Indirect regulation: The unexpected impact of UK financial promotion regime on the digital asset industry

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As the United Kingdom awaits full implementation of the Financial Services and Markets Act (FSMA) 2023, which will integrate digital assets into existing financial regulation, the ‘financial promotions regime’ is providing consumer protection through a form of indirect regulation. But what’s the cost?

Last year saw the passage into U.K. law of the FSMA 2023, which gives the country’s regulators powers to incorporate digital assets into the exiting financial services regulatory framework.

The Act was passed on June 29, 2023, and came into force exactly two months later. The passing of the bill extended the banking rules of the FSMA, such as maintaining adequate capital to withstand financial shocks and implementing robust risk management practices to identify and provide clear and transparent information to customers about stablecoins and digital assets. This means that, for the first time in the U.K., digital assets were officially recognized as a regulated financial activity.

Crucially, it also gave the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA)—the former being the country’s top financial sector regulator and the latter the banking watchdog—the necessary powers to begin implementing the Treasury’s goals set out in its February 2023 consultation on the Future Regulatory Regime for Cryptoassets. This included establishing an issuance and disclosure regime tailored to digital assets, strengthening the rules that apply to financial intermediaries and custodians of digital assets, and adopting a bespoke, digital asset-specific market abuse regime.

The FSMA covers a broad spectrum of financial services, not just digital assets, and the implementation process will be gradual, but one of the first of the new rules to be implemented was the ‘Financial Promotions Regime’ for digital assets, designed to govern the way firms operating in the U.K. can advertise and market their products.

Even before coming into force on October 8, the custodians of the financial promotion rules, the FCA, had an unceremonious introduction to the kind of struggles regulators around the world have to get the digital asset space to comply, and it’s fair to say industry opinion of the regime has not been wholly positive.

“The rules are blanket, and they’re getting enforced strictly,” said Gareth Malna, founder of regulation advisory firm Englebert and Partner at Gunnercooke law firm, speaking at the Exeter 2023 Blockchain and Law conference, where he gave an impassioned insider appraisal of how the U.K.’s new digital asset promotions regime is functioning in practice.

In his talk, titled “Banning Bitcoin: the surprising power of indirect regulation,” Malna explained how the promotions regime amounts to ‘indirect regulation.’

“Crypto assets, as of today, are not a regulated industry. There are regulations that capture them, the money laundering regulation being an example,” said Malna. “But here, suddenly, we have a regulator that can come after a crypto product via its promotions or marketing. If you happen to be a project that the FCA doesn’t like, and they might think this is a good opportunity to remove you from the market, they can use the promotion regime to scare off approvers from working with you.”

The implication is that ‘questionable’ entities who are under suspicion, investigation, or already in court in other jurisdictions can be put on the warning list, which then dissuades any authorized persons from working with them, lest they be tainted in the FCA’s eyes by association and lose their authorizing privileges. Without any legal route to promotions, such an entity could effectively be forced out of the market.

This, explained Malna, is the essence of ‘indirect regulation’ and the current situation where digital asset firms operating in the U.K. find themselves.

CoinGeek caught up with Malna after his talk to delve further into the idea of indirect regulation and how it relates to current U.K. digital asset industry oversight in 2024 and beyond.

“Everyone in the crypto community was delighted when the U.K. came out and said it’s going to be a crypto hub. They’re going to incubate all these crypto projects; the U.K. is going to be it for crypto,” says Malna, referring to comments current U.K. Prime Minister Rishi Sunak made in April 2022 when he was Chancellor of the Exchequer.

“It’s my ambition to make the U.K. a global hub for cryptoasset technology,” said Sunak, after announcing plans to make stablecoins a recognized valid form of payment in the U.K.

However, as Malna points out, “five months later, this regulation comes out and takes a lot of people by surprise.”

The regulation in question is the new financial promotions regime.

The Financial promotions regime

The U.K. announced the new digital asset promotions rules in June 2023, and they came into force on October 8—one of the first changes to the digital asset space to come from the passage of FSMA 2023. They amount to an updated version of the previous financial promotions regulation, adding specific rules for “cryptoassets” to those for traditional financial instruments.

