The Gap In The UK’s Regulatory Framework For Centralised Cryptocurrency Exchanges

How can the UK modernise its cryptocurrency frameworks?

Counter-intuitive is the prevalence of centralised exchanges in the market for cryptocurrencies. Today, centralised cryptocurrency exchanges provide the predominant means by which investors purchase, trade and store the very de-centralised instruments that were created precisely to defy the self-serving, unreliable middlemen from the era of the financial crisis. And similar (if not bigger) problems that plagued the financial sector now haunt users of centralised exchanges.

The first problem is financial loss– centralised exchanges may deal with users’ cryptocurrencies in risky ways (i.e. unauthorised uses and co-mingling of cryptoassets). A similar problem is that exchanges may omit to compensate customers for the loss of cryptocurrencies held on their platforms if the exchanges were hacked. Thirdly, exchanges permit and even participate in the manipulation of token prices, conduct which can cause users losses.

These problems arise from the gap within the UK’s regulatory framework for cryptocurrency exchanges: Since cryptocurrencies (formally known as exchange tokens) are excluded from the UK’s regulatory perimeter, the conduct of centralised exchanges in dealing with cryptocurrencies is unregulated. Untouchable by the corrective hand of regulation, centralised exchanges enjoy unfettered discretion in setting out the terms on which they hold their customers’ cryptocurrencies and oversee customer trading activities.

Strangely, neither the Treasury nor the FCA seem disposed to address the problems (or indeed the regulatory gap). In a recent consultation response, the FCA proposed the “first phase” of legislative changes to regulate cryptoassets–only to exclude cryptocurrencies. The response was shot through with ambivalence: there is “merit in exploring further the case for comprehensive regulation”.  

An (unconvincing) attempt to rationalise the FCA’s indisposition was made last month by Charles Russell, the FCA’s Chair. In a recent article, Mr Russell said that regulating “crypto firms” (including centralised cryptocurrency exchanges) would impose an undue burden on other regulated firms. In the UK, all firms regulated by the FCA are required to contribute some of their resources to the financial services compensation scheme (“FSCS”), which offers compensation to customers of failed, insolvent firms. Since risks of insolvency are particularly high for centralised exchanges owing to their susceptibility to hacking, other regulated firms would be compelled to pool in much more for customers of failed centralised exchanges. 

Lofty as Mr. Russell’s rank may be, his concern would likely fall on deaf ears. The Treasury, which oversees the FCA, has expressed high hopes for the UK to be “the best place for crypto”. It is widely accepted that regulation is the key to a stable, attractive environment for all crypto businesses, including centralised exchanges. Japan and the UAE have taken the point. Canada and the US are following suit. A “global crypto hub” is too attractive as an economic project and as a national brand to concede to the grey, minute calculations embedded within some domestic consumer protection mechanism. Moreover, Mr. Russell’s concerns seem ill-advised. One of the FCA’s objectives is to protect consumers, and the financial interests of financial firms should not be the regulator’s first and foremost concern. Also, the costs of covering centralised exchanges under the FSCS should not be overstated. Under the Financial Services and Markets Act, each customer of a failed firm is only entitled to compensation of a maximum of £8,500. 

The future regulatory landscape for centralised exchanges is far from clear. As the raincloud of cryptoasset regulation swells, it is unclear for how long centralised cryptocurrency exchanges in the UK may keep their dry spot. While by no means may the UK be expected to stride towards regulation, as mysterious forces within the Treasury and the FCA wrestle over the correct regulatory approach to cryptoassets, practitioners should be vigilant to new developments. 

For a safe bet, regulation, if it were decided to be the best way forward, would take the form of incremental amendments to the regulatory perimeter. This can be seen in the HM Treasury’s most recent report, “UK Regulatory Approach To Cryptoassets, Stablecoins And Distributed Ledger Technology In Financial Markets: Consultation And Call For Evidence” (April 2022)Very likely, custody of cryptocurrencies would be governed as a new regulated activity. A fresh tide of crypto insurance products would then flood the crypto sector as firms rush to find coverage for their legal risks. Practitioners in insurance may well find themselves working increasingly with centralised exchanges.

By Oscar Wong