self-regulatory code of conduct it has established. The three principles are UK leadership, support good regulation and self-regulation.
It is not a mandatory organisation and the principles and code of conduct of CryptoUK are not mandatory for participation in the industry.
Global Digital Finance is another prominent industry body in the UK, although its reach is global, which promotes the adoption of best practices for crypto-assets and digital finance technologies, including blockchain, through the development of conduct standards, in a shared engagement forum with market participants, policymakers and regulators. Its purpose is to drive “acceleration and adoption of digital finance to support the next era of digital commerce, dedicated to the advancement of next-generation technologies in finance for society” and it has a live code of conduct, which is member driven, with a set of overarching principles and sub-codes that look at particular areas of market focus such as stablecoin, cryptofunds, cryptocustody and more. Members can attest to the code (in all cases to the overarching principles and to other sub-codes as applicable to the business under consideration) and compliance is monitored for ongoing certification purposes.
There is judicial guidance as well as developing case law which, together, confirm that cryptocurrencies should be treated as property under English law. This has practical implications including with respect to inheritance and wills, the giving of security, exchange/trading and tax.
In November 2019, the UK Jurisdiction Taskforce published the Legal Statement, for further discussion of which please refer to 1.1 Evolution of the Blockchain Market. The Legal Statement recognised that, depending on the nature of the crypto-asset, a crypto-asset may be properly understood under English law as property.
Following the Legal Statement, the commercial court case of AA v Persons Unknown  EWHC 3556 considered the legal status of crypto-assets as personal property under English law. The English High Court held that “a crypto asset such as Bitcoin are property” for the purposes of being subject to an interim proprietary injunction. This judgment was made in respect to the availability of an injunction and does not represent a conclusive finding that all crypto-assets will qualify as property under English law but is helpful in providing additional certainty. Other cases have also been cited in which UK courts have similarly treated cryptocurrencies as property:
We anticipate that the case law will continue to develop but these early cases are helpful in establishing certainty around the legal treatment of crypto-assets under English law.
The FCA is yet to conclude any enforcement matter against a firm or person in either the blockchain or crypto-asset space.
The FCA’s crypto-asset anti-money laundering regime under the MLRs 2017 is still in its infancy, as it only came into effect on 10 January 2020.
In addition to the traditional powers to penalise misconduct by firms and individuals through both civil and criminal systems, the MLRs 2017 provide the FCA a range of new supervisory tools such as:
As part of its Project Innovate, the FCA launched the first regulatory sandbox in 2016. The sandbox continues to be open to firms already authorised by the FCA or firms without such authorisation that are looking to deliver innovation to the UK financial services market. The regulatory sandbox allows participants to test new products and services in a controlled environment with UK customers.
The sandbox is not limited to firms with crypto-asset or blockchain-based projects but does also include such projects. Participation in the FCA’s regulatory sandbox is subject to eligibility criteria, which require the applicant to satisfy the FCA that their proposition has a “clear benefit” and is a “genuine innovation”. Practically, this means that the applicant needs to demonstrate that the service will deliver a benefit beyond what is possible in today’s market by using a new technology or novel business model.
So far, crypto-assets in regulated financial activities have been used in around 40% of tests and are the single most popular technology for testing. The application of blockchain technology has also been frequently put forward as part of the regulatory sandbox in providing genuine innovation.
The FCA is also a member (as well as chair and leader) of the GFIN, as discussed in 1.1 Evolution of the Blockchain Market. Whilst still in its infancy, the GFIN is designed to represent a global sandbox which would occur within a framework of co-operation between regulators.
Her Majesty’s Revenue and Customs (HMRC), the UK tax authority, first clarified the tax treatment of cryptocurrencies in 2014. In November 2019, HMRC published further guidance in a policy statement that set out how individual and businesses should treat crypto-assets including exchange tokens.
In the vast majority of cases, individuals that hold crypto-assets as a personal investment will be liable to pay capital gains tax when they dispose of their crypto-assets. In addition, if the holder is conducting a trade then income tax will be applied to their trading profits. The HMRC policy statement outlines the position for individual on mining, airdrops, income tax losses and blockchain forks.
The HMRC policy statement for businesses notes that businesses involved in the trading of cryptocurrencies will be liable to pay one or more of the following: capital gains tax, corporation tax, income tax, national, insurance contributions, stamp taxes and/or value-added tax.
The FCA, BoE and Her Majesty’s Treasury formed a joint Cryptoassets Taskforce in 2018. The objective of the Cryptoassets Taskforce was to explore the impact of crypto-assets, the potential benefits and challenges of the application of distributed ledger technology in financial services, and assess what, if any, regulation is required in response. In October 2018, the Cryptoasset Taskforce published its final report (Final Report).
