The UK Financial Conduct Authority (FCA) has published its policy statement PS23/11 (PS), containing final guidance (the guidance) on trading venues. A firm requires trading venue authorisation from the FCA if it operates what is defined as a “multilateral system” (see “Unpacking the Multilateral-System Definition” for the definition and our analysis). The multilateral-system definition is the primary focus of the guidance.
Inclusion within the multilateral system definition will determine whether a trading venue must be FCA authorised. The further classification of that trading venue as a regulated market, multilateral trading facility, or organised trading facility, determined by the nature and scale of activity and type of financial instrument, will determine how that trading venue is to be regulated.
The guidance, which will take the form of a new question and answer in the FCA’s Perimeter Guidance Module of the FCA Handbook of Rules and Guidance, will take effect on October 9, 2023.
In unpacking the multilateral-system definition, the FCA recognizes a general distinction between vendors/providers of technology solutions and the operators of trading venues, with only the latter requiring trading venue authorisation. Fintech technology solution vendors/providers should welcome this recognition, though further regulatory analysis will be necessary where they are carrying on other regulated activities.
Because multilateral systems are, by definition, limited to financial instruments, the PS and the guidance do not address cryptoassets that are not classified as financial instruments. However, in its consultation “Future Financial Services Regulatory Regime for Cryptoassets”, on the future financial services regulatory regime for cryptoassets (see our alert Marketing Cryptoassets and Services in and Into the UK: Shifting Regulatory Sands for more), HM Treasury (HMT) states that the forthcoming regime for cryptoasset trading venues will be based on the trading venues regime. The guidance also shines an interesting light on decentralized finance (DeFi) covered in HMT’s consultation.
The PS and the guidance also clarify, among other items, that:
- A crowdfunding platform does not amount to a multilateral system when the business-funding interests of an issuer of securities as expressed in an offer made by that issuer are matched with the interests of investors.
- A bulletin board, such as that used for advertising or posting buying and selling interests or aggregating or pooling potential buying or selling, will not be a multilateral system, provided that trading interests are not able to interact in such a system.
- The internal matching systems of an investment manager will not be a multilateral system, provided there is a direct connection between the internal crossing in the system and the portfolio(s) under its management.
Unpacking the Multilateral-System Definition
The FCA currently defines a multilateral system as a system or facility in which multiple third-party buying and selling of trading interests in financial instruments is able to interact in the system, drawing the definition from EU law. The guidance identifies the following main elements of a multilateral system:
- It has the characteristics of a trading system or facility.
- It comprises multiple third-party buying and selling of trading interests.
- It allows trading interests to interact in the system.
- Those trading interests are in financial instruments.
The guidance goes into detail on each of these elements. The following points are noteworthy:
- Trading systems or facilities include markets composed of a set of rules and a trading platform, as well as those with only a set of rules. The rules could be reflected in contracts and/or operating procedures. As such, a system is technology neutral for these purposes.
As such, general-purpose communications systems, such as websites and chatrooms, would not amount to trading systems or facilities.
- Multiple third parties could include a system in which any two persons negotiate within the system between themselves; this does not make the system bilateral rather than multilateral. What matters is whether the system, at the point of entry, enables one person to interact potentially with multiple others (other than the operator).
- Interaction in a system arises where the system matches trading interests within its system or allows users to respond within the system to other users’ trading interests, including by communicating in relation to or negotiating or accepting essential terms of a transaction.
- Financial instruments include instruments such as shares, bonds, options, and swaps but exclude instruments such as spot foreign exchange and, as discussed below, currently “unregulated” cryptoassets such as Bitcoin.
Good News for Technology Providers?
The PS is helpful in that the FCA states that order management systems and execution management systems “need not” constitute multilateral systems. As noted above, the FCA also recognizes a general distinction between vendors/providers of technology solutions and the operators of trading venues, with only the latter requiring trading venue authorisation. The guidance states expressly that operating a platform requires more than simply providing technology or software.
The FCA’s changes to its guidance on the definition of a multilateral system further reflect this with references to the “provider” of a general-purpose communications system and “provider” of a website, as opposed to the “operator” of a multilateral system.
The Role of Remuneration in Determining whether a Business Is Caught
More broadly, the factors for assessing whether there is a trading system include the determinants of the remuneration of the operator and the extent to which these are linked to the interaction of trading interests in financial instruments in the system.
