On 30 July 2019 the Financial Conduct Authority (FCA) issued its Final Guidance on its approach to cryptoassets. An ambiguity which the Final Guidance has caused concerns the FCA's previously explicit policy of 'technological neutrality'. Tech-neutrality is a policy position that the regulatory perimeter and treatment of financial products and activities is unaffected by the technological medium through which the product is offered or activity takes place. This commitment was made in the interim guidance issued in January 2019. In the Final Guidance, however, several references to tech-neutrality were erased, and those which remained did not directly concern the FCA's mandate or its enforcement policies. This article explores three reasons why the policy may no longer be tenable.
Background to tech-neutrality in financial regulation
The occasions on which cryptoassets, meaning financial or other property which are created or distributed on a 'blockchain', fall within the regulatory perimeter of the FCA have been subject to intense speculation. An ancillary, but important, issue with which the FCA has had to contend concerns the extent to which the use of blockchain technology per se ought to influence its exercise of its authority. Given the FCA's continued focus on promoting and enabling a progressive and competitive financial ecosystem in the UK, it has been reluctant to make rules that would seem to favour the traditional technology used by incumbent financial institutions ahead of new developments which might, in the long run, enable better outcomes for commercial parties and consumers.
In this light, it becomes notable that several of the references to its policy of tech-neutrality have not been included in the Final Guidance. It may be that, in exploring the legal nuances of cryptoassets, the FCA has discovered that there is a distinction between whether it is desirable to treat all financial products and activities equally, and whether the fundamental structure of blockchains necessitates a different regulatory response in certain situations.
Legal title to cryptoassets
One of the core principles of blockchains is that they are 'append only'. This means that although transactions can be added to the blockchain record, a transaction already added cannot subsequently be altered. The 'trustless' nature of blockchains such as Bitcoin and Ethereum relies upon an understanding amongst all participants that the record of every other participant's available assets is correct. In order for this to be guaranteed, the blockchain record has to be determinative, rather than declaratory, of each participant's cryptoasset property.
Such reasoning is familiar to many who engage with financial markets, because is it also the basis of negotiability in financial instruments, whereby legal title to an instrument passes with delivery. The difference is that negotiability remains subject to the requirement that a transferee takes the instrument in good faith. This means that legal title to stolen securities remains with the victim, and doesn't pass to a third party who knows that they were stolen. Such legal title is given substance through the rule of 'quasi-negotiability', whereby the issuer of the securities is liable to undo any change to the register which disentitles the true owner. This rule cannot easily be applied to a blockchain which even a court cannot unravel.
One might suppose that the solution would be to hold that the determinative nature of a blockchain is subject to a bad faith exception, but how is this to be implemented in cryptographic coding? And how does this affect a transferee or blockchain operator who finds that the predictability of a trustless system is now undermined? It may be, therefore, that a share issued on a blockchain can never be functionally identical to one issued on a certificate. Tech-neutrality presumably dictates that the FCA never requires a prospectus to highlight such a distinction, but a failure to do so might amount to an abdication of its responsibility.
Smart contracts as non-contracts
The UK Jurisdictional Taskforce recently consulted on the legal nature of smart contracts. There is a strong belief that a contract between two parties who cannot identify each other cannot be legally binding. This accompanies an array of other concerns which will influence the legal characterisation of smart contracts deployed on blockchains. What, therefore, of contracts for difference (CFDs), or other financial contracts? A simple smart contract escrow, designed on the Ethereum platform, can perform all the functions of a CFD between two mutually anonymous parties. But it is very difficult to imagine how the FCA could characterise a smart contract as a CFD if it is deemed not to be a legally binding contract.
Common sense might dictate that the FCA would nevertheless exert its authority in such a situation. But the recent Treasury Committee report on the FCA regulatory perimeter highlights how its ability to act is sharply curtailed by the scope of the legislation from which it derives its authority. The ramifications of a policy of tech-neutrality are, presumably, that an unregulated activity, such as selling a non-binding smart contract CFD, does not become regulated purely because of the technology on which it is based. The efficacy of this approach, however, is surely questionable.
Geographical jurisdiction of blockchains
The FCA's jurisdiction extends to regulated activities offered to UK consumers, and it cooperates with foreign regulators in order to take action against overseas firms where necessary. Blockchains, however, do not necessarily have any jurisdiction, and the disintermediation which they facilitate can make it more difficult to identify a single party which is performing a regulated activity. The rise of 'decentralised finance' will likely make targets for enforcement that much more difficult to establish. The conclusion that new and creative approaches to the enforcement of financial services rules will be needed is hard to avoid, but also challenging to accommodate under a policy of tech-neutrality.
Responsibility for outcomes
In a recent speech to the 6th Central Bank Executive Summit, Nick Cook, Director of Innovation at the FCA, posed the question:
Can we remain ‘technology-neutral’ in a world where technology is so embedded in the delivery of financial services and so fundamental a driver of consumer outcomes?
It is important that the FCA isn't perceived as arbitrary or favouring certain traditional technologies even in the face of tech-based opportunities for efficiency and financial inclusion. But at the same time, a sophisticated regulatory framework should ensure that an equivalent balance is struck between innovation and protection, regardless of the medium through which both are delivered.
Rory Copeland is a solicitor (pending admission) in the Financial Regulation team at Pinsent Masons LLP. All views expressed are his own.