The Final Report concluded that distributed ledger technology has the potential to deliver significant benefits in both financial services and other sectors, and all three authorities will continue to support its development. The Final Report also concluded that the authorities should take action to mitigate the risks that crypto-assets pose to consumers and market integrity. The outcome of these actions is the regulatory framework outlined in 2.1 Regulatory Overview.
The UK Parliament undertook a digital currencies inquiry via the Treasury Committee. This inquiry published its report in September 2018 (Parliamentary Report). The Parliamentary Report was critical of the sector noting the risks to consumers and that arguments put forward that crypto-assets could further financial inclusion were “unconvincing”. The Parliamentary Report concluded that the government should consider what “activity” related to crypto-assets should be specified in the regulatory framework.
The Treasury Committee was supportive of good innovation, but noted that blockchain should not be pursued for its own sake. Rather, government and industry should identify what problems exist and consider whether blockchain offers the most appropriate solution. The Parliamentary Report did recognise that blockchain technology may have the potential to solve problems caused by a lack of trust in data integrity and may be a more efficient method of managing certain types of data in the long term, offering higher levels of security than centralised databases.
Following the UK Jurisdiction Taskforce's Legal Statement, crypto-assets are to be treated in principle as property under English law. Notably, they are not considered to be documentary intangibles, documents of title or negotiable instruments. Private keys permit transfers and other transactions in respect of crypto-assets, and a person with knowledge and control of a private key (by lawful means) would, as a starting point, be treated as the owner of the associated crypto-asset to the extent of having effective possession. However, this is certainly not the only relevant factor for ownership. Possession of the private key (or one of a number) may be part of a broader agency or trust relationship in respect of the associated crypto-asset, may represent a part or shared ownership, or may be subject to a separate register which is superior for ownership purposes or a security arrangement, for example, so the surrounding circumstances are legally relevant in characterising the ownership.
With respect to transfers, unlike transfer of a physical item of property where the same thing passes between two parties, a transferred crypto-asset will be represented by new data and controlled by a new private key. The point at which transfer of ownership occurs on the blockchain network is understood to be the point when the transferor authenticates a transfer and broadcasts it. However, the Legal Statement also notes that there is no reason in principle for transfers offchain (for example a documentary assignment rather than an onchain transfer) to be precluded, albeit that this is likely to be a less certain arrangement for the transferee due to the knowledge of the private key which lies with the transferor. In that case the transfer would occur in line with usual contractual principles.
As can be seen, there are a number of factors associated with determination of questions of ownership in crypto-assets, but the Legal Statement guidance, which has been applied in case law in this jurisdiction, is bringing greater clarity to these points.
The UK’s approach to the categorisation of digital assets has developed following the taxonomy first set out in the UK Cryptoassets Taskforce’s Final Report (for further discussion of which, please refer to 2.9 Other Government Initiatives). This taxonomy separated tokens into three categories under the sub-groups of “regulated tokens” and “unregulated tokens”. Following feedback received from respondents to FCA Consultation Paper (CP 19/3) on the UK Cryptoassets Taskforce’s taxonomy, the FCA released a Policy Statement (PS 19/22), which amended the taxonomy, by further (non-legislatively) categorising crypto-assets into four broad types: security tokens, e-money tokens, exchange tokens and utility tokens. More detail on these categories is given in 2.1 Regulatory Overview. The position as stated by the FCA remains that “any tokens that are not security tokens or e-money tokens are unregulated tokens.” In order to determine whether a token falls within the scope of financial regulation in the UK, one must analyse its characteristics in line with the existing regulatory perimeter for such asset classes – there is no separate regulation applicable to crypto-assets.
Whilst the stablecoin market can be sliced up for taxonomy purposes in a number of ways, broadly four types of stablecoin are recognised:
Stablecoins in themselves are not separately regulated but will be subject to regulation when the underlying structure actually constitutes a regulated instrument, such as a regulated security, a derivative or e-money; or when the services being provided constitute regulated services, such as payment services or crypto-asset services subject to money laundering regulations – for additional detail refer to 2.1 Regulatory Overview.
There is currently no direct prohibition of the use of cryptocurrencies in the UK with regard to the making of payments for goods or services. However, there is limited vendor acceptance of such forms of payment and they are not commonly used in the retail market. Cryptocurrencies largely fall under the classification of exchange tokens (for further detail see 2.1 Regulatory Overview), which remain outside of the financial regulatory perimeter and therefore are not under the oversight of the FCA.
Guidance by the BoE has expressed a resistance to the use of the term “cryptocurrency” in favour of the alternative – “crypto-asset” due to its lack of “money-like” characteristics (in particular, it has been considered that they serve as a weak store of value). However views on these topics are maturing – as detailed above in 3.1 Ownership, crypto-asset holders are being afforded property protections under the common law, conversations about the potential uses for CBDCs are advancing with the BoE and the strong performance of Bitcoin and other similar crypto-assets during the COVID-19 pandemic has not gone unnoticed (albeit that volatility remains).
