Background
In January 2021, HM Treasury published its consultation on the UK regulatory approach to cryptoassets and stablecoins, together with a call for evidence on distributed ledger technology in financial markets. The consultation response was published in April 2022, confirming the government’s plans to legislate to bring certain activities relating to fiat-backed stablecoins into the regulatory perimeter for financial services on the basis that such stablecoins have the potential to become a widespread means of retail payment.
The Financial Services and Markets Act 2023 (FSMA 2023) was introduced into Parliament in July 2022 and has since received Royal Assent. FSMA 2023 enables HM Treasury to bring activities relating to fiat-backed stablecoins within the financial services regulatory perimeter in order to enable the Financial Conduct Authority (FCA) to regulate such activities, and provides the Bank of England (BoE) and the Payment Systems Regulator (PSR) with powers over systemic and recognised digital settlement asset payment systems and service providers.
In summary, HM Treasury seeks to regulate activities relating to fiat-backed stablecoins in two ways (though the precise legal drafting is yet to be developed):
- by regulating the use of fiat-backed stablecoins in payment chains – in relation to both mixed (fiat/stablecoin) and pure stablecoin payments – through amendments to the Payment Services Regulations 2017 (PSRs 2017); and
- by regulating the activities of issuance and custody of fiat-backed stablecoins when issued in or from the UK irrespective of their uses (for example whether they are used for payments, store of value or as a settlement asset), by including such activities in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (“RAO”).
HM Treasury also seeks to make suitable amendments to the existing regulatory approach to managing the failure of payment systems which are of systemic importance to the UK financial system, in order to address the risks arising from the failure of systemic DSA firms (given the differences between traditional payment systems and DSA systems).
Accordingly, on 30 October 2023, the government published an update (policy statement) which aims to clarify its objectives in regulating activities relating to fiat-backed stablecoins (i.e. “phase 1” of the government’s approach to regulating cryptoassets), covering: the FCA’s regime, the BoE’s regime, the PSR’s regime, and co-responsibility of the FCA, BoE and PSR for supervision of systemic fiat-backed stablecoin firms (the “Policy Update”). The government also published its response to a consultation on managing the failure of systemic DSA firms (the “DSA Consultation Response”).
These developments will be of interest to issuers and service providers of fiat-backed stablecoins as well as other types of digital assets that may be used for payment purposes. In particular, the insolvency regime outlined in the DSA Consultation Response will be relevant to participants (e.g. operators, issuers, wallets or third-party service providers) of payment systems which involve “digital settlement assets”—note that this is a broadly defined category which captures digital assets that can be used for the settlement of payment obligations, and can be transferred, stored or traded electronically, including but not limited to those that are supported by distributed ledger technology.
Separately, with regards to the “phase 1” legislation, the Policy Update clarifies that the regulatory framework for fiat-backed stablecoins will be separated from the regulation of tokenised deposits (which are covered by the existing regulated activity of deposit taking in Article 5 of the RAO). HM Treasury also intends to put in place legislative clarification to reinforce the legal separation of electronic money and fiat-backed stablecoins, which it acknowledges are different products. While it is helpful that HM Treasury acknowledges the distinction between tokenised deposits, electronic money and fiat-backed stablecoins, how this legislative approach will pan out in practice remains to be seen.
HM Treasury on the same day published a response to the consultation on the Future Financial Services Regulatory Regime for Cryptoassets—this response relates to the government’s plans to regulate activities relating to cryptoassets beyond fiat-backed stablecoin (i.e. “phase 2”). Take a look at our Engage article on the phase 2 consultation response for more details.
FCA’s regime
Issuance
The FCA will specify in its rules the requirements in relation to the backing assets for fiat-backed stablecoins, redemption rights, and capital requirements (amongst other things). The FCA (and, if considered appropriate, the BoE) should also have the power to require that backing assets of fiat-backed stablecoins are held in a statutory trust, which will enable the FCA and BoE to make rules on requiring the issuer to hold backing assets for the benefit of customers.
Custody
The FCA’s rules will be based on the existing custody framework for traditional finance custodians under Article 40 of the RAO. The Policy Update clarifies that the activity of custody of fiat-backed stablecoins in phase 1 should be created in such a way that the regulatory framework can be expanded to cover the custody of other cryptoassets in phase 2, rather than creating two separate and overlapping regimes.
Payments
While the intention is that the regulatory regime would cover the use of fiat-backed stablecoin issued in or from the UK, the government is also looking to accommodate overseas stablecoins for use in UK payments for goods and services. The government intends to engage with both industry and the FCA ahead of legislation on this point. It would like to explore an approach where a payment arranger (i.e. the entity who facilitates payment using a fiat-backed stablecoin within the chain) is authorised by the FCA and is responsible for ensuring that an overseas stablecoin meets FCA standards for use in UK payments chains.
If the above approach is adopted, the firm arranging the stablecoin payment services would only be allowed to initiate/arrange a payment if it was satisfied the stablecoin met the requisite FCA standards. Accordingly, the FCA would be given requisite powers to take action against payment arrangers where it believes such arrangers have not undertaken adequate checks. The FCA would also be able to regulate promotions of overseas stablecoins to UK consumers. Additionally, the payment arranger would be required to collect and report information on the number of payment transactions relating to a stablecoin to the FCA and the BoE (which may be useful in determining whether a stablecoin payment system is systemic).
