Cryptoasset Series - Part 3
In our previous article, we described how the decentralised nature of distributed ledger technology removes the requirement for intermediaries and sets protocols in a cryptoasset transaction process. For many crypto enthusiasts, this decentralised principle underpins investor sentiment and drives the significant hype around the crypto market.
But as regulators continue to caution that cryptoassets are high risk and speculative investments, crypto continues to dominate the headlines with news of fraudulent investment schemes - from Initial Coin Offerings and social media scams, to phishing, ransomware attacks and hacks/fraud on exchanges around the world, many of which have resulted in significant insolvencies.
A recent study by Chainanalysis found that criminal transactions involving crypto hit $14bn in 2021. We expect this level of fraud to escalate further as we move towards cashless societies and cryptoassets become even more integrated into the everyday life of businesses and consumers.
So, what happens when cryptoassets or crypto businesses fail? Is there a framework to wind down these structures in an orderly way? Are consumers protected?
In early 2022, members of the UK Parliament formed the Crypto and Digital Assets All Party Parliamentary Group (“APPG”). The APPG’s purpose is to provide a “forum for parliamentarians, regulators, Government and industry to discuss the challenges and opportunities relating to the crypto sector and to explore the need for future regulation of the sector”.
It is perhaps too early to comment on what the APPG will do and whether its approach will support the conclusion of The Kalifa Review, being that the UK Fintech market is a key area of growth opportunity for the UK.
It is however worth noting that the very nature of cryptoassets and its technology transcends jurisdictions and traditional financial service frameworks. It therefore may require a crossborder standardised approach to empower regulators to provide the oversight that is needed to protect investors.
This article explores the existing regulatory and legal framework in the UK and the global setting in order to understand the tools available to insolvency officeholders when dealing with cryptoassets.
UK Regulatory framework
The Financial Services and Markets Act 2000 (“FSMA”) provides the regulatory framework of the UK financial services environment. Under FSMA, a person must not carry on a regulated activity or purport to do so unless the firm is authorised or exempt. The types of regulated activities can be found in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (“RAO”).
We previously described how the UK Financial Conduct Authority (“FCA”) identifies the broad categories of cryptoassets in the context of its existing regulations.
The FCA has indicated that exchange tokens and utility tokens are not regulated financial instruments, but activities relating to cryptocurrency derivatives (such as futures, options and contracts for difference) and securities tokens are regulated. Firms carrying out activities relating to virtual currencies would therefore need to be authorised under FSMA. The prudential treatment of cryptocurrencies has yet to be specified under the current UK, EU and international prudential standards regimes.
Stablecoins, depending on their structure (i.e. whether collateralised by other cryptos, precious metal or other assets), could fall within the FCA regulatory framework.
For example, stablecoins could be considered e-money if issued on receipt of fiat currency as they can be redeemed for fiat currencies.
In January 2021, HM Treasury published a consultation paper outlining proposals to bring stablecoins within the UK regulatory regime; however the results of this consultation are yet to be published as at the date of this release.
The FCA has imposed a ban on marketing, distribution and sale to retail clients of derivatives and exchange traded notes referencing unregulated transferable cryptoassets.
Cryptoasset businesses, such as exchanges or digital wallets, are required to register with the FCA and carry out appropriate anti-money laundering (“AML”) checks on their customers in accordance with the Money Laundering Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017.
To date, just over 30 UK crypto businesses have been registered and another 25 are on the Temporary Registrations Regime.
Despite a firm being registered with the FCA, the FCA is not responsible for making sure that the crypto business protects client assets, i.e. customers’ money. Cryptoassets therefore fall outside the remit of the Financial Services Compensation Scheme and the Financial Ombudsman Service.
Crypto businesses carrying out cryptocurrency derivatives activities would also be carrying out regulated activities under RAO by being an agent in the investment , i.e. arranging, managing and safeguarding investments.
There is no UK regulatory regime that would capture the activities of miners as generally these activities are for virtual currencies that are not regulated financial instruments in the UK; however, miners' activities may involve executing a regulated activity that may fall within the definition of a cryptoasset exchange provider, which would be subject to FCA registration and AML requirements. It is noteworthy that the vast majority of the mining activity across crypto-assets occurs outside the UK.
The UK Jurisdiction Taskforce (“UKJT”) - a taskforce of the LawTech Delivery Panel of the Law Society and a representative body for solicitors in England and Wales - issued a Legal Statement in November 2019 that said, in broad terms, cryptoassets are capable of having proprietary status under English law. This is regardless of their decentralised nature and use of a distributed ledger technology.
