Blockchain 2024

Blockchain 2024: An Introduction

Herbert Smith Freehills is proud to present the Chambers guide to the world of blockchain and digital assets law and regulation. This guide has stood as a testament to the evolution and progress of this emerging field and has prominently highlighted the efforts of lawyers from various jurisdictions striving to clarify and establish legal frameworks.

From a legal standpoint, the past year has not been easy for those engaging with blockchain and digital assets. Policymakers and other authorities around the world have grappled with regulating digital asset businesses and applications, most notably in the United States where the Commodity Futures Trading Commission (CFTC) and US Securities and Exchange Commission (SEC) each took aim at the world's largest crypto-exchanges for allegedly operating unregistered services. The end result – a record-breaking multibillion-dollar settlement – set a frosty tone for the industry.

Spot bitcoin ETFs

However, US legislative activity can also be credited, at least in part, with helping to pave the industry's route out from the “crypto winter”. Having rejected all applications for spot bitcoin ETFs (exchange traded funds that would give investors exposure to bitcoin without having to own or custody the digital asset themselves), the SEC was ruled to have erred in its approach by the District of Columbia Court of Appeals. This forced the SEC to revisit applications, ultimately resulting in the approval of the first spot bitcoin ETFs in early 2024.

This was a key milestone in the world of cryptocurrency, signalling a major shift in the investment landscape. It was followed in April 2024 by Hong Kong’s financial regulator – the Securities and Futures Commission (SFC) – approving both spot bitcoin and ether ETFs, bringing cryptocurrency into mainstream finance, triggering notable capital inflows and returning the industry to record highs.

RWA tokenisation

Demonstrating the increasing maturity of the industry, this rebound has not been driven solely by access to cryptocurrencies. Proprietary blockchain platforms launched by established financial institutions such as Goldman Sachs and HSBC have supported a growing trend in the tokenisation of real-world assets (RWAs) – the process by which physical items are represented digitally on the blockchain – across asset classes including bonds, deposits and gold.

Tokenisation is often seen as a way to improve efficiency, transparency and liquidity, benefiting from fractionalisation, negating the need for expensive reconciliation, and preventing issues such as settlement failures. Citi cited it as the next “killer use case” in its 2023 report “Money, Tokens, and Games”, in which the firm forecasts that the RWA tokenisation market will reach up to USD5 billion by 2030, principally through tokenised debt, real estate, securities and private equity/venture capital.

Regulation

From an institutional and retail investor standpoint, the growing alignment between decentralised finance (DeFi) and traditional finance (TradFi) has been supported by increasing clarity around law and regulation. Financial services regulators around the world – from the UK and Europe to Hong Kong and Australia – have sought to increase consumer protection, ensure market integrity and secure effective competition through efforts to expand financial promotion rules to cover crypto and introduce crypto licensing regimes that align with those for traditional financial instruments.

Legislation is catching up with even the most novel applications of blockchain technology, such as Decentralised Autonomous Organisations (DAOs), which operate using distributed management structures that are facilitated by smart contracts. Laws passed in the US state of Wyoming provide a new legal structure for these innovative entities, while Japan relaxed fundraising requirements for DAOs established as Limited Liability Companies (LLCs).

As evidenced by the success of spot crypto ETFs and tokenisation of RWAs, regulatory-compliant blockchain infrastructure and solutions are helping to usher in a new era for the crypto industry, transforming it from a niche market into one that is trusted by institutions and consumers alike.

UK and EU

Regulatory sandboxes

The EU DLT Pilot regime was launched in March 2023 and allows the testing of the use of DLT for the issuance, trading and settlement of certain tokenised financial instruments. In the UK, the first applications to the Digital Securities Sandbox are expected in summer 2024. The UK government hopes the sandbox will enable the issue, trading and settlement of digital securities to be tested, and help facilitate the adoption of digital asset technology in UK financial markets. Whether the UK sandbox will attract more applicants than the slow start experienced by the EU's DLT Pilot regime remains to be seen.

Crypto-asset regulation

In the EU, the Markets in Crypto-Assets Regulation (MiCAR) was adopted in May 2023; the first phase of regulation will apply from 30 June 2024, with the rest applying from the end of 2024. MiCAR introduces a bespoke regulatory regime for crypto-assets that are not currently regulated by existing financial services legislation, and regulates those issuing and trading crypto-assets across the EU.

Unlike the EU's bespoke approach to crypto-asset regulation, the UK government is planning to regulate crypto-assets by amending existing legislation and via a phased approach, with the regulation of fiat-backed stablecoins used for payment first, followed by the regulation of activities in relation to other crypto-assets.

The Financial Services and Markets Act 2023 introduced the legislative framework enabling fiat-backed stablecoins to be regulated similarly to other payment methods. The new regime for fiat-backed stablecoins is currently expected to be finalised in H2 2024, with implementation at some point in 2025.

Regarding regulation of the wider crypto-asset regime, the UK government consulted in February 2023 and published its response in October 2023, but the timing of the next steps remains unclear. What is clear is that there will likely be divergence in approach and coverage between the UK and EU regimes (eg, unlike MiCAR, which covers advising on and managing crypto-assets, the UK government has said that it is not minded to bring portfolio management and the provision of investment advice on crypto-assets within the regulatory perimeter).

