With Facebook announcing Libra-a new global cryptocurrency and payments system-and its governing body, the Libra Association, uncertainty has arisen over its place in the global economic landscape and the regulatory path ahead. Sushil Kuner, Principal Associate, and David Brennan, Partner and Co-Chair of Tech at Gowling WLG, discuss key technical details of Libra, the response from regulators and its future.
What is Libra and the Libra Association?
Libra is the cryptocurrency, labelled by many as a stablecoin of sorts, being launched by Facebook with the intention that it will provide a replacement for paper money and even credit card transactions. Holders of the cryptocurrency will, in theory, be able to use Libra as a payment system transacting directly through Messenger, WhatsApp and third party apps.
Libra's mission is to create a global currency and financial infrastructure that empowers billions of ordinary people to effectively hold and store financial assets on their mobile device and move those financial assets around globally in an easy and cost-effective manner. The Libra Association-the independent body which governs the Libra Blockchain- claims that 1.7 billion adults globally remain outside of the financial system with no access to a traditional bank, even though one billion of those adults, have a mobile phone and nearly half a billion have internet access. Reasons include:
- people not having sufficient funds;
- high and unpredictable fees;
- banks being too far away; and/or
- individuals lacking necessary documentation.
Libra therefore potentially provides an opportunity to make financial services more accessible to more people.
What is unique about Libra?
Current proposals envisage Libra being built on the Libra blockchain, which would initially start out on a 'permissioned basis'. So, while any node (or computer software) will have the ability to interact with the Libra Blockchain, they will only be able to construct, sign and submit transactions, and issue queries, to a 'validator node'. Validator nodes are entities in the Libra ecosystem that collectively decide which transactions will be added to the Libra Blockchain and hold the history of all transactions on it.
Although the ambition is for the Libra blockchain to become permissionless (where information is available to all and not controlled by a central authority and any node can build blocks on the chain) within the next five years, the Libra Association recognises the challenge that there is currently 'no proven solution that can deliver the scale, stability and security needed to support billions of people and transactions across the globe through a permissionless network.'
Unlike other cryptocurrencies which are highly volatile in nature, Libra is intended to minimise any volatility by being backed by a reserve of low-volatility assets (the Libra Reserve)-eg bank deposits and short-term government securities in currencies from stable central banks-designed to give it intrinsic value. The Libra Reserve will be held by a geographically distributed network of custodians with investment-grade credit ratings and, while the value of Libra will fluctuate as the value of the underlying assets move, it is meant to offer lower volatility compared to other cryptocurrencies which are not backed by a similar reserve.
What regulatory issues is Libra likely to face?
Libra has the potential to be a game-changer for financial services. Facebook is a platform used by billions of people all over the world and while Facebook will have the same commitments, privileges and financial obligations as any other founding member of the Libra Association, its teams will play a key role in the creation of the Libra Blockchain. As such, Libra could reach a mass audience very quickly, offering them potentially cheaper methods to transfer value instantaneously across the globe, subject to any volatility of the underlying assets and therefore of the Libra token itself. This provides an opportunity to facilitate frictionless cross border trade.
The UK government and the UK financial regulators (including the Bank of England (the BoE) through the Prudential Regulation Authority (the PRA) and the Financial Conduct Authority (the FCA)) are generally very receptive to FinTech. Her Majesty's Treasury (HMT) has recognised that the FinTech sector has the capacity to deliver huge benefits across society, driving greater competition by harnessing the latest technologies to deliver faster and better financial services. In March 2018, HMT launched its FinTech Sector strategy in an attempt to secure the future of UK FinTech and make the UK attractive to FinTech businesses.
This governmental approach has influenced the approach of the FCA and PRA who have made it clear that they will embrace FinTech to further competition in the interest of UK consumers and the UK economy as a whole, as long as innovation does not harm consumers or threaten market integrity.
With regard to Libra specifically, Mark Carney, the governor of the BoE, appeared to give Libra a cautious backing, stating that it could 'substantially improve financial inclusion and dramatically lower the cost of domestic and cross border payments.' However, he continued to say that there would be significant regulatory scrutiny of the project. Some commentators referred to Libra as a 'stablecoin' when it was announced but Christopher Woolard, executive director of strategy and competition at the FCA, made clear that the FCA does not recognise this as a distinct category of cryptoasset.
Something labelled as a 'stablecoin' (like Libra perhaps) could sit within or outside of the regulatory perimeter. He stated that 'if this comes to fruition, Libra could be very significant indeed' and announced that the FCA, along with other regulators and central banks, were in discussions with Facebook over their plans.
The first thing the regulators would want to know is whether, and to what extent, Libra falls within the UK's current regulatory perimeter by asking Facebook a series of questions to understand, for example, who would use it? Why would they use it? What type of cryptoasset is it?
They would then determine whether Libra falls within one of the three FCA recognised types of cryptoasset (and therefore where it lies in relation to the perimeter) which they detailed in their July 2019 Final Guidance on Cryptoassets (the Guidance).
