UK regulators consult on approach to stablecoins
12 December 2023
12 December 2023
Following the UK Government's "Update on Plans for the Regulation of Fiat-Backed Stablecoins" (the Update), Discussion Papers have been released by the Bank of England (the Bank) and the Financial Conduct Authority (FCA). Together with a joint regulatory roadmap and a Dear CEO letter from the Prudential Regulatory Authority (PRA), they provide greater insight into the UK approach to stablecoin regulation. Although focussed on stablecoins used for payments – consistent with the Government's phased approach to regulation – the papers open the discussion in a way that will lay the tracks for the future regulatory framework for cryptoassets more widely.
The background to the consultations lies in the Financial Services and Markets Act 2023 (FSMA 2023), which was passed by Parliament in August. Among other things, FSMA 2023 provides a high-level framework for the regulation of "digital settlement assets" (DSAs) used in payment systems. In its Update, the Government confirmed that the stablecoins they intend to regulate as DSAs are those backed by fiat currencies and issued in the UK. Secondary legislation is expected to be laid in early 2024 to ensure that appropriate powers are granted to the UK regulators to supervise the area and to bring certain activities within the scope of regulation. The Discussion Papers, which are open for comment through 6 February 2024, describe the thinking and plans of the Bank and FCA for the implementation of that approach. In this note, we summarise some of the key features of the Discussion Papers and the Dear CEO letter.
Under FSMA 2023, the Bank will supervise systemic payment systems using DSAs, including stablecoins, which have been designated by HM Treasury. In its Discussion Paper, the Bank's focus is on stablecoins backed by sterling which are used as means of payment at the retail level in the UK. Although there are stablecoins which reference sterling, they have not been widely adopted. As the most common stablecoins reference US dollars and are mainly used for transactions involving other cryptoassets, the Bank has not identified any candidates for regulation in the near term. The rules it is considering are anticipatory, rather than reactive.
In contrast with the approach of the European Union towards stablecoins referencing the euro, under the Markets in Crypto-Assets Regulation, the UK is not attempting to assert sovereignty over sterling-backed stablecoins which are issued offshore and are not part of payment chains in the UK. Issuers of systemically important sterling-backed stablecoins will need to be established/incorporated in the UK. The Bank expects that non-UK issuers will create subsidiaries for their activities into the UK or with UK-based consumers, whether they interact directly or through intermediaries, but general onshoring of stablecoin issuers is not expected.
The reserve assets used to back systemically important fiat-backed stablecoins will need to be held in the UK as central bank deposits. Even liquid assets such as government bonds and commercial bank deposits will not be permitted. Interest will be payable neither on central bank deposits by the Bank nor to coinholders by issuers. These conditions will remove the main commercial incentive for the creation of most stablecoins; ie, the ability of the issuer to derive revenues from the investment of reserve assets in money markets or interest-bearing bank accounts. The Bank expects issuers in this category to obtain revenues from payment services.
The reserve assets held with the Bank through its real-time gross settlement system will be subject to a statutory trust for the benefit of coinholders. Deposits will be ringfenced from claims on the issuer, including in insolvency. This is consistent with the FCA's proposed approach for the reserves of non-systemic fiat-backed stablecoins.
The Bank is considering a cap on individual holdings of systemic stablecoins, in line with its proposals to limit the amount of central bank digital currency. This would allow them to be used for day-to-day payments but limit their utility as a store of value and a rival to other forms of money.
The Bank indicates that public/permission less systems are not appropriate for systemic payment systems, given that settlement is probabilistic (undermining settlement finality). It invites comments, but the lack of a central entity with the ability to address settlement risks presents a challenge.
The FCA discussion paper addresses the life-cycle of services for regulated stablecoins and their overseas equivalents. It describes the FCA's preferred approach and seeks input from authorisation, governance, prudential, conduct, client asset, systems and controls, resilience, and administration perspectives. Below, we highlight some of the key elements of the FCA's proposals.
The FCA will become responsible, once HM Treasury has made changes to the Regulated Activities Order (RAO), for the authorisation and supervision of:
HM Treasury is considering empowering the FCA to authorise payment arrangers who facilitate the use of non-UK fiat-backed stablecoins. If that approach is taken, the FCA will require payment arrangers to assess such stablecoins against UK standards. Those stablecoins that qualify could be badged "Approved Stablecoins" or similar, in an echo of the "MAS-regulated stablecoin" label introduced in Singapore.
Under the most common business models, issuers exchange stablecoins for an equivalent amount of fiat currency, which they invest with the aim of securing a return for their own account. Management of the reserve assets needs to give confidence that the issuer can meet liquidity demands; however, in stressed conditions, a run on stablecoins can exhaust liquid reserve assets and promote volatility. At the same time, credit and concentration risks can arise from, eg, uninsured cash deposits being placed with banks that fail. The insolvency of the issuer may also result in losses to the pool of reserve assets if proper segregation practices have not been followed.
The FCA proposes that reserve assets for regulated stablecoins (ie, those issued by FCA-authorised firms) should be held on a 1:1 basis which matches the value of the issue. The reserve is intended to include any in-scope stablecoins held by the issuer, so that no part of the issue is unbacked. If the issuer has multiple regulated stablecoin products, the reserve assets for each are to be ringfenced to prevent cross-contamination. The FCA expects to leverage the existing rules for, among other things, client assets and client money as set out in the CASS chapter of its Handbook. A statutory trust would be cast over the reserve assets, for the benefit of coinholders, with any shortfalls being made up by the issuer.
