What, then, do the markets need? Corporates and individuals need capital, and lenders and other providers need to verify the creditworthiness of their clients. Providers need a global financial market to distribute their products to a wider array of customers through intermediaries and interchange their risks with other market participants. All of this involves multiple relationships, contracts, legal documentation and complex systems, all designed to achieve what are ultimately simple goals.
The means for allowing this revolution to take place is the repackaging of financial services and products through electronic interfaces or through new kinds of virtual assets, which can be described, explained, handed over, traded and returned with ease. Some are virtual representations of existing, tried and tested assets. Others are not. Critically, these financial assets all need to be tradable under a single, clear and trusted legal and regulatory system, providing predictability and the oversight of risk.
These new products and services also need comprehensive and flexible regulation. This is where the UK should be well placed to play a leading role, with its world-renowned legal and regulatory framework, based on the common law and including the concept of the trust, which allows for the holding of client assets off the books of the service provider, a technique upon which the holdings of many financial instruments are based. This framework will engender confidence. But to achieve that the UK needs to take three steps.
First, Parliament needs to define with precision what is and what is not within the area subject to regulation. Many new services and products add relatively little additional risk to customers or the system, and existing definitions of financial services and products can be updated to remove any uncertainties over whether the new offerings fall within them.
Other new offerings may require entirely new concepts to be developed for when regulation applies, and new methods of regulation and supervision. It is vital that any provisions are clear in their effect, providing the legal certainty the market craves.
Second, the use of the new services and products needs to be addressed by making amendments to the existing rules for the financial system, so that financial firms know how to treat such services and products, what capital and collateral they need to hold against them and when they can regard the instruments as liquid.
This additional clarity will allow these new asset classes to engage with the broader financial markets. No doubt there will be winners and losers. The UK should not tip the scales or seek to pick particular technologies, business models or winners, but the regulators must be empowered to adjust the rules dynamically to address problems as they arise.
Third, we must examine the risk exposure for retail customers using these new products and regulate them appropriately. The answer may be different for consumers in the UK, and those abroad seeking to purchase UK products remotely. The current approach is to prohibit the marketing and sale of crypto derivatives to retail investors in the UK, and there is a prospective ban on marketing unregulated cryptos.
This position urgently needs reconsidering if the UK is to generate jobs and wealth in this sector. The UK needs to develop a more nuanced approach for the evolving multitude of products and services.
In each case, the UK needs to reinvigorate its legal and regulatory system. Much of the latter is inherited from the EU. What is needed is the removal of vast swathes of unnecessary EU code, and rewriting EU-inherited rules along common law lines, with clear laws, the highest of standards and less red tape. We must also allow for legal challenges to the decisions of our regulators, so that firms can continue to innovate within a clearer and more predictable regulatory arena.
There is much work to be done, and quickly, but the prize is immense. No other market is better placed to become the world’s leading digital hub for financial services and products. We should grab our opportunity with both hands.
Barnabas Reynolds is a partner at Shearman & Sterling LLP