Proposed UK Approach
to Regulating Stablecoins

The FCA Discussion Paper (DP 23/4) 

The DP is part of a wider rolling regime for the regulation of cryptoassets and various market operators involved in cryptoassets in the UK. See here for a snapshot of the current state of play in the UK as of November 2023.

The FCA has invited comments to the DP and the 40 questions contained within it by 06 February 2024.

Overlapping consultations and reviews

The consultation paper should be read in conjunction with:

Treasury: Update on fiat-backed stablecoins Oct 2023

BoE: Regulatory regime for systemic payment systems using stablecoins and related service providers

PRA Letter to bank Chief Executive Officers on innovations in the use by banks of deposits, e-money and stablecoins

Overview

This DP focuses on the regulation of fiat-backed stablecoins that can be used for payment services.

The proposal is that, to the extent they are not already covered by the e-money regime, the issue and custody of fiat-backed stablecoins will be brought within the Financial Services and Markets Act (FSMA) via the Regulated Activities Order (RAO) and the Payment Service Regulations (PSRs) as referenced in the recent Treasury Update of October 2023.

In-scope stablecoin activities:

• fiat-backed stablecoins issued in or from the UK (referred to as regulated stablecoins);

• custody activities carried out from the UK or for UK-based consumers for UK-issued fiat-backed stablecoins.

The proposed new custody activities will only apply to safeguarding of  regulated stablecoins where issued by an authorised person and cryptoassets that already meet the definition of a specified investment, such as security tokens.

Providers of in-scope stablecoin activities will require authorisation by the FCA under FSMA.

The size and constitution of the stablecoin market

The FCA note:

“In 2022, on-chain stablecoin transactions exceed $7.5 trillion on the Ethereum blockchain alone. The overall landscape primarily captures the US Dollar stablecoins issued by Circle (USDC) and Tether (USDT). As of 12 October 2023, these had a combined market dominance of approximately 87% relative to the total stablecoin market capitalisation of $123.4 billion.”

Non-UK stablecoins

The UK Treasury is also considering how to create a separate pathway for fiat-backed stablecoins issued outside of the UK (’overseas stablecoins’) to be used for payments in the UK.

“Under the approach Treasury is exploring, payment arrangers would be regulated under the PSRs and would have to be FCA authorised to assess overseas stablecoins against a set of standards set out by the FCA. Once authorised, payment arrangers that conclude an overseas stablecoin meets, and continues to meet, our standards, would allow that overseas stablecoin to be used to make payments within the UK, under the potential label of an ‘Approved Stablecoin’.”

Under this overseas Approved Stablecoin model a “payment arranger” is  the entity who facilitates the individual or merchant to pay or be paid using a fiat-backed stablecoin within the chain) and is authorised by the FCA and  responsible for ensuring an overseas stablecoin meets FCA standards for use in UK payments chains.

This option for recognition is particularly relevant given that the international market for stablecoins is predominantly dollar-denominated and not conducted from the UK – as the FCA note:

“We are aware of a small number of GBP-denominated stablecoins, but we are not aware of any currently being issued from the UK.“

Potential benefits of stablecoins

The FCA points to various benefits of stablecoins including:

• their global nature and interoperability

• their ability to be used to deliver faster, cheaper, frictionless payments between consumers and merchants

• to be used as assets to carry out on-chain settlement in wholesale settings. This could form the basis of a wholesale use case that would enable an alternative way to operate settlement systems in the post-trade cycle, by replacing traditional Delivery vs. Payment (DvP) settlement with more efficient arrangements. This would change the role of clearing houses and settlement actors (usually Central Securities Depositories);

• in tokenised funds, it could bring the ‘payment leg’ of the settlement system ‘on-chain’ and dispense with t+ settlement under the traditional DvP systems which “helps to eliminate counterparty-risk and possibly also enhance liquidity”.  The FCA make the point that settlement using stablecoins must be coupled with tokenised securities also being transferred and settled on-chain to get the full benefit of this improved settlement process. Such processes would need to comply with the BIS Principles for Financial Market Infrastructure.

Potential risks of current stablecoins

The FCA states that the focus must be on ensuring that stablecoins are suitably backed to maintain their value and ensure consumers can get their money back if the stablecoin issuer fails. They note that many popular stablecoins have failed to provide suitable information about the composition of stablecoin backing assets making it difficult for market participants to understand whether the stablecoin is fully fiat-backed or is backed by highly liquid assets, and whether the backing assets would be available to customers if something went wrong.

They note the dependency of fiat-backed stablecoins on traditional finance markets and infrastructure to enable the stablecoin issuer to purchase and safeguard the stablecoins’ backing assets with custodians.

