UK Cryptocurrency Regulations and Their Consequences: Capital Flight in the Heart of Europe

editorNovember 2, 2024

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UK Cryptocurrency Regulations and Their Consequences: Capital Flight in the Heart of Europe

The actions of UK regulators are causing a flight of crypto capital, leading to a slowdown in related projects and potentially undermining the country’s standing in the industry.

“As softly as a task may advance, Seek not harshness beyond measure.” — Asadi Tusi in Garshaspname. In this line, the great Iranian poet addresses those close to Garshasp and his court in his final moments, essentially advising statesmen, legislators, and officials to exercise a vital form of wisdom. If only world leaders, politicians, and lawmakers could fully understand the depth of this verse. Recently, certain members of the UK House of Commons and other influential figures have shown a lack of faith in soft and rational approaches to certain matters. They are determined to impose strict, and even radical, regulations across the entire realm of cryptocurrency and blockchain technology.

While UK legislators present themselves as well-intentioned protectors of citizen and consumer rights, their actions seem to stifle this emerging field in one of the world’s financial hubs. This regulatory approach is leading to capital flight and stalling crypto projects within the UK.

In previous issues of Blockchain Research, we covered topics like the history of digital currencies in Hong Kong, the revelation of crypto trades by Chinese users despite the country’s crypto ban, and the growing interest in digital currencies among Turkish citizens in response to inflation. In this issue, we examine the UK lawmakers’ approach to the nascent phenomenon of cryptocurrency.

Introduction

Regulation and Structuring of the Crypto Market

The issue of regulating and structuring the cryptocurrency and digital asset markets appears to be an endless debate. Since this emerging technology first gained global attention, it has sparked numerous discussions among crypto industry players, traditional financial institutions such as banks and international monetary organizations, and governments and politicians alike. It’s safe to say that no clear consensus or unified perspective has yet been established. Historically and logically, regulation and some degree of oversight in any new financial field are beneficial and even essential. The capital and livelihoods of thousands, if not millions, of people may be tied to these developments, potentially impacting the economic and political stability of countries or even globally. However, the real question is which approach and processes should be adopted for effective regulation. Overly controlling, severe, and hasty actions by governmental structures during times when no crisis or urgent situation exists may often exacerbate problems, create confusion, increase risk, or drive capital out and slow down essential economic growth.

Despite the ongoing debates about the regulatory approach to digital assets, governments have not remained idle. Both powerful and smaller governments have tried to control the digital asset market through laws, directives, and executive orders. However, these efforts often result in “unnecessary restrictions” or “black markets and fraudulent schemes.” The United States might be considered to have adopted a more balanced approach. Thus far, it has aimed to work within existing financial laws and has not yet imposed mandatory compliance requirements on businesses or categorized digital assets under any specific legal framework. However, in practice, it has tasked the U.S. Securities and Exchange Commission (SEC) with overseeing this space, leading to numerous legal actions. While the SEC and other U.S. regulatory bodies have acted cautiously and conservatively in issuing licenses or supporting the crypto world, they have, in most cases, been quick and assertive in taking legal actions based on broad and sometimes ambiguous interpretations. This cautious approach yielded minor victories in significant legal battles for the crypto community last year—small steps that could lead to a more consistent legal framework.

Excluding countries fundamentally misguided in economic and political affairs, or in their approach to digital assets, it may be surprising that a country like the UK, known for its liberal, investment-friendly economy, is adopting policies that could result in capital flight and stagnation in its crypto sector. Although it seems unlikely that these UK legislative decisions, given the country’s high administrative and economic transparency and citizens’ general wellbeing, would lead to black-market operations or organized fraud schemes, it still seems odd for a country with an otherwise advanced and robust economy to choose this path. Before delving into the main topic, we’ll provide a brief overview of the UK’s governance and economic structure, supported by statistics, in the section titled UK, Government Structure, and Economic Conditions.

The UK, Government Structure, and Economic Conditions

The United Kingdom of Great Britain and Northern Ireland is a union of Scotland, England, Wales, and Northern Ireland. Due to its colonial history, the country’s official territory spans beyond this island in Western Europe. The UK operates as a constitutional monarchy, where the monarch serves in a ceremonial role, while Parliament effectively governs the country.

The UK Parliament is elected by a direct vote, with parliamentary seats divided among political parties. From the majority or coalition of parties, the leader of the winning party becomes the Prime Minister, who, in turn, selects cabinet ministers from parliamentary representatives. Additionally, an opposition cabinet called the “shadow cabinet” oversees the ruling cabinet. With this oversight, there are few secrets from Parliament, and representatives play an active role in governance. Parliamentary committees have the power to investigate any topic, with no barriers to their inquiries. Despite this wide-ranging authority, a structured legal framework tightly regulates parliamentary powers. Regulatory bodies and the judiciary operate independently of Parliament to oversee legislative actions.