Bank of England’s regime
The BoE has powers under Part 5 of the Banking Act 2009 (as amended by FSMA 2023) to supervise systemic DSA payment systems and service providers to such systems, as well as systemic DSA service providers, following the making of a recognition order by HM Treasury. HM Treasury must consult the BoE and the PSR before making a recognition order.
The BoE’s powers include (amongst others) publishing principles and codes of practice, and requiring operators of recognised payment systems to establish rules. Crucially, the BoE’s regime will ensure that systemic stablecoin payment chains as a whole demonstrate end-to-end financial and operational resilience.
HM Treasury also confirmed in its August 2023 response to its Payments Regulation and the Systemic Perimeter consultation (July 2022) that the forthcoming changes to the BoE’s regulatory perimeter for systemic payment systems and service providers will include a new accountability framework with regards to the Bank’s remit in relation to systemic DSAs, in a similar manner to the accountability framework set out in FSMA 2023 for the BoE’s supervision of central counterparties (CCPs) and central securities depositories (CSDs). Pending the relevant legislation, the BoE will take into account the future establishment of this framework for payment chains as it considers how and prepares to regulate any future systemic DSA payment systems and service providers. For more on HM Treasury’s consultation response on payments regulation and the systemic perimeter, take a look at this Engage article.
HM Treasury will also seek to clarify the application of the Settlement Finality Regulations 1999 (SFRs) to include a system involving the transfer of a DSA (as provided for in the FSMA 2023 changes to Part 5 of the Banking Act 2009). The purpose of the SFRs is to mitigate the potential systemic impact of a participant in a system becoming insolvent. This is achieved by BoE designation of the relevant system under the SFRs.
Payment Systems Regulator’s regime
Similarly to the BoE, the PSR has regulatory powers under Part 5 of the Financial Services (Banking Reform) Act 2013 (“FSBRA”) to regulate DSA payment systems and participants in DSA payment systems, following the publication of a designation order by HM Treasury (‘participants’ include stablecoin issuers, custodians and exchanges). HM Treasury must consult the PSR before making a designation order in respect of a DSA payment system.
The PSR powers include (amongst others) giving directions to participants in regulated payment systems, requiring the operator of a regulated payment system to establish rules and changing them in specified ways; and requiring the operator of a regulated payment system to grant access to the payment system.
Co-responsibility for supervision
The Policy Update clarifies that where an FCA authorised fiat-backed stablecoin firm is recognised as systemic by HM Treasury and is therefore also supervised by the BoE, the BoE should act as the lead prudential regulator while the firm continues to also be regulated by the FCA for conduct. The PSR may also be responsible for regulating fiat-backed stablecoin firms for competition, innovation and access purposes where such firm is already regulated by the BoE or the FCA. The regulators will set out how they will work together in a memorandum of understanding.
Additionally, the BoE’s forthcoming policy statement (required under clause 203C of the Banking Act 2009 ) will cover the matters the BoE may consider when exercising its powers over DSA payment systems or service providers, including where the BoE would replace the FCA as the lead authority on prudential matters in setting rules and making directions for a specific DSA firm.
Approach to failure of systemic and non-systemic DSA firms
The DSA Consultation Response confirms the government’s intention to apply the Financial Market Infrastructure Special Administration Regime (FMI SAR) under FSBRA, with modifications where necessary, as the primary regime to be used in the event of a failure of an operator of a recognised systemic DSA payment system, a recognised DSA service provider to such payment systems and a non-systemic service provider to such payment systems designated under section 112 FSBRA (in each case as defined in the Banking Act 2009) (together defined as "systemic DSA firms"). Modifications would include the introduction of an additional objective focussed on the return or transfer of customer funds and custody assets and a right for the Bank (after consultation with the FCA) to direct the special administrator to prioritise a specific objective. Respondents to the consultation which ran from 31 May 2022 to 2 August 2022 were broadly supportive of the proposed approach.
Government intends to draw on the investment bank and payments and electronic money special administration regimes when considering the modifications required to the FMI SAR to implement its policy objectives. Once regulations implementing these modifications have been laid, insolvency rules clarifying the operation of the FMI SAR as it applies to systemic DSA firms will be produced.
DSA firms not included within the modified FMI SAR will continue to be able to access the already-existing corporate insolvency procedures under the Insolvency Act 1986 (including liquidation and administration). Part 24 of FSMA 2000 provides the FCA with specific powers to participate in an insolvency process of an FCA supervised firm (including where to do so is in the interests of consumers). However, the response flags that Government will consider whether a special administration regime should be developed for non-systemic stablecoin firms, and also whether, in the longer term, a bespoke regime is required for those covered by the extended FMI SAR.
Next Steps
HM Treasury intends to bring forward secondary legislation in relation to the “phase 1” activities relating to fiat-backed stablecoins as soon as possible and by early 2024, subject to available parliamentary time.
In relation to the modifications to the FMI SAR to address the failure of systemic DSA firms, the government intends to lay regulations to implement the policy intent described in the consultation in due course with the corresponding insolvency rules to follow.
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Authored by John Salmon, Christina Wu, Margaret Kemp, and Virginia Montgomery.