The Guidance outlines cryptoassets or 'tokens' which are regulated and those which are unregulated:
These are tokens regulated by the FCA and generally comprise of 'security tokens' and 'e-money tokens'
Security tokens have specific characteristics that bring them within the definition of a 'specified investment', such as a share or a debt instrument which mean they fall within the regulatory perimeter. They include tokens that grant holders some, or all, of the rights conferred on shareholders or debt-holders, as well as those tokens that give rights to other tokens that are themselves specified investments.
The FCA considers a security to refer broadly to an instrument that indicates an ownership position in an entity, a creditor relationship with an entity, or other rights to ownership or profit. Firms carrying on a specified activity, by way of business in the UK, involving a cryptoasset which is a specified investment (e.g. security tokens) may require authorisation and the relevant permission.
Market participants should also be aware of the FCA's financial promotions regime-it is an offence to communicate an invitation or inducement to engage in investment activity unless that person is an authorised person, or the content is approved by an authorised person. An offer of security tokens to the public may also be caught by the UK prospectus regime.
E-money tokens are tokens that meet the definition of electronic money in the E-Money Regulations 2011 ('EMRs'). These tokens are subject to the EMRs and firms must ensure that they have the correct permissions and follow the relevant rules and regulations. E-Money is defined in the EMRs as:
- electronically stored monetary value that represents a claim on the issuer;
- issued on receipt of funds for the purpose of making payment transactions;
- accepted by a person other than the issuer; and
- not excluded from the definition of e-money in the EMRs.
These are tokens that do not provide rights or obligations akin to specified investments like shares, debt securities and e-money. These tokens include 'exchange tokens' and 'utility tokens'. In its January 2019 Consultation Paper proposing the Guidance, the FCA defined exchange tokens as those tokens not issued or backed by any central authority and designed to be used as a means of exchange.
The FCA confirmed at the time that exchange tokens generally fall outside of the regulatory perimeter because they usually provide limited or no rights for token holders and there is no single issuer to enforce rights against. Cryptoasset exchanges simply providing a platform for trading of exchange tokens therefore currently fall outside of the regulatory perimeter. This is the case even when exchange tokens are acquired and held for the purpose of speculation (and in the hope of making a gain). Utility tokens provide holders access to a current or prospective product or service but do not grant holders rights that are the same as those granted by specified investments.
They may have similarities with rewards-based crowdfunding where participants contribute funds to a project in exchange for a reward, for example access to products or services at a discount. The FCA has stated that, much like exchange tokens, utility tokens can usually be traded on the secondary markets and can be used for speculative investment purposes.
However, this does not mean these tokens constitute specified investments. Although they are not specified investments, the FCA has highlighted that exchange and/or utility tokens could still require FCA authorisation if they constitute e-money or are used to facilitate regulated payment services.
Christopher Woolard is encouraging innovators and would-be cryptoasset issuers to ask the following questions in advance of any issuance or product launch:
- Is my product a beneficial innovation for consumers and markets? Or does it include hidden bugs and unmitigated risks?
- Am I prepared to be open and cooperative with domestic and international regulatory agencies? How do I approach issues like anti-money laundering?
- Will the target market I have in mind for this cryptoasset be able to make an informed and balanced judgment of the risks and benefits of investing in or using such an asset?
- Have I completed the regulatory, legal and technical due diligence in advance of launching a new product or service?
Financial crime and tackling anti-money laundering in particular, is one of the biggest global regulatory priorities at present. Therefore, regulators would be keen to understand what controls would be put in place to address any risks of money laundering, given that the Libra Association alludes to the fact that Libra would potentially provide a solution to those consumers who do not have the right documentation to open up traditional bank accounts. Cyber resilience is another key topic and, with potentially billions of consumers having access to Libra and having the ability to transfer value around the world instantaneously, the regulators would expect Facebook to have appropriate systems and controls in place to mitigate any operational and cyber risks. There is also the matter of prudential risk which the regulators will be scrutinising carefully. Libra is backed by a synthetic mix of flat currencies and other liquid assets, each of which may be impacted by different monetary policies.
Regulators are right to take a keen interest in Libra as it could potentially disrupt traditional and incumbent financial services providers and threaten stability in the market, if it is quickly and widely adopted by consumers. The FCA has committed to consult on the future of regulation to ensure that the regulatory landscape is fit for purpose after Brexit which will include looking at its current regulatory perimeter and what it does and does not regulate. Andrew Bailey, chief executive of the FCA, said that in order to ensure the FCA is a regulator that continues to serve the public interest, it 'needs to adapt to the ever-changing environment'. As such, it will be keeping a close eye on Libra, and innovation in general, to understand whether any policy changes are required to preserve the integrity of the markets and ensure consumers are protected from harm. Therefore, even if Libra would not fall within the FCA's current regulatory perimeter, if it would serve the regulatory agenda, there is a good chance that policy changes will be made to bring the likes of Libra within scope, especially given the number of potential customers impacted.
Facebook will of course also need to be mindful that Libra will be subject to different regulatory regimes, depending on which jurisdictions it is accessible in.
This text was first published by Lexisnexis.