CUMMINGS PEPPERDINE ON THE FALL OF FTX
 
COULD IT HAPPEN HERE?
 
Rumours are swirling about the reasons for the fall of FTX, US the crypto exchange, and its trading companion company, Alameda.
 
There only seems to be one thing which is certain, and that is that hard facts are hard to find.
 
But one question which is relevant to the crypto industry in the UK and which we can look into is whether it could happen here.  What does the FCA regime require in the United Kingdom which might help protect UK crypto exchanges and their customers from collapse?
 
Interestingly, we have been given a way in to look at this Changpeng “CZ” Zhao, the CEO of Binance.
 
In an article this week, it was reported that CZ has spoken about his belief that regulations must focus on exchange operations, such as business models and proof of reserves.
 
While in the United Kingdom many crypto rules are found in regulations which focus on anti money laundering and counter terrorism financing, what CZ has done is draw our attention to the wider requirements which the FCA impose on applicants for registration with the FCA as a crypto exchange and/or crypto wallet provider.
 
In this article we look at the information which the FCA delves into in relation to operations, business models and proof of reserve when it looks at those applying to be registered crypto exchange and/or crypto wallet provider.
 
And then we look at the FCA and what it can do.
 
What are the rules?
 
So what are the exchanges operations, business models and proof of reserves which are required in an FCA application under The Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (the “MLR 2017”)?
 
First, let us look at what the FCA has said about the wider issues around acting as a crypto exchange or wallet provider.  Any applicant for FCA registration must provide documentation which supports an application.  The FCA’s will refuse to register an applicant that does not have the systems and controls needed to comply with the MLRs 2017 on an ongoing basis.
 
In our publication on applying to the FCA for registration under the MLR 2017, we set out the various documents which the FCA requires.  This can be found at https://cummingspepperdine.com/wp-content/uploads/2022/03/Cummings-Pepperdine-on-FCAs-regulation-of-cryptoasset-businesses.pdf.
 
What is the aim?
 
The clear aim behind these requests for information is to ensure that applicants have thought out all areas of their business.  It is not just about the people who is are involved, as players or investors, but the robustness of the business across the board. 
 
As well as a detailed business plan (which must also look ahead for 12 months), an applicant must also give wholly drilled down information on the way it has considered its key risks and how to mitigate each one.
 
We help our clients draft risk appetite and risk assessment documentation which provide information, guidance, policies and procedures to supply as part of an application and then use daily once registered.
 
We also believe that it is crucial to have a governance manual which, again, is used on a daily basis and learning plans which set out requirements that are met monthly and updated at least quarterly.
 
Financial resources are also relevant.  While regulatory capital is not a requirement under MLR 2017 registration in the same way that it is a requirement for firms which the FCA authorise under the rules which apply to fund managers, banks, investment advisors etc, financial reserves are part of the process. 
 
In the MLR 2017 application forms, the FCA specifically asks applicants to set out in detail how much annual income from its cryptoassets activities does the applicant firm project for the first year of registration.  The details they ask for include the projected revenue in relation to this activity for the 12 months from the date of registration.  Fully detailed, valid and considered accounting and financial information are a must.
 
So, could it happen here? 
 
In theory it could happen anywhere but perhaps the FCA’s focus now, to prevent a failure in the future, is to find knowledgeable staff from the top to the bottom and work with us in the industry to build a truly robust and world-leading crypto industry.
 
FCA – help us
 
The first step is for us to have more registered exchanges and wallet providers so that consumers have choice at all stages of investment.
 
And for that, we need a fully-staffed and pro-active regulator which looks at applications and helps create fully compliant businesses.  So FCA, please staff-up and work with us in the industry.  We can be world-beating.