- Jamie Burke – Founder and CEO
- Matthew Law – Head of Operations
- Jocelyn Roberts – Head of Legal
- Joel John – Research Analyst
- Catherine Thomas – Business Development Manager
We aim to respond to the following questions framed in the terms of reference document.
- What risks and benefits could digital currencies generate for consumers, businesses and governments?
- How might the Government’s processes adapt should digital currencies be adopted more widely (e.g. tax implications, anti-money laundering measures)?
- Is the government striking the right balance between regulating digital currencies to provide adequate protection for consumers and businesses whilst not stifling innovation?
- Could regulation benefit digital currency start-ups by improving consumer trust?
- How are governments and regulators in other countries approaching digital currencies and what lessons can the UK learn from overseas?
This document is structured to address these questions in the following sections
- An alternative view of the opportunity
- Potential future value to the UK economy
- Cryptocurrencies vs crypto-assets
- Open source as a business model
- The global regulatory environment
- Current global blockchain hubs
- A positive environment to protect consumers and promote business
- Policy recommendations
The aim of this submission is to address why we, as a prominent UK based venture capital firm and advisor to the global blockchain industry, believe it is critical to developing a responsible, balanced and proactive approach to innovations in ‘crypto-assets’, in order to unlock their potential to serve the UK economy and its overall long-term competitiveness.
More specifically, we advocate that the UK assumes an active leadership position through clear guidance, communications, and where necessary policy formation, that builds upon the positive approaches taken in Singapore, Switzerland (and most recently France) to directly promote the UK as a global hub for a maturing distributed ledger technology industry, and the professional services companies, capital markets and wider ecosystem that serve it.
As Europe’s first venture firm dedicated to distributed ledgers, we have invested several years understanding the technology and its impact on various industry verticals, and developed a strong enterprise network. Over that time we have become convinced of the transformative potential of open sourced and tokenised distributed ledger technology. It is our concern that if the innovation of ‘digital currencies’ is itself viewed too narrowly, it will restrict the true potential of crypto-assets and the UK will lose out to an increasingly competitive global regulatory environment.
We believe this is of strategic and critical importance when looking holistically at the stated technology aims in other government policy in areas such as the commercialisation of AI and autonomous vehicles and at the challenges and opportunities Brexit presents.
Furthermore, we believe this directly impacts the UK economy’s ability to both retain and generate high-value technology jobs and deliver revenue to the Treasury. But equally important if not capitalised upon we will fail to introduce innovations in web services that offer an alternative to the extractive and often anti-social business model of centralised platform monopolies like Facebook, Uber, Google and Amazon.
1. An alternative view of the opportunity
Much of the attention in distributed ledgers to date has focused on its narrow application to financial services, most famously in Bitcoin, and to a lesser extent Ripple and others. Undoubtedly, this new means of digital “peer to peer” value transfer is hugely transformative, but we believe it is just the tip of the iceberg, and does not sufficiently circumscribe the wider social and economic innovations.
It is our belief the way to properly frame the opportunity presented by the combination of distributed ledgers, smart contracts and digitally scarce assets (“tokens”) is as an entirely new web architecture that can be thought of as “Web 3.0”. We believe this represents a transformative opportunity for the development of the Internet, similar to the arrival of the world wide web in the mid-1990’s, and therefore requires the UK to regard its approach to the emerging ecosystem as fundamental to its overall Industrial Policy.
What today many refer to as “cryptocurrency” is in reality a series of new “protocol layers” and standards fundamental to the very fabric of the internet, in a similar way to how TCP/IP, HTTP and SMTP have enabled the worldwide web to transform global commerce and culture. The major difference being the new innovation of digital scarcity means these networks can be both open source and be monetised by its creators, offering a new alternative to how they can be financed and owned as well as how the value generated is distributed across society.
In particular, we have seen this emergent Web 3.0 technology stack being applied to help other adjacent technology fields such as IoT, Big Data and AI scale securely both independently and excitingly in concert. This is a trend we refer to as ‘convergence’, and believe will be instrumental to what the World Economic Forum has entitled “The Fourth Industrial Revolution”.
These industrial applications exist in a number of areas of economic activity and industry such as smart cities, autonomous mobility, connected devices, manufacturing as well as health and retail. Because of the overreliance on a few software providers over the last 20-30 years, and now compounded by the requirement for automation and intelligence, there is a demand from industry itself that these systems are decentralised (and open) to reduce the current data and future AI monopolies.
Therefore for these software systems to also become open economic systems which anyone can participate in, it is our belief they will all need digitally native financial assets or “tokens” that allow for shared ownership and seamless peer-to-peer value exchange between machines, software and humans without dependencies on intermediaries.
