Cryptoasset regulation: The insolvency angle

01 June 2023

Cryptocurrencies, such as Bitcoin and Ethereum, have gained popularity in recent years, and as a result are being seen more often in insolvency cases.

However, the unique characteristics of cryptocurrencies, including their volatility and difficulty to trace, have presented new challenges for insolvency professionals.

Recognising the significance of this emerging asset class, the UK government has sought to establish regulations for cryptoassets under a new consultation, ‘Future Financial Services Regulatory Regime for Cryptoassets’.

While we broadly support the proposed new regulatory framework, any new regulation must provide clear guidance for managing insolvency cases involving cryptocurrencies – both as an asset and as a client – and ensure the protection of individuals seeking rightful returns – on their investments and as creditors.

The question of segregation

Regulating cryptoassets is challenging due to their diverse nature and the different rules that apply to them in insolvency cases. For example, handling the insolvency of a bank holding cryptoassets requires a different approach than dealing with a multinational construction company using smart contracts. This complexity makes it difficult to develop a single regime that works for all types of cryptoassets and the organisations involved in using or holding them.

The international and ‘borderless’ aspect of crypto businesses and the absence of regulatory regimes is some jurisdictions, including some British territories, raises concerns about properly safeguarding client funds.

Our consultation response highlights that, for a new regulatory regime to succeed, it must address the appropriate segregation of assets in the event of a firm’s collapse, whilst considering the complexity of the multi-jurisdictional footprint of assets.

A delicate balance

The absence of any kind of international regulatory framework has resulted in significant inconsistencies across different jurisdictions. Where one jurisdiction may have stricter regulations than another, this opens loopholes which allows companies to sidestep regulation and exploit less stringent regulatory requirements by ensuring that entities are based in countries with low, or no, applicable regulation.

The UK needs to address such loopholes if it is to introduce a regulatory framework which is fit for purpose. It must also consider how, in practice, it can introduce a framework which stipulates that  companies operating in the UK must follow UK regulations in order to protect the interests of its investors and consumers and make it easier to recover assets in cases of insolvency.

Without this specification, IPs will struggle to return assets to UK investors and consumers when dealing with companies operating in multiple countries. Yet this needs to be balanced with the risk of introducing a regime which discourages the development of a healthy and competitive cryptoasset market here in the UK.

Collaboration is critical

To ensure the success of the crypto industry in the UK, it's crucial for investors, creditors, and depositors to have confidence the system is both strong and well-regulated system, and capable of recovering their funds in the event of a crypto insolvency.

For this to happen, regulators need to understand that insolvencies involving crypto firms are more complex and riskier for IPs than those involving traditional FinTechs.

One major issue is that funds in crypto insolvencies can vanish quickly, making it difficult and costly to track them down. In many cases, the funds disappear offshore, making retrieval nearly impossible.

In these instances, close collaboration between the FCA, HMRC, the Business Department and the courts is necessary to freeze assets, obtain injunctions, and provide flexibility to support office holders in their efforts to recover assets and make payments to creditors.

Nowhere is collaboration more critical than at Government level. We strongly believe that there needs to be a joint approach across government and industry to ensure that any framework is fit for purpose. The best way to achieve this would be through a structured dialogue, perhaps via a series of roundtables, which would allow all voices with a stake in crypto asset regulation to be heard and for the development of a regulatory framework which meets the needs of both Government and industry, and the public.

A multi-stage process

While it is positive to see the Government making proactive steps towards a new regulatory regime for cryptoassets, we urge that the size and complexity of the challenge is not underestimated. It will take time, innovation and a huge amount of collaboration to develop a framework that can achieve its aims.

The consultation has now closed, but we will continue to push for clarity on the concerns we and the profession have raised at every opportunity.