An Overview of the UK Regulatory Approach to Asset Tokenisation

The?Financial Conduct Authority (FCA)?in the UK has been active in regulating crypto assets and tokenisation platforms, aiming to provide clarity and consumer protection in this rapidly evolving space.

The?UK government?has generally taken a cautious approach to tokenised money, balancing innovation with the need for regulatory oversight to prevent financial crime and ensure market stability. However, there has been growing interest and investment in blockchain and tokenization technologies from both private and public sectors in the UK. One notable initiative is the exploration of central bank digital currencies (CBDCs) by the?Bank of England (BoE). CBDCs are a form of tokenized money issued by a central bank and could potentially provide a digital alternative to physical cash, offering benefits such as increased efficiency, financial inclusion, and reduced transaction costs.

Overall, while the UK acknowledges the potential of tokenized money and blockchain technology, regulatory frameworks are still evolving to address the unique challenges and opportunities presented by this emerging financial ecosystem.

The Deputy Governor of the Bank of England recently outlined the institution's strategy concerning tokenized money, encompassing stablecoins, deposit tokens, and wholesale central bank digital currencies (CBDCs). The Bank will be granted regulatory powers over payment systems and providers utilizing 'digital settlement assets' through the Financial Services Markets Bill. Consequently, the Bank's Prudential Regulation Authority (PRA) is developing regulations for stablecoins.

Addressing the distinction between tokenized bank deposits, the Deputy Governor highlighted two potential scenarios. In one, tokenized deposits would be freely transferable, posing challenges for regulators regarding anti-money laundering (AML) compliance and deposit insurance clarity. The alternative model involves users transacting with tokens issued by their respective banks, which are then exchanged into the recipient's bank tokens. Settlement occurs via distributed ledger networks, ensuring all token holders maintain accounts with their respective banks.

While some banks may opt for the stablecoin approach, concerns arise regarding the potential confusion between bank-issued money and stablecoins lacking deposit insurance, at least initially. Therefore, if banks proceed with stablecoin issuance, it will likely be through separate legal entities with distinct branding to mitigate confusion [1].

UK FCA Fund tokenization blue Print?

The investment management industry has long been engaged in discussions surrounding the potential applications of tokenization, with various initiatives and interest from fintech entities. Despite this, progress has been sluggish due to obstacles such as legal and regulatory uncertainties. However, recent activities by funds in other jurisdictions have sparked interest among UK firms, who perceive an opportunity for market expansion. Given the international nature of the UK industry and its significant role in managing assets for international clients, there is a unique opportunity to not only draw from global experiences but also to lead in advancing this vital ecosystem.

In 2022, the Investment Association (IA) advocated for the UK to embrace fund tokenization as an evolutionary step in fund structure enhancement. Additionally, under its 'Investment Fund 3.0' innovation concept, the IA explored more transformative shifts aimed at fostering a more interactive and participatory experience for investors.

??In continental Europe, the landscape of fund tokenization is diverse, marked by experimentation and the emergence of various models tailored to different distribution channels. Local regulations have influenced the development of digital asset technology, although efforts such as the EU DLT Pilot regime aim to standardize practices across the bloc.

Recent months have witnessed a surge in activity, with notable examples including Metzler Asset Management's issuance of tokens for a single share class of its Sustainable Growth fund in Germany. This pilot, conducted on a public chain with a restricted participant list, signifies a step toward tokenized assets functioning within regulatory frameworks. Germany, in particular, has advanced legislation enabling digital securities to exist natively on-chain, eliminating the need for a central securities depository, and facilitating the tokenization of funds at unit level [2].

In Luxembourg, Archax has progressed its joint project by creating a tokenized representation of interests in abrdn's money market fund, further demonstrating the industry's commitment to embracing tokenization. Notably, the Luxembourg regulator, CSSF, has explicitly permitted firms to utilize distributed ledger technology for their fund register, underlining the regulatory support for innovation in this space.