The ability for tokens to enable speedy, secure and low friction value transfer also underpins an inevitable highly automated machine-to-machine economy that will arise in the coming years. Today, it simply isn’t feasible to enable such high-speed digital value transfers with incumbent payments systems without reliance on data hoarding and extractive monopolies. This is not a libertarian ideal, it is a real and urgent demand from industry to safeguard control of the intelligent systems that will permeate every area of society and economic activity.
All innovation in public, open-source distributed ledger technology will fall within the regulatory purview of any potential future ‘cryptocurrency’ legislation, so without careful thought this will have a chilling effect on the next wave of technological progress, and more specifically the ability of UK based businesses and talent to take advantage of it.
2. Potential future value to the UK economy
Innovation is a major driver for the improvement of living standards, according to the OECD. Those countries that invest in R&D tend to see returns on their investment across a wide range of areas; business performance, employment and international competitiveness.
According to the Tech Nation report 2017, the digital economy in the UK has grown 32% faster than the rest of the economy between 2011 and 2014, and the digital sector already accounts for 1.56m jobs across the UK, with this workforce growing by more than 10pc over the three-year period – three times faster than the wider UK job market.
Much of the focus in the technology space is now flowing to “decentralised technology” projects, including blockchains, cryptocurrency and related innovations. According to WIPO records, there were 1008 blockchain and cryptocurrency patent applications in 2017, three times as many as the previous year, with the majority of these being registered in the USA and China. With our own research data we track over 1300 startups, at least 300 related corporate proofs of concept currently in progress and over 1100 tokens in the market at a total capitalisation over $420 billion USD.
Jobs are estimated to have increased by over 200% in blockchain globally during 2017, and IBM now claims to have over 1500 blockchain trained staff. However, these numbers are tiny in comparison to other technologies. It is estimated that the programming language Java has over 10 million trained developers globally. These new technology jobs are highly skilled and in short supply, with blockchain developers charging up to $200 per hour for their services
Furthermore, since 2016 there has been at least $5.6bn USD of venture funding for decentralised / blockchain focused projects. While there has been much focus on the speculative nature of some of these investments, it is also driving a huge wave of technology innovation, and supporting an ecosystem of talent and business that could provide huge value to the UK economy.
3. Distinguishing between cryptocurrencies vs crypto-assets
Digital currency is regularly used as a current catch-all term for all the new models of digital assets in existence, variously referred to as “cryptocurrency”, “coins”, or “tokens”. However, we advocate for greater nuance in definitions used, especially when that informs regulatory approach, which must reflect both intended and actual utility and function.
It is important to understand there could be any number of different possible functions for a token, that may or may not be purely as a currency or store of value, ranging from a digital commodity, consumable, as well as a security tied to a company, its profits or physical assets.
Whilst we believe “security tokens” (e.g. tokens that represent securities analogous to equities, bonds or derivatives) will grow to the largest token market because of the benefits of fractional ownership and increased liquidity would bring to $2.6 trillion alternative asset classes and their secondary markets, we believe they will already be well catered for by existing securities laws and markets.
However, the focus on our submission is the treatment of digitally scarce and programmable tokens that can act as both a means of exchange and an incentive mechanism to coordinate decentralised networks of participants through the use of open source software in digital economies. Hence why, we believe an expanded term of “crypto-assets” is more appropriate and is something we have been greatly encouraged to see referenced in recent announcements around the UK Crypto Asset Task Force.
That said, it is important to go one step further and differentiate between the nuances of a cryptocurrency and other crypto-assets such as a ‘utility token’ (e.g. a token that represents a pre-payment for future services or products). The former is often simply used as a form of payment and store of value. They tend to be deflationary in nature and are designed to serve the purpose of bolstering an independent and peer-to-peer monetary system for individuals to transact amongst themselves without the intervention of the state. The latter refers to a digital token (like keys to a lock or in software terms an “API key”) used to access a service, product or marketplace in an open network that is distributed and not owned or operated by one central party. These networks use tokens to incentivise individuals or organisations to contribute value to the system which could include generalised secure computation, as seen in Ethereum, file storage like in Filecoin, as well as data, its availability and curation, or the training and operation of algorithms as proposed in Ocean Protocol.
Therefore we believe crypto-assets hold transformative potential for industry and new economies so need to be treated differently and distinctly from cryptocurrencies.
4. Crowdfunding 2.0: Open source as a business model
The reason we advocate for public, open and tokenised protocols is that we believe we are at the beginning of an innovation in how society organises its economic activity that is in direct contrast and response to the closed proprietary systems of past.
