52. Investors in crypto-assets face a number of risks. These include:
• High price volatility compared to other asset classes. In the Governor of the
Bank of England’s speech on The Future of Money, he noted that “the average
volatility of the top ten crypto-assets by market capitalisation was more than 25
times that of the US equities market in 2017”73;
• Investors in crypto-assets also face the risk of hacking of crypto-asset exchanges
(i.e. theft of their investment);
• Those who have purchased crypto-assets typically store them with crypto-asset
exchanges, or in digital wallets on platforms developed by software providers.
There have been instances of consumers losing their passwords for their accounts,
and have subsequently been told by the exchanges and software providers that
they can no longer access their crypto-asset investments;
• The FCA noted in its written evidence that poor market liquidity and considerably
lower trading volumes in crypto-asset markets, mean that “there is greater
potential for malicious actors to coordinate price manipulation”74;
• Crypto assets could act as a vehicle for money laundering; and
• The growth of crypto-assets could have implications for financial stability.
53. Despite this, “crypto-assets themselves […] are generally not within the scope of FCA
regulation. Transferring, buying and selling of crypto-assets, including the commercial
operation of crypto-asset exchanges will also typically fall outside the FCA’s regulatory
perimeter.”
75 This chapter will consider the current regulatory remit and look at each of
these risks in turn.
Current regulatory remit
54. In the FCA’s written evidence to the Committee, it clarified that “crypto-assets
themselves (i.e. those designed primarily as a means of payment / exchange) are not within
the scope of FCA regulation.”
76 This is because crypto-assets “generally will not meet the
criteria to be considered a specified investment under the Regulated Activities Order, nor
would they typically qualify as ‘funds’ or ‘e-money’ in the Payments Services Directive 2
and E-Money Regulation 2009.”
77
55. Whether an Initial Coin Offering (ICO) is regulated in the UK depends on how it
is structured and what the token subsequently represents.78 For example, when tokens
represent a transferable security such as shares and bonds, that ICO would fall within the regulatory perimeter of the FCA. Issuers would thus be subject to the FCA’s Principles79
and relevant rules. If an ICO falls within the regulatory perimeter, the FCA would also
be required to ensure an appropriate degree of protection for ICO investors as they are
‘consumers’ for the purposes of the FCA’s statutory objectives. However, when tokens
represent a claim on prospective services or products, they do not amount to transferable
securities or other regulated products and thus fall outside the regulatory perimeter.80
Issuers would therefore not be required to follow the FCA’s principles and relevant rules,
and the FCA would not be required to ensure an appropriate degree of protection for
investors. The FCA states that “most ICOs are not regulated by the FCA and many are
based overseas.”81
56. David Geale, Director of Policy at the FCA, noted that this distinction creates risks
for consumers,
and that the FCA “have concerns that […] consumers may think they are
operating in a regulated space when they are not.”82 However, he did note that ICOs “can
be a useful way for some small and mediumsized enterprises to raise capital.”83
57. Regulatory initiatives to bring crypto-asset exchanges into the money laundering
regulations are underway in the EU. The European Parliament adopted the Fifth AntiMoney Laundering (AML) Directive on 19 April 2018.84 The Fifth AML Directive will
extend AML and Counter-Terrorist Financing rules to virtual currencies, such that rules
will now apply to entities which provide services that are in charge of holding, storing
and transferring virtual currencies.85 In future, these entities will have to identify their
customers and report any suspicious activity to relevant regulators and authorities.86 The
Directive came into effect on 9 July 2018 and EU member states will have until 10 January
2020 to amend their national laws to conform with the new Directive.
Price volatility
58. As discussed earlier in this report, crypto-asset prices are volatile. The price of a
Bitcoin in January 2013 was less than $20.87 In December 2013 the price of Bitcoin reached
just over $1,000 but its value subsequently fell back into the hundreds.88 In March 2017, the
price of Bitcoin began to rise again and greatly surpassed its previous records, reaching a
peak of $19,206 in December 2017. However, within two months, the price dropped to just
over $7,000 by February 2018. Since then, the price of Bitcoin has fluctuated between just
over $11,000 and just under $6,000, to $6,467.25 in September 2018 when this report was
published.89 Coinbase’s chart below tracks the value of Bitcoin from January 2013 to now.90
59. Other crypto-assets that emerged since Bitcoin have not achieved the same market
capitalisation, but have exhibited similar or greater volatility.91 For example, the price of
Ethereum has varied from $0 to $1,339 between August 2015 and August 2018. At the time
of writing, the price of Ethereum was $203.59.92
60. The chart below plots the volatility of crypto-asset returns over a year against other
assets.93 It shows that Bitcoin (represented by BTC) is in fact not as volatile as other
crypto-assets, such as Ethereum (ETH) and Stellar (XLM). The chart also highlights that
crypto-assets are considerably more volatile than other assets, such as gold, equities and
other financial assets
61. The FCA explained why the price volatility of crypto-assets exceeds that of other
asset classes:
Price discovery in a traditional marketplace is set by the information on the
current consumption and expected future demand for a particular asset or
commodity. […] As most crypto-assets do not have any inherent worth in
and of themselves […] and they are not actively used in commerce or secured
by a central bank of a nation state, their price is reliant on market sentiment
and speculative use cases [rather] than real world applications. This results
in greater price instability—especially over a short time horizon.95
62. Iqbal Gandham, Chair of Crypto UK96 and Managing Director at eToro,97 argued
that the price volatility of crypto-assets has been decreasing over time:
If you have a look at the volatility of individual currencies,
Bitcoin’s volatility
at launch was 50 per cent of its price on a daily basis. Last year, it was 10 per
cent. This year, if I have a look at the data on eToro’s platform—one of our
members, CryptoCompare, supplied the data—it is 4 per cent to 5 per cent.
The same trend can be seen in Ethereum, Litecoin or any other currencies
that have been around for five to six years, so the daily volatility is falling.98
Obi Nwosu, Chief Executive Officer of Coinfloor, shared this view and argued that
increasing liquidity entering the market could reduce volatility further:
Price volatility has been reducing all the time, and one thing that has caused
that is the increase in volume and liquidity entering the market. There are
a number of institutional players that would like to get into the market,
but they can only deal with other regulated institutions. If they enter the
market, they will bring the disciplines that relate to that, but they will also
massively increase the liquidity, stabilise the price and make it a safer place
for consumers.99
63. However, Izabella Kaminska, Editor of the Financial Times Alphaville, argued that
the price volatility of crypto-assets indicates they are not suitable assets for mainstream
investors:
The question we should be asking is this: should this be propagated and
should its use be encouraged among day-to-day people […] Anyone who had
invested in November or December last year would be very disappointed in
the returns they had had. Yes, you can look at the whole picture and say,
‘the early adopters have done fabulously well’, but this turns out to be a
poor case for the currency argument, because that encourages the sort of
inequality that we have never even seen before in any currency spectrum.
Something like less than 1 per cent of all the wallets own most of the wealth
in bitcoin. Yes, you might be able to argue that people who entered it early
have benefited […] if you are a late adopter, you tend to lose out.100
64. Crypto-assets have no inherent value. In the absence of any market fundamentals,
their prices fluctuate according to sentiment. This causes far higher volatility than
other asset classes, exposing investors to larger potential gains, but correspondingly
greater risk of loss. The use of blockchain as a payments system exacerbates these risks,
since the exchange rate (vis-à-vis other crypto-assets, or conventional currency) can
fluctuate significantly during the time it takes to settle a transaction.
65. On account of their volatility alone, crypto-assets are especially risky, particularly
for inexperienced retail investors.