In addition to the elected House of Commons, the UK Parliament includes the House of Lords, composed of aristocrats and established families close to the monarchy. This upper chamber primarily has a consultative role; it can delay legislation for up to a month to suggest amendments, but it cannot alter or repeal laws. The House of Lords can revisit legislation unrelated to the budget or economic and financial policies after a year.

Historically, the UK Parliament (in the form of the House of Lords) began as a consultative council to the monarch in the 13th century. The modern Parliament emerged in the 17th century and has remained unchanged since the early 18th century. This shift resulted in the monarchy’s symbolic role and the empowerment of elected representatives. However, the monarch retains certain ceremonial powers, such as temporarily heading the government in the absence of a Prime Minister, although such instances are rare.

This structure has fostered a vibrant economy, enabling the UK to rank as the world’s sixth-largest economy. Its GDP exceeds $3.1 trillion, with a per capita GDP over $48,000—making its citizens 2.7 times wealthier than the global average. The UK’s Economic Freedom Score, as assessed by the Heritage Foundation in 2022, stands at 72 out of 100, indicating substantial economic freedom. According to the Corruption Perceptions Index (CPI), the UK ranks 18th worldwide in political and administrative integrity. However, recent geopolitical events, such as Brexit and the Ukraine conflict, have caused fluctuations in the UK’s AA- credit rating.

Economic and regulatory decisions in the UK are made by Parliament, the Treasury, and the Bank of England (central bank), with oversight from other specialized bodies. The two most prominent regulatory entities are:

The Financial Conduct Authority (FCA), a strategic financial authority, specializes in regulatory matters. Most of the time, it bases its actions on the country’s existing laws and the procedures and policies of ‘Anti-Money Laundering and Countering Terrorism Financing (AML/CFT)’—a set of practices linked in Iran to FATF. Issuing most licenses, conducting investigations, and determining the compliance of all types of public and private financial and commercial activities fall under this authority’s domain. The government, parliament, or judiciary may assign tasks to the FCA, but no entity has the power to halt its activities in the execution of its duties, investigations, or reviews. On the other hand, any mistakes, violations, or suspected collusion or unlawful activity by the FCA come under the scrutiny of the British judiciary. Naturally, like any bureaucratic structure, there are ways to exert pressure on such an authority.
The House of Commons Treasury Committee, also widely known as the Treasury Select Committee, is another key decision-making and regulatory body in the economic domain. This committee comprises elected members of the House of Commons and is tasked with examining government and national expenditures, overseeing budget allocations, setting Treasury policies, and monitoring the performance of the Treasury along with all related agencies and institutions, including Customs and the Bank of England. Since 2010, it has been granted new powers, including the right to veto and nullify actions and decisions of the Office for Budget Responsibility (OBR). This committee wields significant power, possessing the authority to investigate all matters, propose legislation, or suggest amendments. Its reports are essentially considered the final and expert opinion on economic affairs in the UK. Even when its reports do not contain specific recommendations, they serve as a message and signal to various sectors of the UK economy and its partners, clarifying the government’s stance on diverse issues for economic stakeholders.

UK Regulatory and Legal Decisions on Cryptocurrencies

To begin, it’s important to note that most of the UK’s regulatory and economic decisions originate from two key institutions: the Treasury Select Committee and the Financial Conduct Authority (FCA). The Treasury Select Committee is a group of members from the House of Commons, while the FCA is an independent administrative authority under the oversight of the Bank of England and Parliament. Both bodies hold extensive powers and resources. However, despite their autonomy, they may experience pressure or display certain biases based on the dominant stance of the House of Commons or relevant committees. Consequently, the traditional UK financial and banking system can wield significant influence, with a longstanding British administrative tradition favoring open negotiation.

Regulatory Mechanism and Approach

In terms of legal definition, the British government has yet to introduce a specific law exclusively targeting cryptocurrencies or blockchain technologies that carry financial and commercial weight. Instead, it has adopted a relatively proactive approach. Initially, UK regulatory bodies refer to any form of digital token or encrypted digital money as “Crypto Assets,” encompassing a broader array of blockchain and even non-blockchain-based tools, not just those used for trading. With this perspective, the UK directs digital assets to two existing regulatory frameworks, which industry participants must comply with.

