UK Regulatory Approach to Stablecoins: HM Treasury Consultation Response

Setting The Scene

Since its launch, the cryptoasset market has developed at a rapid pace, with total market capitalisation for cryptoassets estimated to be USD2.6 – 3 trillion in 2021.¹ The market for decentralised finance (DeFi), although small in current scope is expanding quickly too from less than USD10 billion in 2020 to nearly USD100 billion in 2021.² In consumer research conducted by the Financial Conduct Authority (FCA), the uptake of cryptoassets among UK consumers has further increased with 2.3 million (from 1.9 million last year) adults estimated to hold cryptoassets. The government has been keen to note the growing interconnectedness between cryptoassets and the wider financial system.

In January 2021, HM Treasury launched a Consultation and Call for Evidence on the regulatory approach to cryptoassets and stablecoins. The intention of the consultation was to source views on how the UK can structure the regulatory framework to harness the benefits of new technologies, support innovation and competition, while mitigating risks to consumers, market integrity and financial stability.

Diving into the future of regulatory development, the government has proposed a staged and proportionate approach to regulation, which is sensitive to risks posed, and responsive to new developments in the market. As part of its commitments to diversify its regulatory portfolio, the government is developing a Financial Markets Infrastructure (FMI) Sandbox to support firms wanting to innovate through the use of tokenisation and Distributed Ledger Technology (DLT) to provide FMI services. The consultation points out a need for sufficient flexibility to be built into the regulatory framework to allow regulators to adapt rules and requirements as international work in this arena continues to develop. It will also benefit from the agility that will be afforded to UK financial services legislation by the Future Regulatory Framework (FRF).

Notably, it highlighted the newer-developing forms of cryptoassets (and main focus of this article) known as stablecoins which have the potential to develop into a widespread means of payment and deliver improvements to payment cross border transactions. Furthermore, they are playing an increasingly important role in the DeFi space with operation in cases such as staking, providing liquidity for other tokens on an exchange or even applications in the leveraged borrowing of cryptoassets. Considering the importance of stablecoins and their increasing volume and complexity of use, the government is looking to hedge against systemic risks, prudential regulatory gaps and market abuse risks.

On 4 April 2022, HM Treasury published its Response to the Consultation and Call for Evidence on the regulatory approach to cryptoassets and stablecoins. This primarily sets out the UK’s approach to stablecoin regulation, and also comments on the topics of investment and wholesale uses of cryptoassets, unregulated tokens, and new market developments, following the responses it received to the Consultation and Call for Evidence. In this article, we set out the key points from the Response in relation to stablecoin regulation.

The Necessity To Regulate: Key Points

Stablecoins³ are an evolution of cryptoassets that seek to minimise volatility in value. Depending on its systematic design, they aim to maintain stability in their price by being linked to stable assets such as fiat currency. The protocol provides for the increase or decrease in the supply of the stablecoins in response to changes in demand; such coins are typically backed by a central bank. Considering the importance of stablecoins and their increasing volume and complexity of use, the government is looking to hedge against systemic risks, prudential regulatory gaps and market abuse risks. The newly published Response to the April consultation confirms the government’s intention to facilitate the use of stablecoins used as a means of payment into the UK regulatory perimeter through:

• Amendments to the existing Electronic Money Regulations 2011 and the Payment Services Regulations 2017. As a robust framework for payment firms in the UK, it does not provide an explicit regime for regulating stablecoins. There is a focus on adopting an amended e-money framework that places emphasis on stablecoin issuance, and the provision of wallets and custody services. The approach will ensure convertibility into fiat currency, at par and on demand, and facilitate simultaneous payments. FCA guidance and rules will set out in detail the requirements that apply to specific activities. Points of importance include:
  • The requirement for issuers of stablecoins referring to fiat currencies (or issuers of ‘payment cryptoassets’) to seek authorisation from the FCA. The government has stated that the developing definition for stablecoins will be cryptoassets which are a representation of monetary value, stabilised by reference to one or more fiat currencies used as a means of making payment transactions. This is not likely to include stablecoins referencing commodities or stabilising algorithmically (unless by reference to a fiat currency);
  • Regulation of custodial wallet providers⁴ due to their key role in the provision of DeFi services and bring them under the current e-money and payment services regimes. However, the government only proposes to regulate exchanges in as far as they provide or arrange for custody of payment cryptoassets meaning operating an exchange will not itself require specific authorisation. However, it is likely that many exchanges will also provide custody services and will require authorisation for those services. Regulators are increasingly requiring authorised firms to comply with their high-level standards in relation to the firm’s unregulated activities;
  • The compliance requirements will be onerous, and include prudential requirements, in relation to maintenance and management of reserves, safeguarding, systems and controls, conduct of business requirements;
  • In tracking the summary of anticipated stablecoin activities subject to FCA regulation:

• An extension of Part 5 of the Banking Act 2009 to systemic stablecoin payment systems, capturing arrangements that control and facilitate the transfer of digital settlement assets. By extending the existing criteria for payment systems to stablecoins that perform a retail or wholesale function, this will enable the Bank of England (acting as the lead prudential authority) and the FCA to directly supervise such systems. A stable token with potential to be systemic at launch would need to be captured by the enhanced requirements that apply to firms that reach systemic status and which are grounded in the Principles for Financial Market Infrastructures (PFMIs) developed by the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO). Triggers would include potential user base, transactional volumes and avenues for the acquisition of customers.
• An extension of the scope of the Financial Services (Banking Reform) Act 2013 to ensure stablecoin payment systems are subject to appropriate competition regulation by the Payment Systems Regulator (PSR).

Given the increasing regulatory scrutiny on stablecoins and crypto-firms, market players operating in this space should consider a review of existing arrangements and carefully analyse their licensing requirements and the manner in which they structure new products, with due consideration to upcoming regulatory changes in the UK.

Should you wish to discuss the details of stablecoin regulation, or any aspects of the Response, please feel free to reach out to the authors of this article.