Elsewhere in Europe, similar initiatives are gaining momentum. In France, Generali's fund range is now available digitally on a distributed ledger technology platform [3], joining a growing cohort of fund firms leveraging blockchain technology for enhanced accessibility. Moreover, there are ongoing experiments and pilots in countries like Spain and Italy, reflecting a continent-wide drive toward modernizing fund management practices through tokenization.

Digital Securities sandbox

In a significant move to promote innovation in the UK financial sector, HM Treasury (HMT) unveiled plans for the Digital Securities Sandbox in July 2023. This pioneering initiative aims to facilitate the testing and eventual adoption of digital securities across financial markets. Through the Sandbox, industry players will have the opportunity to establish financial market infrastructures leveraging digital asset technology, operating under a temporarily modified legislative and regulatory framework [4].

Renowned as one of the world's most fintech-friendly nations, the UK authorities recognize the pivotal role of policy and regulation in fostering innovation. By providing a clear framework for operation and establishing high standards for business practice, the UK aims to instill confidence in investors and encourage the exploration of new services and providers.

Under the provisions of the Financial Services and Markets Act 2023 (FSMA23), HMT is empowered to establish financial market infrastructure sandboxes via statutory instruments, allowing for agile development based on live activities. Each statutory instrument laid before Parliament will serve as the legal basis for the Sandbox, temporarily disapplying or modifying relevant legislation as necessary. This streamlined approach ensures that a modified legislative framework can be swiftly implemented to accommodate digital assets without the need for further parliamentary procedures, thus expediting the process of innovation adoption.

Participants in the Sandbox will have the opportunity to operate using innovative digital asset technology, conducting activities such as central securities depository functions and operating trading venues within the modified regulatory framework. These activities will initially focus on existing security classes, with limits imposed on participating entities that can be adjusted based on progress and risk management capabilities.

The Sandbox's flexibility and timing position it as a valuable tool for exploring the integration of digital asset technology within the investment management sector. Notably, the proposals in the Sandbox design consultation touch on tokenized units in funds, suggesting potential broader support and clarity around the permitted uses of tokenization, which could significantly bolster industry adoption.

An essential feature of the financial market infrastructure sandbox powers is the ability to enact permanent changes to legislation based on learnings from Sandbox activities. HMT intends to lay a statutory instrument before Parliament to establish the legal framework for the Digital Securities Sandbox, while the Bank of England and Financial Conduct Authority (FCA) will provide further guidance, consult on rule changes, and outline the application process. Prospective applicants are encouraged to engage with regulators promptly to discuss potential Sandbox activities [5].

Bank of England stablecoin regulation

The Bank of England's approach to stablecoin regulation would likely prioritize financial stability, consumer protection, and mitigating risks such as money laundering and terrorist financing. It may involve establishing requirements for stablecoin issuers, ensuring proper reserve backing, and implementing measures to safeguard against market manipulation and systemic risks.

The regulatory framework established by the Bank aims to foster innovation in money and payments while simultaneously managing risks to financial stability.?

Phase 1 of the initiative aims to establish a regulatory framework specifically tailored for fiat-backed stablecoins. The Financial Conduct Authority (FCA) aligns its definition of stablecoins with the approach outlined by the Financial Stability Board, categorizing them as cryptoassets designed to maintain a stable value relative to a specified asset or basket of assets. This definition acknowledges stablecoins' role in providing stability amidst the high volatility often associated with unbacked cryptoassets.

Under this framework, a regulated stablecoin, issued by an FCA authorized issuer, is expected to maintain a stabilised value by referencing one or more specified fiat currencies. This designation encompasses stablecoins that utilize fiat currency reserves to uphold their value, reflecting a key aspect of the regulatory oversight introduced in Phase 1 of the initiative.

The rise of innovative technologies like distributed ledger technology (DLT), which includes blockchain, has paved the way for the emergence of novel digital assets and forms of digital currency. This technological advancement has spurred heightened competition in the financial landscape, with non-traditional entities, including technology firms, expanding their footprint in the provision of payment services [6].

London stock exchange blockchain securities?

