HM Treasury consults on UK regulatory approach to cryptoassets and stablecoins

On 7 January 2021, HM Treasury (“HMT”) published a consultation and call for evidence on the UK’s regulatory approach to cryptoassets and stablecoins, which sets out HMT’s proposals for a new regulatory regime covering stablecoins and its approach to regulating cryptoassets more generally. The proposals follow HMT’s July 2020 consultation on bringing certain cryptoassets within the scope of the financial promotions regime (see our blog post here).

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EU digital finance and retail payments strategies: understanding the big picture

On 24 September 2020, the European Commission (“EC”) adopted a new Digital Finance Package, which it published together with a communication entitled “A Retail Payments Strategy for the EU” containing specific policy measures needed in relation to payment services given their key role among digital financial services. The European Parliament (“EP”) subsequently adopted a nonbinding resolution on the EC’s Digital Finance Package on 8 October 2020. Continue reading

HMT consultations on financial promotions: approving promotions and promoting cryptoassets

HM Treasury has announced two consultations on possible changes to the UK financial promotions regime:

  • a consultation on limiting the scope of firms that can approve financial promotions of unauthorised persons; and
  • a consultation on extending the financial promotions regime to include unregulated cryptoassets.

The deadline for responses to both consultations is 25 October 2020.

These consultations reflect the continued focus by the Financial Conduct Authority (FCA) on marketing and the related risks to consumers, particularly following the mini-bond scandal, as well as the continued focus on the regulation of fintechs and cryptoasset technologies. Continue reading

Cryptoassets and DLT: global stablecoins v CBDCs and the potential for private DLT to connect public payment systems

This article has also been published by the International Financial Law Review (IFLR).

The payments sector is one of the fastest growing sectors within the financial services industry. It is underpinned by consumers’ widespread move away from physical cash and towards electronic payments. Whether consumers are using payment cards or apps, the result has been a continual increase in the volumes of payments being processed electronically. This has created an enormous opportunity for payments businesses such as FIS and Fiserv (in the US) and Nexi and Klarna (in the EU) to establish themselves as key players in the payment chain, with the potential to become systemically important.

These businesses participate in a well-developed and very active area of the payments sector. So, what comes next?

The use of distributed ledger technology (DLT), and the associated use of cryptocurrencies and other cryptoassets, has long been discussed as a potential means for making global payment systems more efficient and more secure. For many years, payment processing has relied on centralised channels to transfer money, by established participants such as card issuers, clearing banks, and merchant acquiring banks and card schemes. By contrast, DLT involves a decentralised, shared ledger, with no need for central intermediation. It is considered immutable.

The question is, to what extent will cryptoassets become more widely used in the payments sector, including their potential use by central banks. Stablecoins, a relatively recent and topical sub-class of cryptoassets, may play a key role here. It will be interesting to see what types of stablecoins emerge and how they fit into the broader UK regulatory framework applicable to cryptoassets. Another important issue derives from two key aspects of stablecoins that are designed to facilitate payments: (i) in relation to the asset itself – concerns raised by private stablecoins, and whether a central bank digital currency could be an alternative; and (ii) in relation to the technology underlying it – its possible utility as a private payment system and question marks over whether it can co-exist with or link into public payment systems.

Stablecoins: how are they categorised and why does it matter?

“Bitcoin, the first and still the most popular cryptocurrency, began life as a techno-anarchist project to create an online version of cash, a way for people to transact without the possibility of interference from malicious governments or banks.” (The Economist, 30 August 2018)

Sadly for the original creators of cryptocurrencies – and despite their anarchistic intentions, cryptocurrencies and other types of cryptoassets cannot be exempt from the application of law and regulation just because they are a technological construct. The tone for the UK regulatory approach was set in the UK Cryptoassets Taskforce report, where the government stated its ambition for the UK to be the world’s most innovative economy and to maintain its position as one of the leading financial centres globally, to be achieved in part by “allowing innovators in the financial sector that play by the rules to thrive”. The message is clear: innovation is encouraged, but only where it complies with high standards of regulation.

The genesis of stablecoins, a relatively recent sub-category of cryptoassets, was an attempt to address the high price volatility exhibited by many cryptoassets so far. Stablecoins are, in short, cryptoassets that are backed by other assets, including fiat, commodities or other cryptocurrencies (a fuller definition is contained in the Financial Stability Board’s (FSB) ‘Regulatory issues of stablecoins’, 18 October 2019).

There are many types of stablecoin, each with different structures, functions and uses. Despite the word ‘coin’, a stablecoin could constitute a financial derivative, a unit in a collective investment scheme (fund), a debt security, e-money, or another type of specified (regulated) investment. They could potentially fall within any of three broad categories of cryptoassets as described by the UK Financial Conduct Authority (FCA), the categories having been revised in July 2019 following an earlier consultation.The diagram in Figure 1 compares the prior and current UK FCA categories of cryptoassets.

The position could change. During 2020 UK HM Treasury is expected to consult on expanding the regulatory perimeter. The EU Commission is also consulting on an “EU framework for markets in crypto-assets”.

It was the prospect of a stablecoin achieving, in a very short timescale, widespread adoption for transactions currently processed by retail and wholesale payment systems, particularly if integrated into existing online platforms or social media, that brought stablecoins into the sharp focus of national and international regulatory bodies. In a Bank of England speech (Responding to leaps in payments: from unbundling to stablecoins), Christina Segal-Knowles noted that: “In India, Google Tez reported having 50 million users 10 months after its launch in September 2017. In China, Alipay and WeChat Pay by some measures handled more than $37 trillion in mobile payments in 2018”.