Much of the development in the economy during the Industrial Revolution was made possible by an innovation that today seems commonplace; “the limited liability joint stock company” which came into existence around 400 years ago, and enabled large numbers of people (investors) to pool resources and undertake grand programs of economic activity (railroads, international shipping, trade endeavours) that would not have been possible for any one individual to perform.
Today, new models of fundraising have sprung up to enable future participants in Internet networks to collectively fund their development. This process called an “ICO” (Initial Coin Offering) or “token sale”, can be thought of as an evolution of crowdfunding (or crowdfunding 2.0) where future users can finance the development of solutions and in turn become stakeholders in the system. Unlike Web 2.0 this aligns the interests of the owner of the network with the users. Imagine how different a new Facebook would act and behave if run on these principles.
These are increasingly powered by crypto-assets that represent a share in the future utility of a computer network enabling an entirely new model of business to emerge. They are often backed by not-for-profit foundations dedicated to maintaining the network and its code base as well as overall governance, financed by an endowment of tokens and capital from their sale.
In this new model, and inspired by developments in open-source software from the 1970s to today, the Intellectual Property is owned by the network itself, and the network forms a common good that it is open to and usable by all participants universally as a utility. The unique properties of distributed ledgers and these programmable digital assets make it possible to for all participants to be rewarded for their contribution, and align incentives in such systems using game theory and behavioural economics.
By extension, this open source approach enables greater levels of innovation through building on the technology that has come before. Anyone, anywhere, can in theory both create their own network making a system that looks more evolutionary in form, with parent and child networks each with slight iterations, as the technology develops.
We believe this is birthing a Cambrian explosion of innovation – replacing the stop-start, zero-sum model of proprietary equity startups which typically see a fail rate of around 90% within the first 3 years. In the old model all value including code, know-how and IP is often lost forever. When you consider the global venture capital industry invests $155 billion USD annually this is a huge opportunity to improve the success rate and efficiency of a big driver of financial and ultimately human progress.
5. Global regulatory environment
Nations around the globe are in the process of waking up to the economic and technological opportunities and challenges that this offers their economies. Approaches vary from an outright ban (e.g.: China who sees digital money as a threat to their attempts to restrict capital outflow) to a broadly positive environment in a number of jurisdictions aiming to become global financial hubs: Switzerland, Singapore, Estonia, Malta and centres of technological innovation such as France.
In parallel at a supranational level the G20’s FSB has been looking at the space closely and suggested that cryptocurrencies do not pose a threat to the wellbeing of global economies. The IMF’s head Christine Lagarde has echoed this sentiment by reminding central banks around the world that the advantages blockchains offer should be integrated into local financial ecosystems.
Naturally, many instinctively fear “cryptocurrency” as a digital cash that could be exploited to circumvent laws, however, the Hong Kong Government’s Money Laundering and Terrorist Financing (ML/TF) Risk Assessment Report has recently suggested that token markets are not necessarily used by crime syndicates or for terrorist financing.
Allowing token-based businesses to set up in a nation brings inward remittances and thereby fuels local economies. Analysts predict Japan would see a surge of 0.3% of its GDP due to capital gains from token investments. Similarly, the United States of America will see a gain of $25 billion in taxes from capital gains on token investments in the region.
Regulators need to be wary of the flight of intellectual and human capital as much as they worry about losing monetary gains with regulations that lag innovation occurring in the token ecosystem. Tokenised startups and the companies that service them are often made up of distributed teams and are highly mobile. Where governments have been unfriendly to token-based innovations, those have been quick to resettle in more welcoming jurisdictions. Japan saw an influx of blockchain startups after the China ban, Binance, one of the largest cryptoasset exchanges, moved from Hong Kong to Malta and Indian entrepreneurs have begun moving towards Singapore as a response to the Reserve Bank of India requesting local banks avoid catering to token-based businesses.
In fact, even the US and its highly prized Silicon Valley ecosystem has become concerned in the light of the SECs inconsistent and often ambiguous communications around tokens. So much so its leading venture capitalists recently joined forces to lobby the SEC to offer a non-exclusive safe harbour to good actors, specifically citing the outflow of talent as a threat to their industries future.
In the next section, we review three case studies of creating a positive, but balanced regulatory environment.
6. Current global “open blockchain” hubs
We submit the following case studies as examples for the committee to consider, and if appropriate to investigate further.