Firms providing payment services using crypto-assets and other connected entities such as wallet providers facilitating these services will be subject to payment services and money laundering regulations – see 2.1 Regulatory Overview.
The guidance published by the FCA in CP 19/3 acknowledges the existence of a diverse assortment of tokens currently on the market, which include “non-fungible tokens”. However, the guidance does not attempt to provide an exhaustive list of such tokens and notes that irrespective of the labelling of an individual token, the regulatory outlook will be determined by what class of token it is. There is no specific category for non-fungible tokens.
It should also be noted that even where a token falls outside the FCA regulatory perimeter, there are other significant laws and legal principles which may apply to the tokens. Included amongst these are consumer rights laws and common law principles including misrepresentation and fraud.
Digital assets markets in the UK are primarily centred around traditional market offerings such as exchanges, funds and custodians. These include fiat-to-crypto exchange, crypto-to-crypto exchange and custodial wallet providers. There are currently no authorised digital assets exchanges in England and Wales and the largest exchanges used by cryptotraders tend to be established overseas (including the US and Asia, noting also that Binance has an establishment in Jersey). There are no specific licences available in England for digital assets custodians.
The UK has a number of smaller cryptocurrency exchanges operating and available to UK customers. Customers are capable of exchanging both fiat currency for cryptocurrency as well as cryptocurrency for cryptocurrency. Customers typically open a virtual wallet offered by a virtual wallet provider which may be linked to the exchange, they load in fiat currency and exchange for crypto. A variety of business models are operated so there are different approaches to trading different types of cryptocurrencies.
Cryptocurrencies are not formally considered to be legal tender in the UK but another way to participate is to withdraw (“cash out”) cryptocurrencies at certain ATMs, which can be used to pay for (limited) goods and services. Cryptocurrency ATM providers are within the scope of the UK anti-money laundering regulations and are subject to registration with the FCA as described in 2.1 Regulatory Overview.
Money transmission businesses are generally covered by payment services and electronic money regulatory frameworks under English law, and these may apply to services associated with cryptocurrencies but it is noted that major cryptocurrencies such as Bitcoin do not qualify as electronic money for these purposes (instead being classified as unregulated exchange tokens) so are accordingly out-of-scope of the payment services and electronic money regulatory frameworks. The Payment Services Regulations 2017 (PSRs 2017) provide the regulatory framework in respect to payment services. Payment services may relate to a “payment transaction”, which is defined as an “act initiated by the payer or payee, or on behalf of the payer, of placing, transferring or withdrawing funds, irrespective of any underlying obligations between the payer and payee”. Importantly, “funds” are defined in the PSRs 2017 to extend to electronic money. To the extent that the cryptocurrency in question may be classified as e-money, services associated with it may be in-scope of this regulatory framework.
Even where the PSRs 2017 do not apply, as mentioned in 2.1 Regulatory Overview, crypto-asset exchange service providers and custodian wallet providers are caught by the MLRs 2017. For further detail, refer to 4.3 KYC/AML.
See 2.1 above for the scope of application of the MLRs 2017.
The MLRs 2017 contain various requirements for relevant persons to engage in know your customer checks – including simplified due diligence, customer due diligence and enhanced due diligence.
Under Regulation 27 of the MLRs 2017, a relevant person must apply Customer Due Diligence (CDD) measures if they:
As part of CDD, relevant persons must:
Crypto-asset exchange service providers and custodian wallet providers may also be able to apply simplified customer due diligence under Regulation 37 of the MLRs 2017 where the customer business relationship or transaction presents a low degree of risk of money laundering or terrorist financing.
Crypto-asset exchange service providers and custodian wallet providers may also be required to apply enhanced customer due diligence under Regulation 33 of the MLRs 2017 in high-risk circumstances.
As outlined in 2.1 Regulatory Overview, cryptocurrencies are generally not considered to be specified investments under the Financial Services and Markets Act 2000 (Regulated Activities Order) 2001 (RAO) unless they are classified as security tokens. Accordingly, only security tokens are subject to the usual financial markets regulatory frameworks applicable in the UK under the regulatory remit of the FCA.
The UK has implemented the Second Markets in Financial Instruments Directive 2014/65/EU (MiFID II). MiFID II, as implemented, sets out a regulatory framework for trading venues whereby venues are classified as either regulated markets, multilateral trading facilities or organised trading facilities. Established markets such as the London Stock Exchange are classified as regulated markets in the MiFID II context.
Cryptocurrency exchanges, to the extent that they do not list any financial instruments or other specified investments, such as shares or security tokens, are not subject to the MiFID II regulatory framework for trading venues. There are no special regulations addressing fraudulent or manipulative practices for digital assets and there have been no notable enforcement actions.
There are no specific regulatory limits on the ability of a digital asset exchange to re-hypothecate (on transfer) the crypto-assets they hold for customers in the UK.