Until a UK crypto-asset regulatory regime is in place, the Financial Conduct Authority (FCA) relies on its enforcement powers under the new crypto-asset promotions regime to protect retail investors from misleading marketing and scams. Just over two weeks after the regime started in October 2023, the FCA had already issued 221 alerts about firms illegally promoting crypto-assets to customers. In its most recent Business Plan, the FCA said that it will continue its supervision of crypto-asset firms’ financial promotions and increase its technological capability to detect harmful financial promotions.

Both the UK and the EU have put in place anti-money laundering rules – known as the “Travel Rule” – regarding the collection, verification and sharing of information on crypto-asset transfers. The rules have been in operation in the UK since September 2023, and will become applicable in the EU from 30 December 2024.

United States

The US regulatory landscape for cryptocurrencies has undergone significant changes over the past year. An updated version of the Responsible Financial Innovation Act (RFIA) was introduced in July 2023, aiming to provide greater clarity for establishing whether a cryptocurrency is a security or commodity. Shortly afterwards, the Financial Innovation and Technology for the 21st Century Act (McHenry-Thompson Bill) was introduced, providing a framework for regulating digital assets, and aiming to fill regulatory gaps. In addition, the Bill gives the Commodity Futures Trading Commission (CFTC) primary jurisdiction over digital asset markets.

The Clarity for Payment Stablecoins Act of 2023 was proposed in July 2023, with the aim of regulating payment stablecoins. The Bill restricts the permission to issue payment stablecoins to select institutions and issuers.

Hong Kong

There have been significant developments in the regulatory landscape for digital assets in Hong Kong. In June 2023, the Securities and Futures Commission (SFC) implemented a mandatory licensing regime for Virtual Asset Trading Platform operators (VATPs). This regime applies to a VATP that carries on the business of operating a centralised virtual asset (VA) exchange in Hong Kong or actively markets (whether by itself or through another person on its behalf) its VATP services to Hong Kong investors (whether from Hong Kong or elsewhere). The VATP licensing regime allows retail access to eligible large-cap, highly liquid VAs through SFC-licensed VATPs, provided that the various retail investor protection safeguards are met.

Furthermore, the SFC regulates VA dealing and/or advisory services and VA fund managers under the existing regulatory framework under the Securities and Futures Ordinance (SFO), by requiring VA uplifts of an intermediary's existing licence (through the imposition of additional licensing conditions) for dealing and/or advising in securities or asset management. The SFC also regulates the distribution of VA-related products under the existing SFO regime. This means that all existing requirements governing the sale of investment products, including the complex product regime, apply to the distribution of VA-related products. Intermediaries involved in VA-related activities are subject to additional requirements imposed by way of circulars.

In addition, the SFC has issued guidance to intermediaries engaging in tokenised securities-related activities, permitting retail access to the distribution and marketing of tokenised securities. The SFC clarified that tokenised securities are fundamentally traditional securities with a tokenisation wrapper and therefore the existing requirements governing the traditional securities market will continue to apply. This is significant as the SFC previously stated that security tokens were complex products that should only be offered to professional investors. The Hong Kong Monetary Authority (HKMA) has issued similar guidance to banks on the sale and distribution of tokenised products.

Earlier this year, the HKMA also issued guidance to banks on the provision of custodial services for digital assets and a joint public consultation paper with the Financial Services and the Treasury Bureau (FSTB) on legislative proposals to regulate stablecoin issuers in Hong Kong. Under the proposed regime, qualified fiat-referenced stablecoin (FRS) issuers are required to be licensed with the HKMA. The HKMA will also introduce a “sandbox” arrangement, conveying regulatory expectations and providing compliance guidance to issuers planning to issue FRS in Hong Kong.

The FSTB has also issued a consultation paper on legislative proposals to introduce a licensing regime for providers of over-the-counter (OTC) trading services of VAs, which would regulate OTC spot trading of certain VAs in Hong Kong under the Anti-Money Laundering Ordinance.

The government continues to develop the legal and regulatory regime in Hong Kong to promote the sustainable and responsible development of the VA sector in Hong Kong. This can be seen through the introduction of various investor protection measures to allow retail access to SFC-licensed VATPs, VA-related services and tokenised securities.

Australia

In 2023, the (relatively new) Australian government restarted Australia’s regulatory focus on digital assets by undertaking a “token mapping” consultation. Following this exercise, the Australian government published a consultation paper in October 2023 on how it proposes to regulate digital assets. The government proposes to regulate those entities custodying digital assets or entitlements in either a token-based or account-based system, which would mean that those conducting normal financial services (eg, advice) in relation to that custody facility (called a digital asset facility) would also be regulated. Being regulated means that the full suite of normal Australian Financial Services Licence obligations would apply to the issuer, dealers, arrangers, advisers, etc, with some tailoring of those obligations proposed.

Separately, where a platform conducts certain other financialised functions (token trading, token staking, etc), additional obligations would apply to those activities (they are not proposed to be separately regulated) and those activities would not be able to be conducted by an entity that is not licensed. The legislation is scheduled to be published in 2024 but its implementation date is currently uncertain with an upcoming election in Australia.

In May 2024, the Attorney-General's Department of Australia invited comments on the proposed regulations for “Modernising Australia's anti-money laundering and counter-terrorism financing regime”, which will also focus on changes to Australia’s current approach to regulating digital currency exchanges from an AML perspective. The “Corporate Plan 2022–26” of the Australian Securities and Investments Commission also identified crypto-assets as a key focus area. The Australian Prudential Regulation Authority is set to conduct a consultation on the prudential handling of crypto-assets by banks in 2024, which is expected to be implemented in 2025.