Crypto Marketing: What Happens When the Music Stops...

A T-Rex skeleton was sold for USD31 million at auction in October 2020. So how much is a T-Rex worth?

A great deal of ink has been spilt on crypto, some arguing it represents a paradigm shift in the future of finance, some arguing it is intrinsically valueless. The blunt reality of the situation is that value, as with any other asset, is determined by what someone will pay for it.

This is hardly unique to crypto-assets – in fact, it is the common denominator of the value of all assets. This is where liquidity becomes important. The more liquid an asset, the easier it is to obtain “true” price discovery. Less liquid crypto-assets, which in this respect are analogous to the T-Rex skeleton, are hampered by the fact that, whatever the perceived value, the reality may be a lack of willing buyers, and if no-one wants to buy an asset, it is effectively valueless.

It is against this backdrop that crypto-assets exist. As an industry moving into adulthood, crypto is still trying to find its feet in terms of working out the fundamentals on which it operates, and one of these is clearly the issue around price discovery. The rise of meme tokens, which generally have no intrinsic value per se, has shown clearly the fact that value in the asset class can be ruled by market sentiment alone, and so underlined the need to attract buyers to a project.

It is against this backdrop that the marketing industry has come into the crypto-asset ecosystem. Tasked with promoting a project, marketing has had a huge impact on the crypto-asset industry.  In some way this has been beneficial – as indeed all industry needs supporters, however it has also in some ways taken an unfortunate turn. Founders, who may be lent on by their investors who are looking to make fast profit, may be tempted to take a strategy that is focussed on the short term.

A particular example of this has been the development of key opinion leaders (KOLs). Commonly used across different industries, these are persons who have a following (for example on social media) and who promote products to that following, often for a fee. Where KOLs are paid in crypto-assets, this has created an interesting market, in which KOLs can pick a relatively obscure token, promote that token (raising its value due to the impact on supply and demand), and then sell their holdings during the hype in order to make an immediate (often significant) profit, generally at the expense of their followers who are holding an asset that loses value as the hype subsides.

For the project this can have a hugely negative impact, as holders of the token feel that they have been misled into buying something of little value compared to the hype. This has led some projects to seek to delay the distribution of tokens to KOLs, for example through vesting, in order to try to reduce the gamesmanship within the industry.

When the music stops

It is against this backdrop that the Financial Conduct Authority (FCA) has been tasked with the regulation of crypto-assets. Over the next year, we can expect to see a full regulatory framework being brought into force across the UK, covering everything from payments in stablecoins to custody, trading, lending and staking.

Regulatory frameworks can generally be split intro two core components: rules that apply to businesses because of where they are based, and rules which apply because of where businesses sell into.

In terms of rules that apply to businesses because of where they are based, firms that sell crypto-assets and which are based in the United Kingdom generally have to register with the FCA (under the Money Laundering Regulations 2017), which has traditionally been considered a relatively onerous process. Furthermore, the regulatory direction of travel is that firms looking to become licensed in the future will in fact have to comply with a more comprehensive regulatory regime that also includes conduct of business requirements for firms (as the registration regime under the Money Laundering Regulations 2017 is eventually replaced by an authorisations regime under the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001).

The effect of this UK regime has historically been lop-sided for crypto-asset firms, however this is changing as new requirements have been and are being brought in that apply to all crypto-asset firms looking to sell into the UK, with a view to creating an even playing field for participants in the industry.

A particular theme of the evolving regime is taking steps to address the potential harm to consumers and indeed this is a core function of the FCA. As such, the potential for consumers to be harmed by crypto-asset businesses has been a core concern, and efforts to remedy the previous perceived freedom to sell crypto-assets into the UK are being scrutinised.

The initial starting point here has been advertising unregulated crypto-assets that are both fungible and transferrable (security tokens were already subject to the restrictions applicable to the relevant security that they represent). In this respect, the general requirement has been to ensure that communications are generally fair, clear and not misleading, and that participants are both aware of and understand the risks involved when participating in crypto-assets, as well as limiting retail investors in terms of the level of exposure they can have to the asset class. It is interesting in this respect that generally the focus has not included NFTs. This is arguably a reflection of the fact that the FCA, as the primary regulator for crypto-assets, is generally a securities regulator – and fungible crypto-assets are more “security like” than NFTs, which is often perceived as more like art (which is generally far less regulated). Indeed, much of the inspiration behind the approach to regulating crypto-assets has been drawn from securities legislation. In this respect, we would note some alignment of approach internationally, for example the European Union, under Markets in Crypto-Assets Regulation (MiCA), now requires White Papers to make a certain level of disclosure prompting some to consider them as requiring White Papers to function more like a prospectus than a purely marketing document.