The FCA is responsible for supervising the anti-money laundering controls of businesses under the MLRs 2017 as amended to bring crypto-asset exchange providers and custodial wallet providers within scope. See 2.1 Regulatory Overview.
Under the MLRs 2017, custodial wallet providers are defined as a firm or sole practitioner who by way of business provides services to safeguard, or to safeguard and administer:
Businesses providing online (hot) or offline (cold) storage solutions for private cryptographic keys are likely to be caught under the custodial wallet provider definition as outlined above and are therefore required to comply with the requirements of the MLRs 2017. A person or firm may be a custodial wallet provider regardless of whether they are otherwise regulated in the UK if they carry on business of a kind that is captured by the above definition.
Under the MLRs 2017, custodial wallet providers are required to, amongst other things:
In the UK, the primary regulation applicable to fundraising activities through the creation and sale of tokens as part of a decentralised network (previously referred to as initial coin offerings (ICO)) is the Financial Services and Markets Act 2000 (FSMA). For further detail on whether tokens being issued are to be considered regulated financial instruments or not, see 2.1 Regulatory Overview. In addition, where tokens constitute "transferable securities" within the meaning of MiFID II, they may be subject to the Prospectus Regulation which, broadly, requires the issue of an approved prospectus, unless an exemption applies, whenever there is either an offer of transferable securities to the public in the UK or a request for the admission to trading of transferable securities on a regulated market. Given the broad definitions involved issuers may also be caught as crypto-asset exchange providers under the MLRs 2017 – see 2.1 Regulatory Overview, 4.3 KYC/AML and 5.4 Broker-Dealers and other Financial Intermediaries for further details.
Where an offering and sale of tokens is effected through a digital asset exchange operating as an intermediary, that digital asset exchange will need to consider whether its activities fall within the regulatory perimeter, which would require it to obtain authorisation to undertake the proposed activity. Acting as an intermediary is likely to be licensable – in its crypto-assets guidance, the FCA has specified that “a firm wanting to create infrastructure for the buying, selling and transferring of security tokens (commonly known as exchanges or trading platforms) must ensure it has the appropriate permissions for the activities it wants to carry on”. Other potentially relevant permissions may include permission to operate a multi-lateral trading facility or an organised trading facility; consideration of permission to carry out safeguarding/custody and wallet services; and, potentially, crowdfunding laws.
There are no specific regulations that are applicable to investments funds or collective investment schemes that invest in digital assets – such funds will be subject to the usual regulatory requirements. However, funds with a digital asset investment strategy will need to undertake case-by-case analysis of the characterisation of digital assets held, as detailed in 2.1 Regulatory Overview.
There are no specific regulations that are applicable to broker-dealers or other financial intermediaries that deal in digital assets – such firms will be subject to the usual regulatory requirements. However, as detailed above including in 4.6 Wallet Providers and 5.1 Initial Coin Offerings, firms will need to consider whether the activity being undertaken is a regulated activity within the scope of the FSMA or the MLRs 2017.
Under the MLRs 2017, a crypto-asset exchange provider is defined as a firm or sole practitioner who by way of business provides one or more of the following services, including where the firm or sole practitioner does so as creator or issuer of any of the crypto-assets involved, when providing such services:
Market participants such as broker-dealers or other financial intermediaries may fall within scope of the above definition and if so will be required to comply as relevant persons under the regulations.
Self-executing contracts, or "smart contracts", are in principle enforceable under English law. No specific legal framework has been established for this; the common principles of contract law apply.
The computer code making up a smart contract can in principle constitute a valid contract, provided the validity requirements under English contract law are met. This was confirmed in the Legal Statement which stated “English law does not struggle with the concept of anonymous or pseudonymous parties contracting; nor with the notion that a contract can be formed between individuals by virtue of them each having agreed to subscribe to a set of rules […]. English law is fully equipped to deal not only with bilateral smart contracts but also those structured around Decentralised Autonomous Organisations (DAOs).”
There are currently no specific laws or regulations which would establish code developers as fiduciaries, in the context of losses that arose through the use of blockchain-based networks they had developed, under English law.
Decentralised financial platforms are not prohibited in the UK and commercial lending is generally not a regulated activity. For registration and potential activities requiring licensing, see further detail in 2.1 Regulatory Overview.
As crypto-assets are considered as property under English law, normal security principles apply. English law has a number of flexible options for taking security which may be applied to crypto-assets and it is also possible for private keys to be held by separate agents in order to establish appropriate control over secured digital assets.
Under MiFID II”, cryptocurrencies are not considered a form of currency or commodity and, as such, firms would not typically be subject to MiFID II requirements. This, however, is contingent on the fact that the crypto-assets are not classified as derivatives or transferable securities under MiFID II in which case the requirements will apply.