Specifically, under the new regime, any promotion of digital asset products or services needs to attach a ‘clear warning,’ and firms marketing digital assets to U.K. consumers need to introduce a 24-hour cooling-off period for first-time investors to allow them to think about and possibly back out of spur-of-the-moment or potentially unwise investments.

But perhaps the crucial change is that there are now only four lawful routes firms can take to communicate digital asset promotions in the U.K.:

• The promotion can be communicated by an “authorized person,” as defined by the FCA. This includes ICVC, the Society of Lloyd’s, and persons with Part 4A permission.
• An unauthorized person can communicate a promotion that has been approved by an authorized person.
• The promotion can be communicated by a digital asset business registered with the FCA under the Money Laundering, Terrorist Financing, and Transfer of Funds Regulations 2017 (MLRs).
• The promotion meets the conditions of an exemption in the Financial Promotion Order.

Promotions not using one of these legal routes will be considered in breach of the new rules and thus “a criminal offence punishable by up to 2 years imprisonment, an unlimited fine, or both.”

The regime was not exactly taken up with enthusiasm after its June announcement, leading the FCA to issue a warning letter in September to digital asset firms operating in the U.K. who had not yet registered with the regulator, firmly reminding them of the incoming rules and expressing concern over a lack of engagement from the industry.

Apparently, the warning fell on deaf ears, as in the 24hrs after the rules kicked in, the FCA issued 146 warnings to non-compliant digital asset promoters. By early November, that number had risen to 221.

The three most common issues the FCA identified were:

• Promotions that made claims about the safety, security, or ease of using digital asset services without drawing investor attention to the incumbent risks;
• Risk warnings that are not visible enough owing to too-small fonts, hard-to-read coloring, or non-prominent positioning;
• And firms failing to provide investors with adequate information on the risks associated with specific products.

For Malna, some of this non-compliance can be explained by the relative speed with which the regime was introduced:

“The implementation of the regime has been very quick. It was announced around May that it will be coming in October, that didn’t give firms very long to implement, and the guidance documents that often support regulatory change were only finalized after the regime took effect.”

The finalized guidance documents that Malna refers to were published on November 2 and, amongst other things, elaborated on previous guidance around authorized persons’ approval and the requirement for promotions to be “fair, clear, and not misleading.”

While it’s true this finalized guidance came almost a month after the regime took effect, the FCA would likely argue that they gave firms several months fair warning of the key changes and, after they saw a lack of preparation from the market, responded with a further urging reminder in September.

Whether or not firms were prepared for the regime, the fact remains that it is here, and according to some its impact reaches far beyond the bounds of its intended purview of simply regulating ‘promotions.’ This is where the idea of indirect regulation comes into the picture.

Indirect regulation

Indirect regulation is a concept rooted in economics and governance theories. It relies on influencing behavior through mechanisms other than direct mandates and laws, such as market or peer pressure, collaborative frameworks, and taxation.

In the U.K., Malna believes the financial promotions regime, in its current form, fits this description and can be used by authorities to bar certain players from the market relatively easily.

“It’s about consumer protection from the FCA. Protect consumers from people they consider to be inappropriate for consumers to deal with,” explains Malna. “The way that they will do that is warn consumers about those entities by putting them on the warning list, and if they’re on a warning list, that means consumers have been duly notified that they shouldn’t engage with them.”

The warning list he refers to is the FCA’s list of firms and individuals that it has identified as potentially operating without its authorization and supervision or that it has concerns about for other reasons.

The list is currently 12926 names long—recent additions include Bitfinex, Huobi, and KuCoin—and a number of possible red flags may land a firm on the list, such as operating without authorization, fraudulent activities, high-risk investments, asset safeguarding concerns, lack of transparency, market abuse, and consumer complaints.

Failing to comply with the new financial promotions regime will also land you on the warning list, which causes a problem, as in order to get compliant, a firm needs to have their promotions approved or communicated by an “authorized person.” This, suggests Malna, is where the indirect regulation kicks in.

