On 6 November 2023, the Bank of England (the UK’s central bank) issued a discussion paper on the regulation on stablecoins, alongside another paper by the UK Financial Conduct Authority (FCA) (DP23/4) and a “Dear CEO” letter from the UK Prudential Regulation Authority (PRA) addressing the topic of tokenised deposits (together, the Discussion Papers). This series of publications sets out an approach and framework for the regulation of stablecoins in the UK. HM Treasury (HMT) first announced this programme of work (referred to as Phase 1 of the UK’s new cryptocurrency regulatory regime) on 4 April 2022. The Discussion Papers now confirm that:
- Activities related to “fiat-based stablecoins” will be subject to FCA authorisation and supervision.
- Stablecoins that become widely used for payments will be designated by HMT as “systemic payment systems using stablecoins” and will become subject to FCA, Bank of England and Payment Systems Regulator (PSR) supervision.
- Activities related to “tokenised deposits” remain within the PRA’s and FCA’s existing remit to regulate UK-based credit institutions.
Background
Currently, stablecoins are used primarily to convert fiat currency (e.g., pound sterling or US dollars) into cryptoassets and vice versa (as “off-ramps” and “on-ramps”) and to facilitate transactions between cryptoassets. To date stablecoins have not been widely adopted as a means of payment. The Discussion Papers set out a fulsome framework through which UK regulators are seeking to balance the aim of encouraging sustainable innovation of cryptoassets with safeguards against consumer harm and financial instability. Regulators have designed the framework in accordance with a “same risk, same regulatory outcome” principle.
At the time of the announcement of Phase 1 in 2022, the scope of the potential stablecoin regime was ambiguous, raising questions about whether such a regime would be fit for purpose because there are no major GBP-based stablecoins, and those that do exist would not fall within the scope of the proposed regime, as they are issued outside the UK. The HMT announcement stated that stablecoin custody would become a regulated activity, which could potentially cover those exchanges providing custody. This would have meant that exchanges would be subject to custody requirements only in relation to stablecoins, and so subject to full UK authorisation in respect to only a limited subset of their business activities.
Activities That Will Be Regulated Under the Stablecoin Regime
Issuance and Custody of Fiat-Backed Stablecoins
In summary, the FCA is proposing to subject the following activities to UK regulation:
- Issuance of stablecoins that are based in, or from, the UK.
- Custodial activities for stablecoins carried out from the UK or for UK customers.
Issuers will be subject to stablecoin backing requirements (requiring issuers to hold the equivalent in fiat currency or short-dated government bonds), remuneration requirements and redemption requirements. Issuers will be required to hold assets backing stablecoins in a statutory trust in favour of underlying customers. Custodians will be subject to rules for asset segregation, safeguarding (based on existing CASS rules for traditional financial instrument custodians), auditing and reporting requirements. Both issuers and custodians will also be subject to the FCA’s consumer duty obligations, which arrangement confers several duties: inter alia, to act in the best interest of customers, to ensure fair treatment of customers and to communicate clearly. This will represent a significant increase in regulatory requirements on stablecoin issuers within the scope of the regulation.
Ancillary Activities to Cryptoasset Custody
The FCA is also consulting on requiring cryptoasset exchanges to establish separate legal entities for all custody-like activities. Regulators note that cryptoasset exchanges offer a range of integrated services such as trading, brokerage, market-making and lending, requiring clients to transfer assets to an exchange’s wallets for pre-funded transactions (akin to margin deposit requirements in traditional finance). These services facilitate on-chain real-time settlement but can blur the lines between client and custodian assets, potentially leading to conflicts of interest. Further complexity arises when exchanges also provide stand-alone custody services, and the lack of clarity in terms and conditions can lead to confusion about asset ownership.
This proposed restriction would cover exchanges that provide custody of stablecoins, which exchanges will be subject to FCA authorisation and to segregation requirements across all custodial activities. Custodians that only provide custody of non-stablecoin cryptoassets may remain outside of the proposal’s scope. Again, if introduced, these proposals would result in increased regulatory requirements on in-scope custodians, including potential structural changes to their current operating structures.
Payment Arrangers
The FCA is also proposing to regulate certain “payment arrangers” that initiate or arrange payments using stablecoins under the payment services framework.1 Currently, the UK payment services regime only covers the transfer of “funds,” which excludes the transfer of value using stablecoins.
This regime would cover both (i) hybrid business models (where stablecoins are used as an entry or exit point for transactions that are ultimately settled in fiat through conventional payment systems) and (ii) pure stablecoin models (which involve direct on-chain stablecoin transactions between payer and payee).
Firms that use either of these models will require authorisation under the payment services regime, requiring them to, among other obligations, disclose information about payment services, rights related to transaction execution and remedies for defective or unauthorised transactions, as detailed in the guidance.