In acting as custodian, firms may carry on regulated activities including safeguarding and administering investments or arranging for one or more other persons to carry on that activity – certain exemptions apply and it should be anticipated that professional legal advice will be required to navigate this environment.
As mentioned elsewhere in this chapter, including in 4.6 Wallet Providers, custodial wallet providers must comply with the MLRs 2017. There are no specific exemptions to compliance with the MLRs 2017 and only a general exemption found under Regulation 15 for firms solely coming in-scope of the MLRs 2017 as a result of engaging in financial activity on an occasional or very limited basis. It is unlikely that many custodian wallet providers would be able to satisfy the conditions required to rely on the Regulation 15 exemption.
Our analysis on this point notes that there are many apparent issues between the GDPR requirements and blockchain technology, not least including the interaction between immutability of blockchain-based information and the right to be forgotten. The UK Information Commissioner’s Office has noted that it has no plans to publish particular guidance at the present time and without endorsing the guidance provided by other regulators, recently noted that the guidance developed by CNIL, the French data protection authority, will be useful to people working in the field. The CNIL guidance notes that when a blockchain contains personal data, the GDPR is applicable and, amongst other things, that a participant, being the person registering data on a blockchain, can often be considered as a data controller as they determine the purpose and means of data processing. We anticipate that further legal work will be carried out in relation to the interaction between blockchain and GDPR/privacy rights at the European level, and potentially by the UK national government, in due course.
See 8.1 Data Privacy.
There is no prohibition on the activity of mining cryptocurrencies using “proof of work” consensus protocols to validate block transactions in the UK. The FCA crypto-assets guidance states that miners and transactions processers engaging with decentralised tokens are “unlikely to be carrying out regulated activities”. This is likely the case as cryptocurrencies fall within the category of exchange tokens (as described in 2.1 Regulatory Overview), which remain outside of the regulatory perimeter.
Note that this will not exclude the activity from attracting tax-related implications. See HMRC guidance referred to in 2.8 Tax Regime.
There is no specific regulatory regime overseeing the staking of tokens in the UK. Any activity held in connection with the use of a “proof of stake” consensus protocol, when in relation to decentralised tokens, is unlikely to fall within the scope of the regulated activities under the FSMA regime.
Such validation systems may have similar characteristics to a debt position, whereby token holders can mine or validate a block transaction according to how many tokens they hold, by depositing such tokens into a staking mechanism in exchange for a form of economic reward (additional tokens), should the block be successfully validated. Whilst unlikely, should the tokens gained from the activity of mining amount to a specified investment by resembling traditional financial instruments then there is a possibility that engaging in proof of stake validation may amount to a regulated activity, requiring authorisation, permissions and oversight from the FCA.
Blockchain: Convergence and Implementation
The implementation at scale of distributed ledger technologies such as blockchain is nascent and their full potential has yet to be realised. Increasingly, however, we are seeing and advising on meaningful applications of these exciting technologies, and we expect this trend to continue through 2020 and beyond.
The emergence and proliferation of blockchain technology will influence a diverse range of sectors, from energy, healthcare and logistics, to financial services, real estate and entertainment.These influences, and the disruption which will flow from them, are part of the reason that Gartner predicts that blockchain will create USD3.1 trillion in business value by 2030.
We see 2020 as a breakthrough year for distributed ledger technologies. The disruption caused by the COVID-19 pandemic has forced governments and businesses to re-evaluate their service and business models more fundamentally than ever before. Organisations that have historically been slow to embrace change – lawyers included – are now, of necessity, making great strides to innovate and are looking to emerging technologies such as blockchain to help them do so.
The proliferation of blockchain applications will be driven by three main factors, which have each made great progress in the last 12 months: (i) the convergence of blockchain with other emerging technologies such as artificial intelligence, machine learning and the internet of things; (ii) the development and availability of enterprise-ready blockchain platforms; and (iii) the provision of legal certainty.
Although blockchain is a fascinating and rapidly evolving technology, it does not exist in a vacuum. Blockchain is just one, albeit important, component of a broader emerging technology ecosystem that includes a vast array of interesting innovations. We are increasingly seeing a convergence of such emerging technologies, leading to the creation of new business and service models. The emerging technology ecosystem is as broad as it is rapidly changing. At the time of writing, it includes, amongst many others, nanotechnologies, quantum computing, machine learning, gene therapy and robotics. This article focuses on the convergence of blockchain with two of the better-known emerging technologies: artificial intelligence (AI), and the internet of things (IoT).
The convergence of emerging technologies is a fascinating yet complex and rapidly evolving field. We strongly advise organisations to seek expert commercial, legal and regulatory advice as early as possible when considering the design, development or implementation of an emerging technology application. Early expert engagement can help to mitigate the risk of costly delays and issues with the deployment of such an application.