The London Stock Exchange Group (LSEG) is in the early stages of developing a blockchain-based exchange targeting private markets. Unlike traditional cryptocurrency-focused platforms, LSEG's initiative aims to tokenize real-world assets to facilitate cross-border digital asset trading. While some reports suggest LSEG would be the first major stock exchange to implement end-to-end trading and settlement using blockchain technology, this claim overlooks SIX's Digital Exchange (SDX), which launched in 2021, including a regulated digital central securities depository (CSD).

Murray Roos, head of capital markets at LSEG, envisions a global platform that enables seamless interaction among participants across jurisdictions, ensuring compliance with respective rules and regulations. LSEG has initiated discussions with the UK Treasury and regulators in other jurisdictions to advance this vision. Meanwhile, AsiaNext, a joint venture between SIX and Japan's SBI, is also eyeing international trading, initially focusing on cryptocurrencies before expanding its scope.

Numerous stock exchanges worldwide are advancing blockchain and tokenization initiatives, ranging from end-to-end exchanges to post-trade solutions. For instance, Deutsche Borse's CSD Clearstream introduced D7, a DLT-based post-trade solution, reflecting the growing interest in leveraging blockchain technology within capital markets. Other exchanges, including HKEX and the Tel Aviv Stock Exchange, are also exploring blockchain applications for post-trade scenarios and digital asset plans, respectively [7].

FCA updates position on cryptoasset Exchange Traded Notes for professional investors

The Financial Conduct Authority (FCA) has announced that it will approve requests from Recognised Investment Exchanges (RIEs) to establish a UK listed market segment specifically for cryptoasset-backed Exchange Traded Notes (cETNs). However, these products will be exclusively available to professional investors, including investment firms and credit institutions authorized or regulated to operate in financial markets. Exchanges seeking to introduce cETNs must ensure robust controls are in place to maintain orderly trading and provide adequate protection for professional investors. These products must also adhere to all requirements outlined in the UK Listing Regime, including those related to prospectuses and ongoing disclosure.

The FCA's decision to permit cETNs for professional investors follows a period of increased trading activity, providing exchanges and investors with greater insight and data to evaluate risk. However, the FCA maintains its stance that cETNs and crypto derivatives are not suitable for retail consumers, and the ban on their sale to this demographic remains in effect.

Despite allowing cETNs for professional investors, the FCA emphasizes the high risks associated with cryptoassets, which are largely unregulated. Investors are urged to exercise caution and be prepared to incur substantial losses.?

Furthermore, the FCA is actively collaborating with government, international partners, and industry stakeholders to develop and enhance the UK's regulatory framework for cryptoassets, aiming to establish leading international standards in this rapidly evolving space [8].

FCA Licensing regime of crypto assets

Cryptoasset businesses must register with the Financial Conduct Authority (FCA) in accordance with the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs). Compliance with these regulations is mandatory for cryptoasset businesses intending to offer specific services, provided as part of their business activities within the United Kingdom.

As part of our supervisory assessment, cryptoasset businesses are required to demonstrate the implementation of robust policies, controls, and procedures to effectively manage money laundering and terrorist financing risks, tailored to the size and nature of their services. Regular assessments of these measures are necessary to ensure their ongoing relevance and appropriateness, particularly in light of any changes to the business's operating model [9].

Outlined below are essential requirements for cryptoasset businesses, although this is not an exhaustive list and does not encompass broader rules and guidance imposed by the Financial Conduct Authority (FCA) under the Financial Services and Markets Act (FSMA) alongside the MLRs:

Risk Assessment:

• evaluation of money laundering, proliferation financing, and terrorist financing risks specific to the business.
• Assessment of the risks associated with new technologies before implementation.

Policies and Controls:

• Implementation of policies, systems, and controls to mitigate the risk of the business being exploited for illicit purposes.

Compliance Oversight:

• Appointing board members or senior manager to oversee MLR compliance.
• ?Nominating officer responsible for reporting suspicious activities to the National Crime Agency.

Internal Audit:

· Establishing an independent internal audit function to assess the adequacy and effectiveness of policies, controls, and procedures.

Employee Screening:

Conducting employees screenin to prevent infiltration by individuals with questionable backgrounds.