Going into the next year, a new area of focus will be on market abuse. In this respect it is worth noting the fact that KOLs are often paid in the crypto-assets they promote, meaning that the more they popularise a token, the more their existing holding of that token is worth. Whilst some may argue that this encourages “skin in the game”, the reality is that it encourages KOLs to promote a token, sell their holdings whilst the price is (maybe artificially) high, and then move onto another project. The effect of this is that their followers often are left to absorb the loss as the token reverts back towards its “true” value. This is in some ways similar to the concepts of frontrunning and market abuse in securities, however there are nuances, for example in the fact that market manipulation may be less in terms of profiting from inside information (which is an issue with equity) and more in terms of giving a token undue popularity. Whilst it is clear in this respect that the same underlying harm needs to be tackled, how that is managed will require consideration and it will be interesting to see how the new rules in the UK impact this practice.

Another core area of focus will be the requirement to comply with the FCA’s consumer duty. In broad terms, consumer duty requires firms to act to deliver good outcomes for retail customers – ie, to take steps to ensure that firms act in the best interests of their customers. The effect of the consumer duty is that customers of firms should be able to expect (i) helpful and accessible customer support; (ii) timely and clear information that the customer can understand, in order to make good financial decisions; (iii) that firms offer products and services that are right for the customer, rather than pushing products and services the customer does not need; (iv) that products and services provide fair value; and (v) that firms consider if their customers are in a vulnerable situation when dealing with the firm. The overall impact of this is to require somewhat of a cultural shift so that firms have to take steps to consider their products from the perspective of the customer, rather than seeking to only protect the firm’s best interests.

A brave new world

As the new rules come into force, it will be interesting to see how the market is impacted. The starting point is that the new rules are unlikely to stop crypto-asset businesses – particularly as they represent somewhat of an alignment of the crypto-asset framework with more traditional frameworks applicable to securities. Equity, for example, is bought and sold regularly within a strict regulatory regime and it is not considered that the effect of the regulatory regime stopped new firms entering into the market. Overall, the effect of the new rules will likely be twofold. Firstly, businesses will have to be better funded in order to be able to operate in the United Kingdom. Secondly, those that operate in the industry will need to be far more regulatory aware, in order to comply with their obligations.

We have seen an element of denial from some regarding the need to deal with regulatory change. This is arguably to be expected as such persons are not used to dealing with regulation and will not want to adapt to it, in part because the origin of the industry can in some respects be seen as a push against traditional finance which is symbolised by regulation, and also because the requirements of the regime may render certain currently highly profitable practices unfeasible.

In terms of simply avoiding regulation, therefore, one approach is to simply always avoid the UK. However, successful projects will not want to omit a potentially lucrative market – and indeed those projects with ambitions to be successful will not want to set themselves up for failure where they are not able to expand in the future by breaching UK requirements, so bringing into question whether they are run in a way which is fit and proper. More fundamentally, breach of the FCA’s requirements, for example in relation to advertising, is a criminal offence, and so banking and other service providers to crypto-asset businesses will not want to deal with these projects if the consequence could be that they are handling the proceeds of crime or otherwise enabling criminal activity.

Rather, the core impact will more likely be in terms of the prioritisation of approaching the UK against other jurisdictions. The Web3 industry is inherently international, and as such, firms will be looking at how best to structure their expansion globally, usually expanding the range of different jurisdictions into which they sell on a cross-border basis as the business becomes more successful. In this context, firms will be balancing the cost of entering into each jurisdiction against the value to be gained from selling into that jurisdiction. The cost of compliance in this respect simply becomes part of the cost of entry into a jurisdiction, and so the greater the compliance hurdle (particularly when balanced against the likely client base), the less likely it is that firms will sell into a jurisdiction.

The result of this is that different jurisdictions can therefore be seen as being in somewhat of a competition, as the benefit of compliance with local requirements is compared against the value of compliance. It is therefore worth looking at the UK position against the global position, as new regimes are coming into force across the globe, and it is in this context that the UK can be seen as a less likely place for start-ups to sell into initially (given the cost involved), however becoming a natural place for more mature businesses to sell into, given the large population interested in dealing in crypto-assets. The unsung aspect of this, however, is as regards the position of the holding company – because the act of owning an offshore subsidiary that sells crypto-assets is not a regulated activity, and there may be various advantages to having holding companies in the UK, including in terms of tax and in terms of being a trusted jurisdiction in which to do business. The net effect of this has been slightly disjointed, as there is a thriving crypto-asset industry in the United Kingdom in terms of substance, however as these businesses tend to operate via a subsidiary in an offshore jurisdiction, this is not the perception of the United Kingdom market.