Blockchain and AI
In this article, when we refer to AI, we do so using the broad definition proposed by the European Commission's High-Level Expert Group on AI, which describes AI as referring to "systems… that, given a complex goal, act… by perceiving their environment through data acquisition…[and decide] the best action(s) to take to achieve the given goal." This broad definition includes various subsets of AI, and we do not intend it to be overly prescriptive or rigid in its application.
AI can be an extremely valuable tool for organisations but, in order to produce meaningful results, AI-enabled applications require significant volumes of data. The accumulation and aggregation of such data can be, depending on the specific type of data concerned, an expensive and time-consuming exercise. This is compounded by the absence of widely accepted data sharing standards (that, amongst other things, would need to address concerns regarding data protection and cybersecurity), meaning that today our datasets exist in siloes, generally in the hands of organisations with vast resources.
One of the developments we continue to work on and monitor closely is the emergence of data as an asset class. Indeed, we are of the view that data will be the most important asset class of the twenty-first century. Not all data is created equal, however, with matters of provenance, accuracy and collection date, amongst other factors, affecting each piece of data's value.
Distributed ledger technologies such as blockchain can serve to address many of the issues facing AI by facilitating a distributed data marketplace. This is the concept that underpins Ocean Protocol, with whom we have worked closely, for example. Ocean, according to its white paper, "aims to spread the benefits of AI, by unlocking data while preserving value." It is also the foundation upon which the Abu Dhabi Digital Authority (ADDA) intends, as announced at the World Economic Forum 2020 in Davos, to develop a "secure data exchange" that will allow "a value-driven data-exchange programme." We designed this platform for ADDA in partnership with one of our valued clients.
The key characteristics of blockchain make it a suitable candidate technology to facilitate data marketplaces. It provides, amongst other things: (i) a fully auditable, theoretically tamper-proof ledger that can be used to record provenance; (ii) a data structure which could enable data providers to aggregate and "package" their datasets; and (iii) a means by which datasets could be tokenised and exchanged (whether by way of sale, licence or lease) for value.
In a similar vein to the data marketplace concept outlined above, blockchain may also enable the sharing of AI tools, whereby providers of such tools (who are often academics or sole trader entrepreneurs who lack the requisite resources to obtain the computing power required to process the data required by AI systems) might share their tools. A distributed marketplace would enable such providers to monetise their tools while retaining a proprietary interest in them. Such platforms exist (see, for example, SingularityNET), though they are yet to reach maturity and widespread adoption.
There also exist a number of ways in which AI might support the efficacy of blockchain solutions. These are beyond the scope of this article. Suffice to say, the relationship between blockchain and AI is, and will continue to be, close. It will be important for clients to engage legal, regulatory and technical experts in both fields as they continue to converge.
Blockchain and IoT
In this article, when we refer to the IoT, we do so using the broad definition adopted by a May 2015 European Parliament briefing paper entitled The Internet of Things: Opportunities and challenges. That briefing paper defined the IoT as "a distributed network connecting physical objects that are capable of sensing or acting on their environment and able to communicate with each other, other machines or computers." As with our adopted definition of AI, we do not intend this IoT definition to be overly prescriptive or rigid in its application.
The IoT ecosystem is growing exponentially. Gartner reported that, at the end of 2019, there were 14.2 billion devices connected to the IoT, and predicts that there will 25 billion connected things by 2021. The IoT will increasingly influence all aspects of our lives across a vast range of industries. IoT use cases range from individual consumer applications within smart homes (eg, smart lighting, appliances and security features), through to society-wide implementations, such as smart cities and smart societies, on which we are working with a number of government clients.
The IoT is exciting, but faces a number of challenges. These include the data protection and cybersecurity concerns associated with billions of devices collecting, processing, storing and transacting data. In addition, a more practical issue exists whereby the vast quantity of IoT data is stored in siloes. These siloes, coupled with the fact that large technology vendors own the great majority of widely used IoT platforms, increase the risk of vendor lock-in – indeed, the point at which antitrust authorities engage with the ecosystem will be a strong indicator of the blockchain market's increased importance. In the absence of clear and effective governance frameworks, these proprietary platforms may also facilitate the exposure of IoT-collected data by such technology vendors.
Many of the risks and challenges posed by the proliferation of IoT devices may, in theory, be addressed by more traditional approaches to data management, for example client server or cloud-based systems. There are flaws in these approaches, however, which will become more and more prevalent as the scale of IoT device deployment increases. Critically, these traditional, centralised approaches provide single points of failure for IoT networks (that are under near constant cyber-attack and require regular maintenance) and lack the flexibility required to accommodate a rapidly evolving and innovative IoT market.
