First published on Thomson Reuters Regulatory Intelligence on 12 June 2019 (this version includes updates as at 28 June 2019).

In our first article on cryptoassets we discussed considerations for boards and senior management. This second article considers regulatory risks specific to cryptoassets which the second line of defence (i.e. compliance and risk functions) within the three lines of defence (TLOD) model of compliance should consider.

Traditional Sector: Banks and Investment Firms

When dealing with cryptoassets, banks and investment firms will need to be able to:

  • identify the risks associated with a cryptoasset proposition;
  • design and implement an appropriate control environment which ensures that cryptoasset business is undertaken in compliance with applicable requirements and in alignment with the firm’s risk appetite; and
  • review, test and assess the control environment.

So what are the key concerns relating to cryptoassets and how might banks and investment firms need to adapt their control environment to address risks specific to these assets? Here we focus on some key risks relating to the trading (and custody) of cryptoassets. Matters relating to transaction monitoring, restrictions on trading, and abusive behaviours etc. will be covered in subsequent articles in the series.

Monitoring the perimeter – assets within scope of the regulatory regime

The regulatory regime(s) as it applies to cryptoassets will continue to evolve probably at an accelerating rate. A key task for compliance and risk personnel will be monitoring the horizon for regulatory developments and (the more nuanced) changes in regulatory interpretation of existing regimes. Whilst the focus of this article is on financial services law and regulation, relevant developments in other areas such as civil law, anti-money laundering and tax law etc. will also need to be monitored.

The FCA noted in its 2019/20 business plan that many authorised firms carry out activities outside its existing regulatory perimeter which have an impact on the FCA’s objectives (FCA: Business plan 2019/20 (April 2019)). In its first annual perimeter report for 2018/19, the FCA identified cryptoassets as a specific area of concern because the intangible nature of many cryptoassets  presents challenges to the regulatory perimeter (see FCA: Perimeter report 2018/19 (June 2019)). The FCA clarified that its finalised guidance on the perimeter for cryptoassets (further to FCA consultation paper: Guidance on cryptoassets (CP19/3) (January 2019)) will be published this summer.  However, the appropriateness of the existing perimeter will soon be subject to reconsideration.  The FCA acknowledged the challenges in identifying whether the existing regulatory perimeter is fit for purpose to manage the potential harm cryptoassets pose.  HM Treasury has already indicated that it will be consulting in 2019 on:

  • “whether other cryptoassets, that have comparable features to specified investments but that fall outside the current perimeter, should be captured in regulation”; and
  • “whether and how exchange tokens and related firms, such as exchanges and wallet providers, could be regulated effectively, in the case that other measures outlined in the Taskforce’s Report (see Cryptoassets Taskforce: final report (October 2018)) do not adequately address all relevant risks”.

Regulatory messaging and dialogue

The second line of defence typically liaises with regulatory supervisors. It will need to be able to assist:

  • the business in developing an understandable narrative about any new proposition and risk management, in order to get supervisors on board; and
  • by explaining to regulatory supervisors the firm’s exposure to cryptoassets (and related risks) both in terms of formal data requests and as part of everyday supervisory dialogue (the BCBS, for example, is planning a structured data collection exercise as part of Basel III monitoring). Firms should be ready to be challenged, and to demonstrate that their risk management processes adequately cover their cryptoassets business and exposures.


To the extent that cryptoassets qualify as “financial instruments” under the second Markets in Financial Instruments Directive (such as “security tokens” as described by the FCA and ESMA), ESMA has highlighted a range of concerns in relation to satisfaction of requirements under the Settlement Finality Directive and the Central Securities Depositaries Regulation (“CSDR”). Of particular note are the concerns in relation to settlement finality and Delivery versus Payment (“DvP”) in a distributed ledger technology (“DLT”) environment. The process of ‘consensus’ validation and the risk of forks present challenges to defining and achieving settlement finality. Achieving DvP may be particularly challenging when there is a ‘cash’ leg of the transaction that is not processed on DLT. The current speed (or variability of speed) with which transactions are completed on DLT under some trading models may also pose challenges to meeting settlement deadlines CSDR.