Further, this regime would also subject overseas stablecoin issuers to indirect UK regulation where an overseas stablecoin is used in UK payment chains: The payment arranger will need to evaluate the overseas stablecoins according to FCA standards. Public information will be considered insufficient for this assessment, so the FCA expects payment arrangers to liaise with issuers directly.
Regulation of Systemic Payment Stablecoins
UK regulators have outlined a two-tiered approach to regulating stablecoins. The first approach relates to fiat-based stablecoins, falling solely in the FCA’s remit. The second approach relates to stablecoins that are widely used for payment, which will be recognised by HMT as stablecoins used in systemic payment systems and become regulated by the Bank of England.2 Certain payment systems may also be deemed “systemic at launch” due to their scale and user base at launch.
Systemic payment stablecoins will be subject to enhanced requirements in comparison to fiat-based stablecoins. We summarize the key requirements and differences in the below chart.
‘Dear CEO’ Letter Regarding Tokenisation, Innovation and Deposits
In a “Dear CEO” letter, the PRA addresses issues related to innovations in deposit-taking, e-money and stablecoins. The letter mentions that innovations in digital money and similar instruments present opportunities for enhanced payment and settlement systems efficiency, yet bring potential risks to the financial stability and safety of institutions. The PRA has issued guidance that outlines expected risk mitigation strategies, particularly emphasising the avoidance of confusion among retail consumers due to the simultaneous offering of deposits and digital money-like instruments such as e-money and regulated stablecoins.
The PRA urges deposit-takers to separate the issuance of e-money and stablecoins from their deposit-taking activities, employing distinct and nonconflicting branding to preclude consumer misapprehension regarding the varying levels of protection afforded by different instruments. Furthermore, deposit-takers contemplating the adoption of new technologies such as “tokenisation” must align with the PRA’s rules, ensuring depositor protection under the Financial Services Compensation Scheme (FSCS). Extending depositor protection to holders of stablecoins would represent a significant extension of the current protections available to holders of cryptoassets as well as increased operating costs for issuers. Deposit-takers must engage proactively with the PRA regarding plans to innovate or restructure their offerings, adhering to the highest governance standards and involving senior management in risk assessment of new technologies in critical business services. The PRA encourages firms to transparently communicate with their designated supervisors regarding significant plans or developments in their use of digital money.
A Prospective Central Bank Digital Currency
As part of a broader project to develop and regulate cryptoasset markets in the UK, HMT and the Bank of England have also been exploring the introduction of a “digital pound.”
In a speech on 26 October 2023, Sir Jon Cunliffe, until recently the deputy governor for financial stability at the Bank of England, discussed the impact of Facebook’s announcements about its creation of a new multicurrency stablecoin, which energised the approach of central banks and financial regulators to digital currencies. Work undertaken on the digital pound exemplified this renewed ethic of innovation.
Sir Jon reiterated that proposals are not yet finalized to introduce a digital pound in the UK. Thus far, an HMT consultation paper explored the concept without proposing its introduction. The document assessed the likelihood of a need for a digital pound by the end of the decade and detailed a model for potential implementation, and HMT invited public commentary on the proposals. The decision on whether to proceed with the digital pound will only come following further testing, which is expected to occur over the next two to three years.
The digital pound is anticipated to be a joint venture between the Bank of England and private entities that operate under a “platform model.” The central bank would be responsible for creating the digital pound and its core infrastructure, while various firms would develop interfaces, such as wallets and payment services, for user interaction. Overall, the digital pound initiative aims to enhance the credibility of digital currencies and promote a more competitive digital economy.
Feedback from the consultation paper, however, raised issues concerning privacy, the sustainability of cash and the technical facets of a digital currency. To address the privacy concerns, once the digital pound is created, the central bank will refrain from accessing personal data, leaving that aspect to individual payment companies. Additionally, the bank has committed to maintaining physical currency as long as public demand for it exists. Were the digital pound to be widely adopted, preliminary models suggest a gradual introduction strategy to prevent disruption in the banking sector.
Next Steps for Stablecoins in the UK
The UK’s regulatory authorities are laying a comprehensive foundation for the safe and innovative integration of digital currencies into the financial landscape, balancing the need for innovation while maintaining consumer protection and financial stability. The approach by UK regulators in relation to stablecoins contrasts significantly with the approach by regulators in other jurisdictions, in particular the approach of the SEC in the United States. The coordinated approach between the UK regulatory authorities will be welcomed by market participants. The deadline for responses to the Discussion Papers is 6 February 2024.
Trainee solicitor Sahej Grewal contributed to this newsletter.
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1 The Payment Services Regulation 2017 and the Electronic Money Regulation 2011.
2 This is the framework used to regulate payment systems such as Faster Payments, CHAPS, Visa and Mastercard, which was expanded under the Financial Services and Markets Act 2023 (FSMA 2023) to include digital settlement assets.
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