This indicates that the manner in which technology is paid for will indicate the role of a business in connection with that technology: if remuneration paid to the business is linked to volumes and/or size of trades, such as in the form of commissions, this will tend to indicate that the business is an operator of a multilateral system as opposed to the provider of the technology used in that system. The breadth of the definition will, of course, require that each case is looked at individually.
The Regulated Activities of Technology Providers as “Service Companies”?
In the guidance, the FCA points to the fact that, in providing technology to the operators or users of a multilateral system, providers may be carrying on regulated activities, in particular the regulated activity of making arrangements with a view to transactions in investments.
In so doing, the FCA highlights its service company regime, and the FCA has made some technical amendments to that regime via the PS. The service company regime is intended to be a lighter-touch and tailored regulatory regime for providers of order routing, post-trade processing and similar services to market participants that assist them in dealing with investments or arranging (i.e., bringing about) deals in investments among themselves.
Service companies are firms whose regulated activities are restricted to making arrangements with a view to transactions in investments and agreeing to carry on that regulated activity. Their regulatory permission must be limited to dealings with “professional clients” and “eligible counterparties” and, by definition, exclude services to retail customers.
An Eye Toward Crypto-trading Venues
As noted above, the PS does not address venues for the trading of cryptoassets, saying that cryptoassets “such as Bitcoin and other currently ‘unregulated’ cryptoassets, which are not financial instruments” fall outside the scope of the multilateral system definition.
However, HM Treasury’s consultation “Future Financial Services Regulatory Regime for Cryptoassets”, on the future financial regime for cryptoassets, sets out a proposed regulatory approach for cryptoasset trading venues and indicates that HM Treasury is looking to establish a regulatory framework based on the existing regulated activities of trading venues.
The PS and the guidance should, therefore, be relevant when considering the types of technologies that will be classified as cryptoasset trading venues and regulated under the future regulatory regime for cryptoassets in the United Kingdom.
The Crypto Consultation and DeFi
One aspect that will require consideration is the impact of the guidance on DeFi, which HMT uses in its crypto consultation as an umbrella term used to cover financial services that are offered without the use of traditional financial intermediaries.
In this context, the crypto consultation uses a description of smart contracts as open-sourced, codified sets of rules that automatically execute and record transactions on the blockchain when certain parameters are met, noting that, once deployed, smart contracts are immutable, enabling peer-to-peer transactions without centralised decision making from intermediaries.
In a way similar to the EU Commission under the EU Markets in Crypto Assets Regulation (see our alerts “Marketing Crypto-Assets in and Into Europe: MiCAR, the EU’s New Uniform Crypto Code” and “Doing Crypto Business in Europe: MiCAR, the EU’s New Uniform Crypto Code – Part 2”), which is required to prepare a report by the end of 2024 that includes an assessment of DeFi, HMT’s crypto consultation contains a call for evidence rather than identifying a set regulatory outcomes.
That said, the crypto consultation contains some indication of HMT’s preferences. In this respect, HMT recognizes that there is a spectrum of decentralisation among current DeFi offerings and states the objective is not to regulate the activity of developing software, but if software developers maintain, run, and operate systems used for regulated financial activities (e.g., exchange or lending), then they should be subject to financial-services regulation.
The Impact of the Guidance on DeFi?
HMT’s comments on DeFi bring one back to the guidance on the meaning of a multilateral system and, for this purpose, the characteristics of a trading system or facility and the words, noted above, that operating the platform requires more than simply providing technology or software. The FCA’s statement in the guidance that it will consider, among other factors, whether (a) the system is designed to enable trading of any kind among users; and (b) remuneration connected with the system is linked to the interaction of trading interests in the system’s financial instruments may be telling as to whether the FCA seeks to treat a DeFi offering as a multilateral system and identifies the DeFi provider as an operator because there is no one else, such as a trading venue operator, that fulfills this role.
In this case, the issue for HMT may not be so much whether DeFi providers should be regulated: the crypto consultation suggests that this is HMT’s preference. Instead, the issue for HMT is how DeFi providers should be regulated. The desire must be for a proportionate approach that avoids the imposition of a regulatory burden suited to a trading venue operator on a DeFi provider where, despite the trading functionality the provider’s solution provides, that burden is not justified. HMT’s exploration in the crypto consultation of the DeFi-specific regulated activities, such as “establishing or operating a protocol” as part of a tailored regime for DeFi providers, takes on even more importance in light of the guidance.