“You can’t pull a warning notice once it’s live; it’s always going to be on record. So the downstream question is going to be, as an approver, ‘What will you do if a firm on a warning list approaches you for the provision of services?’ And the only correct answer to that question is not to provide those services,” says Malna.

In other words, being on the warning list does not necessarily mean a firm is banned from operating in the U.K. However, it does identify you as being on the FCA’s radar. From that point on, anyone seen doing business with you, even if it’s to help remedy the very reason you were put on that warning list in the first place—i.e., failing to comply with the promotion regime—may be tarnished by the association and the future recipient of unwanted FCA attention themselves.

This unwanted attention is important because the FCA also has the power to revoke a firm’s permission to conduct or authorize financial promotions, including on the basis of consumer harm or financial stability concerns. Any “authorized person” seen approving promotions for someone on the warning list may be at risk of having their authorizing privileges yanked away, meaning they’d have to go to someone else to get their own promotions authorized… and so the circle continues.

Without an authorizer willing to approve your promotions, a firm has two options: try to become an authorized approver themselves or register with the FCA under the MLRs. The former, according to Malna who’s company Englebert is currently going through this process, is a near impossibility until digital assets are fully integrated into the financial regulatory framework (which might not happen until 2025); the latter option involves submitting to substantial disclosures, risk assessments and controls by various U.K. authorities—a level of transparency digital asset firms are not known for embracing.

The end result is that firms finding themselves unable to legally market in the U.K. will likely also find themselves with a potentially insurmountable competitive disadvantage in the country.

The financial promotions regime itself is, of course, regulation of the very direct kind, but the way it extends beyond its immediate goal of governing financial promotion and changes the behavior of companies in the market towards each other resembles a form of indirect regulation through peer or market pressure. Firms end up doing the work of keeping ‘questionable entities’ out of the market without the need for additional regulation, much like the practice of blacklisting in Hollywood during the days of McCarthyism and the 1950s red scare.

“By putting them on a warning list, the FCA is cutting off the ability of anybody else to provide services to that firm without that authorized firm suffering its own repercussions… Ultimately, the approver is the one that’s going to get it in the neck from the regulator in the first instance. They’ll stop them from approving future promotions, take away their permissions, cut the whole business off if they’re not doing it properly,” says Malna.

“That is the indirect regulation in play. That’s the FCA able to effectively close out that entity from the market.”

But in terms of regulatory logistics, why might the FCA be in favor of such market self-correction?

A useful, safety-first stopgap

“Often it’s done in the right way because there is a scam there or there is some illicit activity,” says Malna, who suggests that the FCA’s approach to the financial promotions regime is not just a case of trying to squeeze the digital asset market for kicks, it’s primarily about consumer protection.

“What we’ve got to be mindful of is that if you do create this hub where anyone and everyone comes in, you’ve got to find a way to quickly protect the consumers in that market from projects that will fail and disappear,” says Malna. “They might think that their money is protected if they invest in that token over there. It’s not because it’s not a regulated activity yet.”

The current government of the U.K. still sees the country as a future digital asset hub, but the tumultuous events of 2022 and 2023 in the global digital asset sector have demonstrated the need for robust protections and regulation to govern the space. This is the pro-business vs. pro-consumer protection balancing act the FSMA 2023 was brought in to solve.

The problem, however, is this broad-sweeping integration will take time to implement.

“The market is expecting to see proposals in 2024 for a full regime, akin to the business and traditional financial services regime, but with parallel activities,” explains Malna. “I would expect that to start coming down the line in more clarity in 2024 with a view that it probably starts coming into effect 2025.”

Once the goals of the Treasury’s consultation are fully realized, UK-based digital asset firms will be able to get direct authorization to approve their own promotions. Once a U.K.-based digital asset firm is an “authorized person,” they will also be able to approve promotions for other digital asset businesses that don’t want to set up shop in the U.K. but want to advertise to U.K. customers.

Where the financial promotions regime comes into the picture is that while the market waits for these changes to arrive, investors still need to be protected. This is why the promotions rules are potentially being used as a form of indirect regulation, until the full regulation framework for digital assets is ready.