Investments in high quality liquid assets will be expected of issuers. Reserve asset requirements for non-systemic stablecoins could be met by short term government treasury debt (<= 1 year) or short-term bank deposits. Money market funds, however, would not be accepted as substitutes for direct holdings of government treasury debt.
The FCA notes that coinholders do not have the right to redeem their holdings against reserve assets directly in many cases. Consequently, they are exposed the risk of de-pegging in secondary markets. The FCA intends to require redemption at par to be a right of all coinholders, at least before the end of the business day following the receipt of a redemption request, provided that the consumer has supplied all documentation required for AML/KYC checks.
The FCA acknowledges that, under certain circumstances, it may be challenging for an issuer to redeem stablecoins within the required timeline. They are seeking input from industry about the operational challenges that might arise, the impact of involving a third-party custodian in the process, any current restrictions to redemption that should be allowed to continue, and the costs that would be expected to arise from the proposed redemption policy approach.
The stablecoin issuers and custodians who are brought within the regulatory perimeter will need to comply with the consumer duty, which requires FCA-authorised firms to deliver good outcomes for retail customers. This will apply, eg, where a regulated stablecoin issuer creates an in-scope product that can be accessed by retail customers. The issuer will need to identify the target market for the stablecoin product and ensure that its design meets the needs, characteristics, and objectives of the target market. They would also need to avoid causing foreseeable harm to that target market.
The FCA is considering whether in-scope stablecoins should be subject to its recently-implemented rules on financial promotions involving cryptoassets. The challenge is that, having classified cryptoassets more broadly as "restricted mass market investments," the rules designed to protect retail investors could present an obstacle to the widespread adoption of regulated stablecoins for payment purposes. This was flagged by the FCA in its Policy Statement on Financial Promotion Rules for Cryptoassets, in June 2023, but it has not proposed specific changes to the final rules to accommodate regulated stablecoins.
The Discussion Paper is clearer in the expectations that will surround disclosures by issuers, including the need for information to be communicated in a way that is fair, clear, and not misleading. The FCA expects key information to be published on Web sites and other important communication channels that describes the size of the issue, the mechanism used to maintain price stability or links to fiat currency, the nature and composition of the reserve, evidence of audits, the name of the custodian holding reserve assets, redemption rights and requirements (including fees), and a statement of the risks relevant to the value of the regulated stablecoin and its reserve assets.
The FCA notes that custody services for cryptoassets have unique features because of the nature of DLT-based transactions and holdings. Although its CASS rules provide a tested set of principles for intermediaries responsible for holding client assets, it anticipates that some changes may be required to address the novel features of cryptoassets. For example, the definitive record of ownership of a cryptoasset may be the distributed ledger itself. The FCA is considering allowing the use of on-chain records to enable custodians to meet the requirements to maintain accurate books and records that, eg, distinguish the assets of a client from those of the custodian or its other clients.
The FCA also is interested to receive comments about the ways that third parties could become involved in cryptoasset custody and data reconciliations could be adapted to protect client holdings. More broadly, it is also looking at how controls and governance requirements such as dedicated CASS officers, regulatory reporting, auditing, and client statements could be adapted.
Because custody of cryptoasset holdings is a service often bundled with execution or other services, the FCA is looking at the risks of vertically integrated business models. To address these, its preference is to require custody services to be provided by a separate legal entity. Noting that it would have an impact on many business arrangements, particularly in the retail segment, it is inviting views on alternative solutions and the ways that they could manage, eg, conflicts of interest.
There is a gap in UK legislation for payments made purely in stablecoins. The FCA anticipates applying the existing conduct rules for payment service providers in the Payment Services Regulations (PSRs) to payment arrangers/intermediaries for pure stablecoin activities, as well as to ancillary payment services for hybrid (ie, cash and stablecoin) payments. They note that, as the Treasury is renewing the PSRs, they may need to issue interim guidance on the application of the PSRs to payment arrangers.
As the lead regulator for banks in the UK, the PRA has written to CEOs on its expectations for stablecoin business. Stablecoin and e-money businesses are to be kept separate from UK banks, drawing a bright line between commercial bank deposits and new forms of digital money. Banks which undertake stablecoin or e-money issuance through affiliates will have to ensure they are distinct from a branding perspective, so that consumers are not confused about which products attract deposit insurance protection. Firms that have already issued regulated stablecoins or e-money will be expected to transition their customers to deposit products. International deposit-taking firms with UK branches will be expected to follow the same approach.
Anticipating the launch of tokenised deposit arrangements, which represent transferable claims on commercial bank deposits, the PRA directs that they should be designed to benefit from deposit insurance and be issued through banks only. Although novel products, the "single-customer view," which allows deposit insurance entitlements to be calculated and paid, must include them.
Senior accountability is expected for the use of new technology, addressing the risk assessment framework for its use in important business services and critical functions.
The release of the discussion papers by the Bank and FCA, along with the Dear CEO letter from the PRA, represent a milestone in the regulation of stablecoins in the UK. Although there are significant areas where policy still needs to take shape, by opening the discussion in a coordinated way, the regulators have created an opportunity for market participants and consumers to shape the future framework. Many of the detailed proposals are sensible, drawing upon existing principles and rules while recognising the features which make stablecoins novel. As the resulting regulations will impact the regulation of services for a diverse range of cryptoassets in the next phase of UK regulation, it is important to get this right.