The first framework covers all digital assets or activities that could present risks or effects related to money laundering or fraud. In such cases, any company or entity dealing with these assets must register with the FCA to fall under the legal regime for Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT). The government established a “Regulatory Sandbox” at the FCA in 2016 to oversee FinTech regulations. (The term “sandbox” here precisely refers to a separate, controlled environment where specific activities can be conducted without affecting the wider system.)

The second framework is based on whether each blockchain asset fits within the scope of the Financial Services and Markets Act. According to this framework, all digital assets must adhere to the rules known as Regulated Activities (RAO).

At first glance, the UK’s approach may seem reasonable and balanced, but in practical terms, all activities within the digital asset sector must comply with the full array of existing bureaucratic financial and commercial regulations within the UK. In reality, even legal details unrelated to cryptocurrencies must undergo regulatory review, meaning that all blockchain technology can potentially be entangled in traditional administrative structures and progress at the pace set by these institutions. Hence, it’s not an exaggeration to suggest that these actions contradict the fundamental spirit and philosophy of cryptocurrencies.

But this is not the end of the story. Placing digital assets within these two frameworks means that any advertising for projects in this field that could ‘impact the financial and commercial sectors in the UK’ may be subject to restrictions. These measures aim to prevent issues like misleading information, crimes stemming from lack of awareness (such as fraud and Ponzi schemes), or economic instability leading to losses. Such inclusion depends on whether the product, service, or activity in question falls under the definition of a ‘controlled investment’ or ‘controlled activity’ as outlined in Article 21 of the Financial Services and Markets Act. In simple terms, the UK government has imposed a range of actions that cryptocurrency assets must navigate. Since regulatory bodies have not previously handled them within the blockchain technology framework, a considerable amount of time will be needed to conduct reviews. This process is bound to lead to disputes, varying legal interpretations, and serious conflicts.

Regulatory and legislative bodies have adopted a ‘same risk, same regulation’ philosophy as their guiding principle for creating a regulatory legal regime for this new sector. This means that any form of regulation should be based on the level of risk and associated principles, without considering the technological aspect, area of activity, unique definitions, or applications of the field. This is in contrast to the European Union’s approach, which aims to establish a specific regulatory framework for crypto assets to harmonize the new field with existing structures, facilitating the development and utilization of available capacities. This approach is also recommended by the International Monetary Fund.

The UK’s approach to creating a legal regulatory framework for crypto assets involves four planned steps:

By limiting cryptocurrencies to two existing regulatory frameworks, only “eligible crypto-assets” can be promoted and advertised under specified regulations.
Existing laws help clear the way for stablecoins backed by fiat currencies, facilitating the establishment of a digital currency compatible with central bank oversight.
Next, the government plans to establish regulatory guidelines for broader cryptocurrency activities, including trading and investment, with tailored provisions for higher-risk activities to protect markets and consumers. This step covers a wider range of crypto activities subject to regulation and oversight, such as issuance, payment, exchange, lending, borrowing, custodial services, and governance in blockchain networks.
Finally, the government actively seeks feedback to inform future policies, aiming to devise strategies for evaluating developments in the crypto market, taking into account industry, consumer, and regulatory perspectives.

Cryptocurrency Sales and Distribution Regulations

The UK’s legal and regulatory framework divides the sale and distribution of cryptocurrencies into three main categories: 1-financial promotions, 2-disclosure regulations,, 3-consumer protection and remote selling laws.

Under the financial promotions regime, any communication or action that invites or encourages individuals to invest must be categorized as either ‘controlled investments’ or ‘controlled activities’ and fall under regulatory oversight. In this framework, crypto assets are considered ‘specified investments’ under regulation. With this perspective, when ‘qualifying crypto assets’ fall within the scope of financial promotions regulations, any financial promotional communications related to these assets must be issued or approved by authorized persons or fall under an exemption. Simply put, any framework or operation in the realm of digital assets is only within this legal regime if recognized by a competent authority. In practice, blockchain businesses and projects must pursue legal authorization.

The ‘prospectus regulations’ also require companies to make a verified prospectus available to the public when offering transferable securities or applying for their admission on a regulated market. Whether this regulatory system applies to crypto assets depends on whether the asset is classified as a transferable security. So far, based on government actions and decisions, only security tokens are considered transferable securities. This means that in practice, any token offering aimed at participation, issuance of preferred shares, or governance tokens for use in blockchain network governance and decision-making mechanisms must be authorized and deemed compliant within UK jurisdiction, even if it does not yield results outside the blockchain network.