Blockchain (and other forms of distributed ledger technology) can provide (theoretically infinite) scalability without single points of failure across IoT networks. An open source blockchain platform would enable new and innovative IoT devices to plug into an existing ecosystem, while the provision of common protocols and standards would support interoperability between IoT devices. It is important to note that, at the time of writing, blockchain has yet to mature to the extent that it can process such large volumes of data. Nevertheless, significant progress is being made in this regard, with innovation in blockchain and alternative forms of distributed ledger technology, such as directed acyclic graphs (DAGs), demonstrating significant potential to scale in ways hitherto considered impossible.
In a similar way to that referred to in Blockchain and AI above, blockchain technology can also be used to record and maintain the provenance of data as it is collected and shared amongst IoT devices. This audit trail and proof of data authenticity will be extremely beneficial as IoT networks are increasingly used to enable and inform automation and smart contract execution.
For illustrative purposes, take Project Provenance, one of our valued M:Tech clients that provides a platform to empower brands to take steps towards greater transparency. Project Provenance collate supply chain data to clearly demonstrate the impact, and authenticity, of its users' products. Where a Project Provenance client uses cold storage as part of its supply chain (eg, meat or poultry), an IoT-enabled temperature sensor in the relevant container may regularly share temperature data to the Project Provenance platform. This data is made available to the various supply chain actors, from farmer to wholesale purchaser and even the Food Standards Agency. Such data is also made available to the end user (ie, the consumer), who might wish to make a discerning purchase for ethical or health reasons.
An IoT underpinned by blockchain would also pave the way to the realisation of the so-called Internet of Value – ie, an internet that enables the transfer of value, for value, without the need for intermediaries or offline manual steps. This disintermediation is a key tenet of blockchain and other distributed ledger technologies, and will become more influential as data continues to emerge as its own asset class in the years to come. One interesting project working on such a vision is Mattereum, a London-based, venture capital-backed company, which aims to digitally organise and enable the digital trade of the world's physical assets. This represents a very exciting trend and development in the blockchain space that we continue to monitor with interest.
The initial hype around blockchain, which for so long was intrinsically linked in the public consciousness to Bitcoin, is beginning to settle. Nevertheless, Gartner argue that "IT leaders must prepare for the inevitable blockchain "spring" on the horizon, bringing with it core-enabling technologies and significant opportunities for digital businesses." Indeed, the Gartner Blockchain Spectrum predicts that the blockchain ecosystem will begin to reach maturity by 2025.
The blockchain "spring" will bring with it widespread implementation of blockchain-enabled solutions. A number of developments will underpin this widespread implementation, including: (i) technical innovations to improve the speed and scalability of distributed ledger technology platforms; (ii) the availability of blockchain platforms fit for enterprise adoption; and (iii) an improved awareness of distributed ledger technologies such as blockchain, and their functionality. In this section, we explore each of these in turn.
If blockchains are to transform industries, first they need to be capable of reaching scale. This is extremely difficult to achieve using the first generation public permissionless blockchains available today. Increasingly, however, we are seeing the development and implementation of new innovations to address these shortcomings.
One of the challenges associated with the scaling of traditional blockchains is the manner in which node consensus is reached as to the state of the ledger from time to time. A traditional blockchain requires the validation of transactions by all participating nodes in accordance with the relevant consensus protocol adopted. This becomes more challenging as a network grows and the number of participating nodes required to validate the transactions increases, resulting in slower performance.
One innovation we are increasingly seeing applied to blockchains looking to scale is sharding. The term "sharding" in the context of distributed ledger technologies, refers to the horizontal partitioning of the ledger into rows called shards. Typically, shards are categorised by (and are apportioned ledger entries based on) characteristics. For example, one shard might store ledger entries pertaining to one type of digital asset, with other shards storing ledger entries relating to other types of digital assets. This innovation is not without its risks – clients should seek expert advice as to the governance of the network to ensure that each shard is sufficiently distributed, for example. Nevertheless, sharding represents an interesting and promising development that will assist the scalability of blockchain solutions.
Another innovation that we are increasingly advising on is DAGs. DAGs are a well-established branch of graph theory and computer science. Unlike blockchain, which stores its ledger's transactions in blocks, DAGs store their ledgers' transactions in the nodes themselves. Blockchains establish a chronology by ensuring that each block contains a hash of the preceding block. DAGs approach the problem of chronology differently, however, by imposing a one-directional ledger entry protocol and prohibiting "loops". DAGs require each new transaction to be validated by two earlier transactions before confirming its entry to the ledger. One advantage of a DAG is that the consensus mechanism adopted means that multiple transactions can be validated and confirmed in parallel. Indeed, the larger a DAG network becomes, the more transactions it can confirm in parallel, thus maintaining its performance at scale.
The last couple of years have seen a significant growth in, and the increased sophistication of, enterprise-ready platforms and applications. These have been welcome developments for businesses who wish to enjoy the benefits of a blockchain-enabled ecosystem but which lack the resources required to build their own ecosystem from scratch.