This view has also been reached in other courts. For example, the court in New Zealand found that Cryptopia Ltd (in liquidation) (“Cryptopia”) was not the owner of its clients’ cryptocurrencies but was instead a trustee. In AA v Persons, the court granted a freezing and proprietary injunction in respect of the Bitcoin held with the crypto exchanges.
Whilst the application of common law inevitably varies from case to case, the UKJT Legal Statement has implications for bankruptcy and insolvency, fraud, theft or breach of trust and may tackle questions of jurisdiction and procedure which are key to officeholders.
UK insolvency law has developed since the 2008 financial crisis which highlighted deficiencies in the Insolvency Act application to investment banks, in particular in protecting and returning assets belonging to clients held by a failed investment firm. This has resulted in the introduction of the Special Administration Regime (“SAR”) in 2011 for investment banks. In 2017, the definition of investment bank was extended to include other businesses such as stockbrokers, fund managers and foreign exchange traders as they all have a focus on protecting client assets. In 2021, a new SAR was introduced for e-money and payment institutions.
The SARs are set out in the Investment Bank Special Administration Regulations 2011, the Investment Bank Special Administration (England and Wales) Rules 2011 and The Payment and Electronic Money Institution Insolvency Regulations 2021.
Currently, crypto exchanges are likely to fall outside of any SAR and instead officeholders would be required to rely on Berkeley Applegate orders to secure funding and are likely to require directions and orders from the Court in order to be able to operate under the Insolvency Act.
Developing a SAR for the handling of cryptoasset exchanges or incorporating these businesses into the existing SARs is likely to provide benefits when insolvencies occur. However, as the regulators grapple with how best to regulate the sector more broadly, it may be that specific insolvency regulation only follows the first failures occurring, once a spotlight has been shone on the issues at hand.
As the courts of England and Wales have to date accepted that cryptoassets are property, the courts have been able to assist parties protecting their rights by providing necessary orders such as proprietary and freezing orders or compelling third parties to produce certain information aimed at identifying fraudsters and asset tracing.
Cross border insolvency recognition
The fundamental principle of decentralised cryptoassets and blockchain technology distributed amongst global users makes the location of the digital assets not clear cut. Equally, some cryptoasset exchanges have advised they have no registered address despite a sprawling global network of entities and operations. The traditional model of an insolvency associated to a company managed from one jurisdiction does therefore not deal with the new crypto business concept.
Traditionally, within the EU, it has long been the case that the legal system applicable to the insolvency of a company should be the law of the jurisdiction where that company has its Centre Of Main Interest (“COMI”). It is problematic to link a cryptoasset blockchain transaction or a cryptoasset operation to a particular jurisdiction. For example, wallet providers and exchanges operate through the use of software which is made available to a global audience, often free of charge. These entities are likely to hold no physical assets, occupy no office space and transact with customers all over the world. How then, can COMI be readily determined?
A number of insolvent crypto exchange cases around the world have shown the need for officeholders and trustees to seek enforcement orders in various jurisdictions.
In Torque Group Holdings Limited (In Liquidation) – a Singaporean platform with a British Virgin Islands (“BVI”) address and employees based in Vietnam and Singapore – the winding up of the company commenced in BVI but a further application was filed in the Singapore High Court for orders which include the recognition of the BVI insolvency proceedings in Singapore as a “foreign main proceeding”, and certain ancillary orders to facilitate the winding up process in Singapore.
In Cryptopia, the liquidation proceedings started in New Zealand; however, the liquidator had to file a petition in the Bankruptcy Court in the Southern District of New York seeking recognition of the New Zealand liquidation in the USA in order to retrieve the company’s information - including all account holders’ individual holdings of cryptocurrencies and the account holder contact details, which was stored and hosted on servers controlled by a US based web services firm which refused to grant access to the information stored on its servers without the payment of approximately $2m.
In the absence of a single, standardised and internationally accepted process for insolvency, there are many legal and regulatory issues that need consideration when winding down crypto businesses.
These include cybersecurity, sanctions, conflicts of laws, ownership of intellectual property and consumer law. Officeholders are likely to take appointments on crypto businesses that will require court orders in multiple jurisdictions.
At the inaugural event of the Crypto Fraud and Asset Recovery Network in London, Sir Geoffrey Vos, chairman of the UKJT, stated that the English common law system is inherently flexible and can adapt by analogy existing principles to new situations as they arise. Whilst this may offer reassurance to officeholders with regard to the main untested crypto questions in the framework of a flexible judicial system, it does not take away their concerns of running expensive and inefficient insolvencies around the world.
Our Next Crypto Series Article
In our next release we will be covering the practical challenges of an insolvency for officeholders when appointed on crypto businesses or estates.