“Recent events, such as the temporary de-peg of USDC with the US Dollar following the collapse of Silicon Valley Bank, have highlighted the important relationship between stablecoins and traditional financial services. It also showed how market confidence for insufficient backing assets can influence a stablecoins ability to achieve stability.”

Redemption

A particular issue noted by the FCA concerns redemption and the often limited ability for consumers to be able to directly redeem stablecoins with issuers, thus forcing them to take their chances in the secondary market where, in times of stress,  the stablecoin may have seriously depegged from the underlying fiat currency.

“For example, when a USD stablecoin de-pegged from the dollar to a low of $0.87, very small trades were executed as low as $0.12. Using a wholesale operation model, the issuer was able to offer redemption at par to their direct clients. However, this was not available for retail clients who did not have contractual recourse to the issuer. They likely lost money if they sold their stablecoins on the secondary market at a price below par, in fear that the value may drop further”

Other risks identified by the FCA under the current market include:

• custody risk arising from inadequate controls and failures to properly segregate assets;
• money laundering risks given that it enables users to  operate within a secondary market that doe snot have the same controls in place as for traditional finance;
• the lack of controls and suitable oversight of the market increase the risk of fraud, scams and misperception of the risks involved with stablecoins.

Bringing stablecoins within the regulated payments perimeter

Ultimately regulating a wider range of stablecoins will enable them to be used as a recognised legal form of payment by a wide range of merchants (e.g. e-commerce sites, travel,  financial services) and not just for cryptocurrency-related or DeFi transactions.

Bringing stablecoins within the regulated payments regime requires suitably regulated issuers and clear published rules relating to information, redemption, backing, settlement and fees.

Systemically important stablecoins

Systemically important regulated stablecoins will be required to be prudentially regulated by the Bank of England. Note this applies to GBP-only stablecoins and only those used primarily as a retail payment solution (for payments-related activities and innovation within payments). The BoE make clear that the regime is focused on payment system operators that are responsible for the payment chain (i.e. use of a stablecoin across the payments sector).  

“Treasury’s assessment of whether a payment system of a firm is systemic will focus on whether any deficiencies in the design of the system, or any disruption of its operation, would be likely to threaten the stability of, or confidence in, the UK financial system, or could have serious consequences for business or other interests throughout the UK.”

Asset Backing Requirements

Issuers will need to back the stablecoin with assets that are:

(i) sufficient to back all their issued stablecoins;

(ii) stable in value; and

(iii) sufficiently liquid to support consumers’ right to redeem the regulated stablecoin promptly.

Backing assets would also need to be properly identified, recorded, segregated as well as protected in the event of insolvency of the stablecoin issue. Segregation and safeguarding would be by way of a statutory trust and any material deviation (shortfall or excess) from the collateral required to back the stablecoin would need to be addressed daily.

Monitoring and reporting to the FCA would be dealt with by way of modification to the current CASS regime. Stablecoin issuers would be expected to appoint a CASS oversight officer.

Low risk, secure and highly liquid assets

The DP suggests that short-term Govt bonds with a maturity of 12 months or less and diversified cash deposits could be suitable.

What is not considered suitable for backing?

Anything else including:

• long dated Govt bonds,
• money market funds
• corporate bonds and equity

Sharing benefits with Stablecoin holders

As with electronic money, the intention is to prohibit the granting of income or interest for stablecoins holders. This prohibition has been long-standing in the EEA and UK for payment products that are not regulated ‘deposits’ and is seen as a way to ensure there is no confusion or competition with bank deposits.

General Crypto Risk Warning

The FCA take the opportunity to remind cryptoasset users that even as elements of the market become fully regulated in the UK there are irreducible risks involved in cryptoassets compared to traditional financial products and markets:

“even when the future regime for cryptoassets more widely is finalised it will not offer market integrity or protect consumers to the same degree as in traditional markets for financial instruments. This is due to the structure of the cryptoasset market. In particular, the inherently cross-border, fragmented nature of the market, the pseudonymity of wallets and the lack of a corporate ‘issuer’ of the cryptoasset. Consumers should be aware of these risks.”

Credit & Counterparty Risk-Free Custody?

The DP invites comments about ways in which options for improved custody management could be achieved and notes:

“Still, deposits exhibit counterparty credit risk that would need to be managed though diversification with different banks.”