France is currently in the process of setting up a regulatory framework aimed at assisting entrepreneurs with raising funds via tokens and is currently in the process of drafting a legislative framework for digital currencies. The French Finance Minister has also been vocal about his intent to make the region a leader when it comes to token-based innovations. It is expected that the framework in France would enable companies to gain a formal stamp of approval for their token sales. In addition, the regulators in the region routinely issue warnings for investors about possible scams. The aim is to ensure France does not miss out on the blockchain revolution according to the Finance Minister.
Singapore has become a hotbed for blockchain innovation in South East Asia. The region steadily attracts firms from China and India due to their hostile approach to the token economy. The Monetary Authority of Singapore has been clear about its stance on virtual currencies and routinely issued guidelines for them. Some tokens issued in the region may be subject to security laws. The nation has even tested the issuance of Singapore Dollars on a blockchain.
As is relates to foreign direct investment London and Singapore have continued to jostle for the top city to receive the most investment generally over the last ten years; London welcoming 433 companies in 2016 and Singapore 392. However, the value of FDI flows to Europe fell 9 per cent to $176 billion in 2016, following a turbulent year in European politics, as well as the UK’s vote to leave the EU in the referendum on 23 June 2016, which has led to caution among some investors. While FDI data doesn’t drill down to blockchain specific companies, we expect that London and Singapore, as key financial and tech global hubs, will continue to compete heavily to attract FDI.
The region’s forward-looking approach to providing financial institutions a framework for investing in emergent token-based projects have attracted a high number of hedge funds to the region in the recent past
Switzerland, and in particular the canton of Zug, has long been a leader with respect to providing token-based projects a regulatory framework. Zug is currently home to a number of prominent token-based foundations such as that of Ethereum and Tezos.
The FINMA has issued a framework for the categorization of tokens. The regulators in the region believe that each token should be categorised on the basis of their merits and have provided clear guidelines on how tokens will be judged. However, the region is not ignorant of the possibilities of money laundering and securities regulation violations and as such have strict requirements for organisations in the region to provide documentation to regulators when requested. FINMA remains aligned with the long-term growth potential blockchains offer in the region and have been vocal supporters of token-based innovations.
7. A positive environment to protect consumers and promote improved standards
Because anyone, almost anywhere, can now issue a token and in doing so (almost by their very nature) are creating something that is borderless, it has meant many have done so either in deliberate or accidental breach of various local securities laws. In the worst case some bad actors have even done so purely for fraudulent purposes. In response, like most good actors focused on the long-term sustainability of the industry, we welcome the active and targeted protection of consumers in both how token sales are promoted as well as the highest possible standards in KYC and AML.
It is our feeling the industry as a whole would benefit greatly from a major world economy actively engaging with it through clear guidance that encourages adequate levels of corporate governance, disclosure and reporting. The industry today is currently incredibly opaque, giving rise to a greater potential for market manipulation and insider trading. Our concern is that if it is not effectively and sensibly integrated into the existing financial systems, it will fail to reach its potential and protect investors who may fail to understand or manage the risks involved on their own.
We are of the opinion that regulation is necessary to protect consumers, but a balanced approach to regulation is necessary to minimise risks while continuing to enable innovation.
As referred to above, there is a broad spectrum of possible functions for a token. It is our view that it is not therefore possible to take a one size fits all approach to the regulation of ICOs. For example, as highlighted by the FCA, some tokens may constitute transferable securities and therefore fall within the prospectus regime, in addition to involving activities regulated by the FCA. However, on the other hand, an ICO of tokens that represents the pre-payment for future services or products may be regarded as akin to pre-payment crowdfunding, which falls outside the FCA’s regulatory remit (except with respect to connected payment services).
Aside from financial and capital markets regulation, ICO issuers are subject to a wide range of other legislative and regulatory considerations, such as AML/KYC requirements, tax, data protection and privacy, intellectual property and consumer protection considerations. For example, from the AML perspective, relevant persons subject to the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 and involved in ICOs would be subject to customer due diligence requirements, while all businesses have responsibilities not to facilitate money laundering pursuant to the Proceeds of Crime Act 2002.
To summarise, on the whole, our view is that to reinforce the UK’s status as a global financial hub, as well as to maintain our leadership in European technology, particularly at this time of uncertainty regarding the future outcome of Brexit, policy should be positive, and clearly signpost existing regulation to protect consumers and stimulate innovation whilst promoting sufficient standards for token issuance and resale as well as the ongoing operation of the governing entities.
8. Policy recommendations
Considering all the points raised throughout this document we propose a series of recommendations for consideration by the committee. The objective of each is to improve standards to protect consumers whilst enabling the sustainable growth of the blockchain industry in the UK. Both for the benefit of its existing industries in technology and capital markets, as well as for entirely new areas of economic activity and growth.