Customer Due Diligence:

Performing due diligence when initiating business relationships or occasional transactions with customers.

Enhanced Due Diligence:

Applying enhanced due diligence measures for customers presenting higher money laundering, terrorist financing, and proliferation financing risks, including politically exposed persons.

Ongoing Monitoring:

Continuously monitoring customer transactions to ensure alignment with the business's understanding of their customer, business, and risk profile.

Conclusion

Advancements in financial technology, particularly the emergence of tokenised money and digital assets, have spurred significant developments in the global financial landscape. In the United Kingdom, regulatory bodies such as the Financial Conduct Authority (FCA) and the Bank of England (BoE) have been actively engaged in shaping the regulatory framework for these innovations, aiming to strike a balance between fostering innovation and ensuring consumer protection and financial stability.

The UK's approach to tokenised money encompasses a cautious yet forward-thinking stance, with regulatory initiatives aimed at providing clarity and oversight in this rapidly evolving space. The FCA's regulatory regime for fiat-backed stablecoins, for instance, seeks to establish a framework that balances innovation with risk management, ensuring stability and consumer protection. Moreover, ongoing efforts by the BoE to explore the potential of central bank digital currencies (CBDCs) reflect the UK's commitment to leveraging blockchain technology to enhance the efficiency and inclusivity of the financial system.

Furthermore, the UK investment management industry is witnessing a growing interest in fund tokenization, driven by the potential for enhanced liquidity, accessibility, and efficiency. Initiatives such as the Investment Association's advocacy for fund tokenization underscore the industry's recognition of the transformative potential of blockchain technology in revolutionizing traditional fund structures.

In parallel, the UK's regulatory sandbox initiatives, such as the Digital Securities Sandbox, exemplify the government's commitment to fostering innovation in the financial sector. By providing a conducive environment for testing and experimentation, these initiatives aim to accelerate the adoption of digital securities and blockchain technology, paving the way for a more robust and resilient financial ecosystem.

Overall, the UK's regulatory landscape for tokenized money and digital assets reflects a balance between promoting innovation and safeguarding against potential risks. As the regulatory framework continues to evolve, collaboration between regulatory bodies, industry stakeholders, and international partners will be crucial in shaping a regulatory environment that fosters innovation while ensuring consumer protection and financial stability.

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References

[1] Bank of England, “Bank of England to provide guidance on tokenized bank deposits,” 2023, [Online]. Available: https://www.ledgerinsights.com/bank-of-england-to-provide-guidance-on-tokenized-bank-deposits/.

[2] “Metzler issues tokenised shares for sustainable growth fund,”?Ignites Europe, 2023. https://www.igniteseurope.com/c/4229884/546143/metzler_issues_tokenised_shares_sustainable_growth_fund?referrer_module=emailForwarded&module_order=0.

[3] C. D. E. Presse, “Partenariat IZNES et Generali : Succès rencontré dans l ’ usage de la blockchain au service de la gestion d ’ actifs en unités de compte,” no. 1, pp. 1–3, 2023.

[4] HM Treasury,?Consultation on the first Financial Market Infrastructure Sandbox : The Digital Securities Sandbox., no. July. 2023.

[5] A. B. F. O. R. Implementation, “Interim Report from the Technology Working Group UK FUND TOKENISATION :,” no. November, 2023.

[6] H. van Steenis, “The Future of Finance Report,”?Bank Engl., no. June, 2019, [Online]. Available: https://www.bankofengland.co.uk/report/2019/future-of-finance.

[7] Financial Times, “LSE Group draws up plans for blockchain-based digital assets business,” 2023. https://www.ft.com/content/ce177de8-2828-4fe2-827f-1c25dcbc99ff.

[8] “FCA updates position on cryptoasset Exchange Traded Notes for professional investors,”?Financial Conduct Authority (FCA), 2024. https://www.fca.org.uk/news/statements/fca-updates-position-cryptoasset-exchange-traded-notes-professional-investors.

[9] Financial Conduct Authority, “Cryptoassets: AML / CTF regime.” https://www.fca.org.uk/firms/cryptoassets-aml-ctf-regime/registering.