Transaction reporting

For cryptoassets which qualify as MiFID financial instruments, reporting requirements would apply. The regulatory technical standards concerning transaction reporting, instrument reference data, transparency and double volume cap (“DVC”) data were designed to capture traditional instruments, as were the currently used identifiers and classifications. ESMA’s view is that until the regulatory technical standards are revised, impacted market participants will not be able to comply with these requirements. It remains unclear what view the FCA would take on these reporting challenges, especially in the context of the FCA’s active enforcement agenda in respect of transaction reporting breaches (at least for traditional MiFID financial instruments).

New entrants: Crypto-exchanges

The rapid proliferation of tokens applying for listing has the potential to raise issues for compliance and risk, particularly where the control environment may not have kept pace with the business. As discussed above in relation to banks and investment firms, it will be important for exchanges to monitor and understand whether tokens fall within or outside the regulatory perimeter. Unregulated exchanges may be asked to explain why their business falls outside the regulatory perimeter, and that position may be subject to change.

Listing criteria

Crypto-exchanges should consider whether their listing criteria need to be expanded to reflect the specific risks and considerations that attach to security tokens (over and above those that are relevant to traditional securities). Such criteria may cover a wide variety of matters, ranging from attributes of the issuer to attributes of the underlying technology. For example:

  • Issuer criteria: to address the issuer’s technological experience; track record; reputation; cybersecurity controls.
  • Underlying technology: availability of an appropriate wallet solution for the asset; details of the protocol and underlying infrastructure – whether it leverages a new or existing architecture system and whether it is scalable; the relevant consensus control; whether the security token has any in-built anonymisation functions and if so whether the holder of the security token can be identified; whether the security token has been used or was used with any smurfing technology, or mixers or has been traded on any Darknet marketplaces; whether the security token has been traded on any sidechains (defined below); and whether the security token has any inbuilt mechanism which caters for settlement failure, such as resolution mechanisms.
Smurfing Smurfing is a type of denial-of-service attack that relies on flooding a network with a large volume of traffic through the manipulation of IP addresses in that network.
Mixers Mixers are a service used by cryptocurrency owners in order to enhance the privacy and anonymity of the digital currency transactions. They pool funds together and create a web of new transactions, making it near impossible to trace the source of a cryptoasset.
Darknet The dark web (also known as the “darknet”) refers to encrypted online content that is not indexed by conventional search engines, such as Google or Yahoo. The dark web is part of the ‘deep web’ which contains content which does not appear through regular internet browsing activities.
Sidechains Sidechain is a mechanism that allows cryptoassets to be transferred securely from one blockchain to another (then moved back to the original chain if required). A side-chain is attached to its parent blockchain using a two-way peg, which enables interchangeability of assets at a predetermined rate between the chains.

Custody of cryptoassets – use of wallets

Given the current regulatory focus on operational resilience and cyber-security, crypto-exchanges which offer custody will need to carefully consider how they provide those custody services in relation to cryptoassets. Including the type of wallets they use; who the wallets are provided by; the security arrangements in relation to those wallets; and the application of more traditional account opening and operating procedures. Whichever option is chosen, robust systems and controls must be in place to manage the specific risks arising from use of technology to facilitate custody of assets.

There are different formats of crypto wallet. These span software wallets, which are usually ‘hot’ (i.e. connected to the internet), and hardware wallets (i.e. a physical device such as a USB) that are generally ‘cold’ and require connection to the internet to use. Cold/hardware wallets are potentially more secure given they need not be continuously connected to the internet and permit greater authentication options. Whichever approach is chosen, appropriate technological controls and oversight must be in place.

This should further be considered in the context of the technology creating the wallet, and also its functionality. This may vary from sending and receiving cryptoassets and monitoring balances, to storing public and potentially private keys as well. Cryptoexchanges will need to have robust processes in place concerning access to and use of those keys. The importance of having such processes in place, and the potential severity of the consequences of such processes failing, is highlighted by the Quadriga case. QuadrigaCX was a Canadian cryptocurrency exchange that held cryptocurrency for around 115,000 customers. The founder of the exchange, who had sole responsibility for handling funds and coins for the exchange, died suddenly. Quadriga apparently used cold wallets for storage of cryptocurrency. Whilst the initial concern was about being able to gain access to those cold wallets, upon subsequent access they were found not to contain any balances and in excess of CA$100m of user assets are yet to be found. Quadriga appointed EY to investigate, and there may be important lessons to be learned once the final outcome of the investigation is known.

Clive Cunningham
Clive Cunningham
Partner, London
+44 20 7466 2278
Wendy Saunders
Wendy Saunders
Senior Associate, London
+44 20 7466 2373