Public advertising, online and remote sales, and consumer protection laws also apply to the marketing of crypto assets. Advertisements must follow guidelines set by the Advertising Standards Authority and should not be misleading or contain incorrect or incomplete information. Other laws, like the Consumer Rights Act 2015 and the Electronic Commerce Regulations 2022, are also applied to protect consumers and regulate businesses offering goods or services digitally. In reality, regulating within the ecosystem has become a complex matter, and participants and investors may find themselves highly confused. However, the relatively defensible aspect of UK-style regulation is precisely this segment, as it provides a clear legal path for consumer rights and requires vendors to meet at least minimum standards for legal and ethical sales.

Cryptocurrency Income Tax

The next issue is taxation. Lawmakers have not overlooked the potential of transactions in this space to be a significant revenue source for the government. As such, UK law identifies three distinct types of crypto assets: 1) Utility tokens, 2) Security tokens, and 3) Exchange tokens. Under this classification, the Treasury only subjects the third type to taxation. Furthermore, personal income tax remains in place, meaning that, in addition to direct tax on crypto transactions, each participant in this field must also pay tax on their digital income. This way, the government collects tax through two channels: from commercial activities and from individual income. Simply put, for income generated from exchangeable crypto transactions, tax is collected twice, while for other blockchain activities, tax is collected once.

The first regulations were drafted and published in 2014, with updates in 2019. According to these guidelines, exchangeable tokens that are tradeable on exchanges are considered a new type of intangible asset, also recognized as a means of payment. However, it is very likely that the law will be expanded and modified further.

Treasury Committee or a Surprise?

Much of what has been discussed is the outcome of regulatory activities in the UK between 2016 and 2022. Despite the relatively challenging and high-pressure environment for starting or continuing blockchain asset activities in the UK, it was rare for news of a project closure or capital exit from the country to make headlines. This suggested that only serious, well-backed projects could endure in the UK. However, in May of this year, the Treasury Select Committee released its fifteenth report for the 2022-2023 financial year, shocking a wide range of blockchain and even broader digital economy participants. This 28-page report, focusing solely on digital assets, is notably lengthy compared to typical reports, which rarely exceeded 10 pages in recent years. For instance, reports spanning 20 to 30 pages—like the twelfth to fourteenth reports in the 2021-2022 financial year—covered five different topics. This alone indicates the committee’s heightened focus on the issue and the legal uncertainties they felt needed addressing.

Initially, the report mentions some of the real and potential benefits of digital currencies. However, in a surprising turn, it argues that cryptocurrencies, due to their lack of intrinsic value, high price volatility, and the absence of discernible social benefits, should be categorized alongside “gambling.” Despite the government’s efforts to regulate this area and protect citizens and consumers by recommending various requirements for cryptocurrency exchanges, the committee argues that these measures create a false sense of security. They cite experts who liken crypto trading to gambling, calling for stronger, more comprehensive actions against unbacked digital currencies. To put it bluntly, this massive shock seems less about creating public insecurity around digital assets and more like an all-out assault on the government’s relatively stringent regulatory approach.

Naturally, the crypto industry criticized the committee’s report, emphasizing the potential benefits and uses of crypto assets. This alarmist viewpoint has been presented without any specific discussion of fraud risks, volatility, or energy consumption linked to digital currencies.

While parliamentarians have raised concerns, they also recognized the potential of blockchain technology and cryptographic security, admitting that these technologies could reduce transaction costs and difficulties in payments. Furthermore, the government has stated its intent to make the UK a hub for digital currencies. The report mentions that separate efforts are underway to explore the issuance of stablecoins to protect the national currency’s value and reduce transaction costs. The Treasury also aims to ensure that tax revenues from digital assets are correctly collected and even increased through all relevant organizations, such as customs. The question remains: were committee members and regulators themselves surprised by the entirety of the report?

The Results of the UK’s Regulatory Efforts and Shocks

Here, we highlight some practical responses from the crypto industry to the actions of UK regulators.

As noted, regulatory efforts are initially focusing on stablecoins, while DeFi (decentralized finance) projects are likely to face restrictions until appropriate regulations are developed. This situation led Marinade Finance, the most prominent and widely used DeFi protocol for Solana, to block UK users from accessing its platform. This major blockchain project, with $350 million in Solana blockchain assets, explicitly stated that this move was in response to actions by the FCA. Following Marinade’s lead, Orca Finance, Solana’s largest decentralized exchange, also announced that UK-based IPs would no longer have access.

Previously, Bybit and PayPal had also announced that they would cease operations in the UK and no longer provide services to UK citizens. The digital assets handled by these two exchanges are immense. Bybit alone oversees $74 billion in assets, with daily trading volumes consistently exceeding $1 billion. Additionally, as of October 16, Binance, the most well-known online crypto exchange, announced that due to FCA regulations, it would no longer accept new UK users, meaning UK citizens abroad can no longer register or complete verification with Binance. While Binance has stated that this suspension is temporary until new regulations are implemented, it has not specified when UK users will again be able to register.