The involvement of large technology vendors in the development and provision of blockchain infrastructure has been varied. Some have opted to develop their own bespoke platforms – for example, New York City-headquartered technology company R3 has developed and leads the ecosystem of Corda, a distributed ledger used across a variety of industries with an initial focus on financial services. We worked with Corda when we advised HM Land Registry on the UK's first digitised end-to-end residential property transaction.
Other vendors have made significant contributions to existing projects. For example, IBM has been the lead contributor to the Hyperledger Project, an umbrella project of open source blockchains started in December 2015 by the Linux Foundation. We have worked closely with IBM on healthcare-related projects underpinned by Hyperledger Fabric.
Another of our valued clients, Microsoft, has opted to provide plug and play infrastructure in the form of the Azure Blockchain Workbench, which aims to simplify solution and development and facilitate experimentation with prebuilt networks and infrastructure. Amazon has taken a similar approach, with AWS Blockchain Templates intended to help users create and quickly deploy blockchain networks.
The variety of approaches taken by large technology vendors in respect of blockchain technology is a testament to the diverse nature of the space. As more investment flows into the industry in the coming years, we expect to see that diversity continue to the betterment of innovation for years to come.
The dream of a democratised, public, permissionless internet of value is a beautiful one, and it remains alive and well. Nevertheless, a lack of awareness and understanding of distributed ledger technologies, such as blockchain, and their potential applications continues to be among the most significant barriers to their widespread adoption.
Occasionally we still encounter the misconceived belief that distributed ledger technologies are too complex to warrant significant investment and investigation. Furthermore, the interchangeable use of terminology between blockchain and crypto-assets (in particular, the so-called "ICO boom" of late-2017, which saw a significant number of fraudulent and/or misleading claims made regarding the potential functionality and value of various crypto-assets) has in some cases had a chilling effect on innovation.
It is incumbent on those of us working in emerging technologies to raise awareness of their potential and advocate for their adoption where appropriate. We offer half-day and full-day workshops for clients wishing to enhance their understanding of blockchain technology, its potential applicability and the strategic, legal, regulatory and technical considerations surrounding its implementation. These workshops often involve whiteboard sessions to help identify potential use cases within the relevant client's business, and make recommendations as to the necessary technical and legal steps that the client might take to investigate further.
PwC's Global Blockchain Survey identified regulatory uncertainty as the single biggest barrier to blockchain adoption for its respondents. This is unsurprising – distributed ledger technologies such as blockchain raise a number of legal and regulatory questions, from data protection and system governance rules, through to tax and property law.
Thankfully, the last two years has seen the English legal system take a number of significant strides to provide certainty to the blockchain space. Though there are no blockchain-specific legislative or regulatory frameworks in the UK, recent developments have made it clear that many applications of blockchain technology fall within existing legal and regulatory perimeters. For example, the fifth Money Laundering Directive as implemented in the UK makes explicit reference to distributed ledger technology in the context of crypto-assets and, amongst other things, brings providers of custodian wallet services and virtual currency exchanges within the scope of anti-money laundering (AML) regulations.
The relevant authorities published a number of blockchain-related guidance pieces in 2019, enhancing legal certainty in the UK. For example, in July 2019, the Financial Conduct Authority (FCA), following consultation, published guidance in a Policy Statement (FCA Policy Statement 19/22) for market participants wishing to understand whether their activities might fall within the FCA's regulatory perimeter. This was followed in November by a statement by the UK Jurisdiction Taskforce (UKJT) regarding legal questions as regards the status of crypto-assets and smart contracts, to which we were delighted to contribute. In December 2019, the UKJT's statement was referenced and endorsed by the High Court of England and Wales in AA v Persons Unknown. In addition, the UK tax authority, HMRC, continued to update its guidance on the taxation of crypto-assets in the UK.
We anticipate further legal clarity to be provided regarding blockchain and other distributed ledger technology applications in 2020 and beyond. The FCA is consulting on whether to prohibit the sale, marketing and distribution of derivatives (ie, contracts for difference, futures and options) and exchange traded notes that reference certain crypto-assets. Its final policy statement and Handbook rules are expected in Q2 2020, though may be delayed by the COVID-19 pandemic. In addition, HM Treasury is consulting on legislation that would seek to expand its regulatory authority to include crypto-assets, with a view to bringing further crypto-asset service providers with the scope of the UK's AML and counter-terrorist financing regimes. We would expect the FCA and the Prudential Regulatory Authority to review their own positions following the release of HM Treasury's findings. There are also various other legal and regulatory issues that we expect to face blockchain platforms in the coming years, including in respect of competition law. Finally, the Legal & Regulatory sub-working group of Tech London Advocate's Blockchain Working Group, in partnership with The Law Society of England & Wales, is due to release guidance for legal practitioners working on transactions involving smart legal contracts in Q3 2020.
We are confident that these developments will continue to pave the way for the UK to embrace blockchain technology and remain a strategically important technology hub for years to come.