Greater legal clarity and certainty
Lawyers look to the jurisdiction which can best reduce risk and protect their issuing clients. Globally, a huge amount of uncertainty still exists around the future, and even retrospective treatment, of crypto-assets and cryptocurrencies. No major world economy has yet taken the step to provide absolute certainty as to the treatment of an ICO that does not represent a ‘security’. This would ideally include guidance on which existing regulations should apply to this new class of assets, where new regulation is required and its timeline, as well as a consultation process with industry on its design.
Constructive collaboration to improve standards
We recommend working constructively with industry on improving standards around reporting, disclosures and managing risks to help professionalise the industry and to protect retail investors and users. Active engagement and support of the issuers / non-profit foundations behind blockchain projects formed in the UK and Europe with open discourse, legal and tax support, as well as encouraging normal access to the existing financial system, will also spur the industry.
The existing “FCA sandbox” program is very positive and effective, and could be extended further into open distributed ledger technology and tokens. Again reference could be taken from the Singaporean Government regulatory sandbox piloted by its Chief Fintech Officer for ICOs to the UK. The Singapore Government’s “Guide to Digital Token Offerings”, released in November, offers valuable insights on a model worthy of consideration.
Encourage issuers to domicile in the UK
We recommend that the UK adopt similar policies to create a level playing field with existing blockchain hubs like Singapore, whereby tokens that are for open source protocols be issued without the funds received (flowing to a not-for-profit foundation) being immediately taxable as business income. This change will encourage many blockchain projects to base themselves in the UK, an already existing major tech hub, and will attract talent, business, support services and innovation to the UK.
To this end, we also recommend a cross-party study of the actions of Singapore and Switzerland and their respective approaches to responsible development of the industry through balanced regulation.
Extend innovation incentives
The UK historically has a very forward-thinking approach to stimulating innovative business. We recommend exploring how we can use some of these existing tools and levers to encourage emerging blockchain business models to flourish in the UK.
For instance, currently, the EIS and SEIS investment relief programs present one of the world’s most forward-thinking spurs to innovation. Measures could be considered to extend this to private funding and crowdfunding of tokenised investments in addition to equity investments as each share the common feature of bearing risk. This would include both investments in the form of pre-token launch sales, through Simple Agreements for Future Tokens (commonly known as “SAFTs”), which involve providing early-stage funding to high-risk new ventures, and also in wider crowd-funding of security-like tokens.
In a similar manner, the corporation tax reliefs could be considered to explicitly target blockchain focused innovation, with the focus on R&D scheme, or the creative and film industries as potential models to follow.
Alternatively, another way this could be achieved is that private companies that donate code to open source foundations could receive R&D tax offsets. This will attract blockchain projects to the UK and incentivise the open source movement, which will be an efficient use of capital and a huge driver of innovation.
Capital Gains Tax regime on crypto-assets
The inquiry could also consider extending the exemption from Capital Gains Tax of foreign currency bank accounts under TCGA92/S252 to include holdings of crypto-assets in a wallet or exchange.
Crypto-assets are most often exchanged for other crypto-assets without being converted to Sterling or other national currencies. The administrative challenges and cost of tracking and reporting this are harder than for conventional foreign currency because there is usually no definitive exchange rate to Sterling for each leg of the transaction.
Most of the potential tax revenue could be captured by only requiring capital gains taxes to be paid when crypto-assets are converted back to Sterling or exchanged for goods or services. Alternatively, a complete exemption would also make the UK a very attractive international destination for the blockchain industry.
Active incubation of blockchain as part of the Government’s Industrial Policy
A proactive policy to encourage innovation and jobs in the UK in this rapidly growing sector would also be welcome. Subsidies of blockchain startups’ costs, or the provision of support via bodies such as Digital Catapult would be very welcome in the UK capital and regional technology hubs.
Similarly, budget to encourage upskilling and training for in-demand technology roles via academic engagement and via sector deals should be considered. The existing AI sector deal for training and PhD sponsorships serves as a great reference point.
To conclude, we are at a crossroads in the development of the technology that we believe could be fundamental in the next wave of business and industrial innovation. Many of the world’s forward-thinking governments are preparing the ground for a significant area of future economic activity by supporting the blockchain industry.
While we understand the tendency for caution following some of the stories of excess in the birth of the industry, we would like the inquiry to consider the potential benefit and how it could support the UK’s aims to be a world leader in technology and finance. We hope we have provided insightful evidence regarding ways in which this could be applied in the UK.
We would also like to thank the committee for the opportunity to make this contribution to the public debate.