It is worth noting that in June this year, the FCA published a list of over 140 cryptocurrency exchanges that are no longer considered authorized, registered, or safe within the UK, which included exchanges such as KuCoin and Huobi. The UK also disclaimed any responsibility for these platforms. Legally, this move is entirely logical; however, it has practically caused losses for many UK citizens and forced numerous blockchain users to withdraw their assets not only from these exchanges but from the UK jurisdiction altogether.

Regulatory Shocks and Their Consequences

Such events have led to reduced investments in the UK’s crypto assets sector and triggered a crypto capital flight. In a country where regulations are strict and public opinion has been swayed negatively, investors are likely demoralized and may shift their investments elsewhere. However, if the government maintains its focus on tax revenue while providing no support, it could further drive investors and capital away. This move sends a clear message of reduced economic freedoms without compensatory measures.

There are no precise estimates of capital flight from the UK crypto sector or broader economy due to digital assets. However, regulatory processes impact the decentralized and global nature of crypto markets without necessarily reducing trading volumes, as capital does not simply vanish but may relocate. The UK is the world’s sixth-largest economy with a significant crypto market presence, making it plausible to deduce that substantial crypto capital has moved outside the UK’s economy entirely. Normalizing for market fluctuations, it seems likely that crypto volumes and revenues within the UK are on a downward trend, ultimately reducing the anticipated tax and ancillary revenues.

Why Have British Politicians Taken This Approach?

In both the shocking report and in personal comments made by Members of Parliament in the UK, incidents such as the collapse of exchanges like FTX, the decline in value of certain cryptocurrencies, and similar news have worried the committee and its experts. As a result, they are considering consumer protection measures and safeguards and have even started to refer to cryptocurrencies as gambling. At first glance, this could seem like well-intentioned policymaking. But is this the full story? Is this cautious approach solely motivated by such concerns? Let’s take a closer look at the UK’s political and economic background.

After the 2008 financial crisis, the UK was one of the hardest-hit countries, yet the government’s exceptional economic austerity measures enabled a steady recovery. However, around 2015, this recovery approach began to wane as public discontent grew, culminating in the long-standing issue of leaving the European Union. Many citizens believed that the presence of European employees and unauthorized migrants from the EU was draining jobs and resources. When the Conservative Party took office, it started curbing economic freedoms to respond to these concerns.

In 2015, the UK had an economic freedom score close to 80 out of 100, making it one of the most economically liberalized countries in Europe and globally. But over time, government intervention and regulations steadily increased across various sectors, diminishing incentives for foreign investment. This approach aimed to appease public opinion, a stance that aligned with conservative values. However, even after Brexit, the public remained discontent; despite the absence of foreign workers to “take jobs,” there was no noticeable improvement in people’s conditions. Current forecasts suggest that the UK’s economic freedom score will drop to 68 by the end of this year—a score below 70 is seen by economists as an alarming sign.

Now, let’s consider this viewpoint alongside the nature of cryptocurrencies. These global digital assets operate independently, are decentralized, free from government control, and derive their value from security, trust, and transparency, bypassing many limitations of traditional banking and payment systems. Clearly, these characteristics do not sit well with increased regulation. Politicians with this mindset often worry about capital outflow and foreign influence. Therefore, they scrutinize any perspective, stance, or action from other nations or experts. Cryptocurrencies that originated in China or the US and are now spreading in the UK provoke concern in this context. Let’s examine a similar historical case: Around 2015-2016, China essentially shut down its cryptocurrency market. Both Chinese researchers and policymakers realized that Chinese exchanges were enabling users to buy cryptocurrencies with yuan, which were then easily sold on US exchanges, allowing people to convert their capital to dollars and transfer it to the US effortlessly—one of China’s major red lines. Could we not extend this historical example to UK conservatives? For conservative policymakers and a significant portion of the UK public, this ease of capital movement is more of a threat than a benefit. From this perspective, this technology is only beneficial if it reduces payment and capital transfer costs domestically and strengthens the national currency and central bank’s authority.

Conclusion

The UK’s regulatory approach will undoubtedly make conditions challenging for crypto within the country, and digital assets will likely continue down a separate path. This industry has already penetrated traditional stock and securities structures, making it improbable that it will decline globally. The UK’s regulatory framework may eventually provide a stable and attractive base for crypto, but it risks losing its international position in this sector. Time will reveal whether this approach proves beneficial or detrimental.