It is a sensible approach in theory, but if, in practice, it means a substantial number of digital asset firms are effectively forced out of the U.K. market, it’s easy to see why the industry has not wholeheartedly embraced it.

Negative reactions and positive perspectives

“What you find is that firms who have an intent to come into the regulatory regime, either in its current form or in a potential future form, and want to have a good relationship with the FCA are very much gung-ho in terms of applying the rules and engaging with the regulator about them,” says Malna. However, he goes on to point out there are also “those who are questioning the U.K. as a market for their business overall and might consider whether they actually just get rid of the U.K. as a market.”

As well as those pro-actively getting themselves in line with the new rules or those looking at closing down their U.K. operations because of them, you can add the third category: those that, through ignorance or defiance, continue to operate as before, in non-compliance of the promotions regime (221 firms as of November 2023).

Malna believes some of these varied responses may be due to the nascent nature of the digital asset space in comparison to traditional financial services.

“It works well in the traditional financial services world, but they understand what they’re playing with. This is a new market with participants that have no idea of what acting properly in this space looks like and what working with a regulator, or at least a regulated entity, looks like,” says Malna, who suggests that the financial promotion regime is the wrong way to go about bringing these naïve digital asset firms into line.

“We’re doing it cart before the horse in a way, regulating the marketing before regulating the activities themselves.”

Based on the number of names on the FCA’s ever growing warning list, it’s not hard to see where this view of the promotions regime may come from. Yet, critiques of this approach aside, there are compelling reasons why indirect regulation is actually an effective temporary solution.

“One of the reasons that this is effective, in the short term at least, is because you don’t have to create a broad, complex regulatory framework that takes a long time to consult on and get right,” explains Malna. “The U.K. can sit and watch other jurisdictions’ regulatory regimes unfold, see what’s effective and what’s not. There will always be one eye on the U.S. and how the regulation by enforcement is going, and then the MiCA style approach, which is more collaborative and clearly codified in the way that good regulation is.”

Technology and innovation move fast, often too fast for the slow-turning wheels of regulation and lawmaking to keep up—the regulatory stalemate in the U.S. is a good example of this in action… or inaction.

Partisan politics in Congress continues to slow down efforts by lawmakers to bring in digital asset specific regulation. In the meantime, the U.S. Securities and Exchange Commission (SEC) is frequently left holding the cheque as it juggles the competing demands of laissez-faire capitalists on the Hill with a market filled with fraud, non-compliance, and other illicit activities.

In contrast, in June 2023, the European Union relatively harmoniously agreed to its sweeping Markets in Crypto Assets (MiCA) regulation. When it gradually comes into force this year, it will bring digital assets, issuers, and service providers under a broad regulatory framework, including mandating digital asset service providers, such as exchanges and wallet providers, to obtain a license from national regulators to offer services to EU citizens.

The U.K., with its February 2023 consultation and the passage of FSMA 2023, has opted for the integration of digital assets into its existing and well-functioning financial services regulation. But as we’ve seen, this will take time for the FCA and PRA to implement, potentially up to 2025, and while arrangements are being made and exact details are finalized, why not sit back and observe how other major markets are faring with their approaches?

“It gives the regulators and the policymakers time to think through the issues properly and then codify it fully,” says Malna. “You’ve got to look at this in the short and long term. Regulators will always be looking at how quickly we can protect the market and then how we can ensure its long-term stability, those two things always have to be balanced.”

But this ‘slow down and see what’s working elsewhere and what’s not‘ approach still requires some level of protection to be in place in the meantime to shelter consumers and reign in the wildest parts of the crypto-wild west.

This seems to be the essence of the FCA’s approach to implementing the financial promotion regime and how the regime encourages market participants to do the work of weeding out potential bad actors for it.

Whether ‘good’ actors are also getting caught in the crossfire, or firms were given too little time to get themselves in line with the promotions rules, is debatable. Either way, the current message seems clear: get in line with the new financial promotion regime, or you won’t last long in the United Kingdom.

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