Bank Of England – CB deposit backed Stablecoins

The Bank of England are focusing on ensuring lower credit and counterparty risks in their stablecoin consultation paper for systemic stablecoins used for retail payments:

“The Bank’s preferred option is for systemic stablecoin issuers to back the stablecoins in issue fully with central bank deposits. Combined with the other protections proposed in this paper, this would ensure that the stablecoins always maintain their value. It would also ensure that the stablecoins can be used for payments with full confidence, can be exchanged at par for other forms of money and that coinholders can redeem their funds at full value – and hence maintain singleness of money.” 

The BoE state that their preferred model for systematically important stablecoins meets the requirements of CPMI-IOSCO guidance which states that backing assets should minimise both credit and liquidity risk, and the FSB High-level Recommendations that reserves be composed of conservative, high-quality and highly liquid assets.

“Contagion risks will be lower for stablecoins used in systemic payment systems regulated by the Bank, than for e-money or other regulated stablecoins captured by the FCA’s regime.”

Click to access innovations-in-the-use-of-deposits-emoney-and-regulated-stablecoins.pdf

However, the BoE is not proposing to allow such stablecoin issuers to benefit from central bank deposit rates (though they welcome feedback).

“4.2: Remuneration

In line with the principle that stablecoins used in systemic payment systems should be primarily used for payments, the Bank proposes that issuers should not receive interest on their central bank deposits or pay interest to coinholders.”

The Bank of England also state that this approach passes through to ensuring no additional benefits transfer from issuers to holders:

“In line with its view that stablecoins used in systemic payment systems should not be used as a means of investment, the Bank further considers that issuers under its regime should not pay interest to coinholders. This would align the treatment of systemic stablecoins with cash, e-money, and a potential digital pound. Prohibiting e-money institutions from paying interest already incentivises the use of e-money for payments rather than as a means of investment.”

However, the financial benefits of holding central bank deposits with access to the Bank Rate could make the stablecoin model much more commercially attractive for issuers (notwithstanding that the UK Bank Rate has seen huge volatility in the last 3 years  – from 01.% to 5.25% : Interest rates and Bank Rate | Bank of England

Final Thoughts

Given that stablecoins – and electronic money – are not allowed to be competitive with deposits then the risks must be structurally lower and any unnecessary counterparty risks should be avoided.

People should be able to choose between fractional reserve financial products with higher returns and embedded risk versus credit ‘risk-free’ money without always stacking the deck against lower risk money.

Forcing assets used to collateralise stablecoins to either:

• be held with financial institutions (with the additional concomitant risks)
• or, for systemic stablecoins, to be held with the central bank but not benefit from the Bank Rate

may not be the best way of protecting consumers. It begs the question as to why the UK and other governments are still not willing to consider radically reshaping the modern financial system.

As part of this proposed regulation, a model could be developed whereby all stablecoin issuers are able to access (directly or indirectly) Bank of England reserve and settlement accounts for credit risk-free custody and settlement of fiat liabilities but with interest paid on deposits to issuers. 

This would also encourage non-UK issuers to consider issuing under the UK regime so that they can benefit from access to counterparty risk-free deposits with the central bank. See BoE: RTGS and Chaps and BoE: payment and settlement BoE: New Form of Digital Money and BoE: Digital Pound

However, I do not pretend that I know better than the BoE about the potential follow-on consequences that offering a Bank Rate on stablecoin deposits would have on credit creation and transmission, monetary policy and financial system stability risks. It would however be helpful to understand the modelling that underpins and justifies those concerns (for e-money and stablecoins), since it goes to the heart of how our financial systems operate and the role (and risks) of credit institutions compared to other types of financial institution. 

In the USA, this discussion has centred around the risks and challenges of what they call ‘narrow banks’ – see e.g.:

Golden Ticket or Bad Egg? The Case of the Narrow Bank | ABA Banking Journal

‘Narrow bank’ challenges traditional industry model, but Fed pushes back | S&P Global Market Intelligence (spglobal.com)

The Fed stalls the creation of a bank with a novel business model (economist.com)

Why does the Fed oppose narrow banking? – Econlib

Is It Finally Time for Narrow Banking? | Cato Institute

Regulated stablecoins could be structured in way that ensured they had a lower risk profile than traditional market instruments and be attractive to issuers,  if the UK Govt was willing to grab the bull by the horns. These benefits (e.g. payment of the Bank Rate on deposits) to issuers would not necessarily need to be passed on to stablecoin holders in a way that competes with bank deposits.

At the moment, it is not clear what the benefits will be for non-banks looking to operate systemically important stablecoins from the UK, especially since they will not be able to be remunerated on such deposits but will have all the costs, additional capital requirements and significant regulatory burdens. 

See here for our UK Guide to Cryptoasset Law and Regulation.