The UK and other regulators consider that an appropriate regulatory framework needs to be adopted for stablecoins prior to their launch.

Global stablecoins as a payment asset

Key drivers for the creation of stablecoins as an alternative payment asset include improving
cross-border payments, to increase speed and reduce costs; assisting with financial inclusion
and providing payment tools for people who are underbanked or underserved by financial
services; and the growing preference in society for peer to peer interactions.

However, there are significant challenges and risks arising from use of stablecoins. These include difficulties with legal certainty, sound governance, AML/CFT compliance, operational resilience (including cyber security), consumer/investor and data protection and tax compliance. If stablecoins reach a global scale, they could pose challenges and risks to monetary policy, financial stability, the international monetary system and fair competition.

Here are a selection of key policy points identified by the G7 Working Group on Stablecoins, highlighting why regulators are so concerned about global stablecoins:

  • Competition: global stablecoin arrangements could achieve market dominance due to their strong existing networks and the large fixed costs that a potential competitor would need to implement large-scale operations, and the exponential benefit of access to data.
  • Stability mechanism: the mechanism used to stabilise the value of a global stablecoin must address market, credit and liquidity risk. If these are not adequately addressed, it could trigger a run, where users would all attempt to redeem their global stablecoins at reference value. Other triggers for a run could include a loss of confidence resulting from a lack of transparency about reserve holdings or if the reporting lacks credibility.
  • Credit risk: global stablecoins whose reference assets include bank deposits may be exposed to the credit risk and liquidity risk of the underlying bank.
  • Increased cost of funding for banks: if users hold global stablecoins permanently in deposit-like accounts, retail deposits at banks may decline, increasing bank dependence on more costly and volatile sources of funding.
  • Change in nature of deposit: in countries whose currencies are part of the stablecoin reserve, some deposits drained from the banking system when retail users buy global stablecoins may be repaid to banks by way of larger wholesale deposits from stablecoin issuers. If banks were to counter this by offering products denominated in global stablecoins, they could be subject to new forms of foreign exchange risk and operational dependencies.
  • Exacerbation of bank runs: easy availability of global stablecoins may exacerbate bank runs in times when confidence in one or more banks erodes.
  • Shortage of high-quality liquid assets (HQLA): purchases of safe assets for a stablecoin reserve could cause a shortage of HQLA in some markets, potentially affecting financial stability.
  • Reduced impact of monetary policy: this could happen in several ways. If, for example, there were multiple currencies in the reserve basket, the return on global stablecoin holdings could be a weighted average of the interest rates on the reserve currencies, attenuating the link between domestic monetary policy and interest rates on global stablecoin deposits. This would be particularly true where the domestic currency is not included in the basket of reserve assets.

The FSB is due to submit a consultative report on stablecoins to the G20 Finance Ministers and Central Bank Governors in April 2020, with a final report in July 2020.

Central bank digital currencies: alternative, interoperable or additional solutions?

Central bank digital currencies (CBDCs) are new variants of central bank money that differ from physical cash or central bank reserve/settlement accounts. There are two potential types of CBDCs: (i) a “wholesale” or “token-based” CBDC – restricted-access digital token for wholesale settlements (for example, interbank payments or securities settlement); and (ii) a general-purpose variant available to the public and based on tokens or accounts, allowing for a variety of ways of distribution.

So how would a CBDC act as an alternative to global stablecoins? A general purpose CBDC would essentially give effect to a disintermediated currency of which the central bank, rather than a private entity, would keep control. The view of the UK central bank, which first raised the possibility of CBDCs in 2015, seems to be evolving. Back in 2018, in his ‘The Future of Money’ speech (March 2 2018), Bank of England Governor Mark Carney identified that a general-purpose CBDC could mean a much greater role for central banks in the financial system. He noted that central banks could find themselves disintermediating commercial banks in normal times and running the risk of destabilising flights to quality in times of stress.

An independent report commissioned by the Bank of England on the Future of Finance noted that there was no compelling case for CBDCs and that the focus should be on improving current systems to allow for private sector innovation. However, in January 2020 the Bank of England announced that it would be participating in a central bank group with six other banks to assess potential use cases on CBDCs.

Payments systems and the transfer technology underlying stablecoins

In his ‘The Future of Money’ speech in 2018, Carney noted the potential for underlying technologies to transform the efficiency, reliability and flexibility of payments by increasing the efficiency of managing data; improving resilience by eliminating central points of failure, as multiple parties share replicated data and functionality; enhancing transparency (and auditability) through the creation of instant, permanent and immutable records of transactions; and expanding the use of straight-through processes, including with smart contracts that on receipt of new information automatically update and if appropriate, pay.

An European Central Bank (ECB) Occasional Paper (‘In search for stability in crypto-assets: are stablecoins the solution?’) notes that: “A platform for the recording of stablecoins and other assets using DLT and smart contracts may either benefit interoperability and competition among different DLT-based infrastructures and issuers – if its governance aims at harmonising the business and technological standards adopted by different operators and issuers competing in the market –, or lead to increased fragmentation if multiple initiatives emerge that compete for the market.”

The Bank of England confirmed in July 2018 that its renewed real-time gross settlement (RTGS) service would support DLT settlement models following a successful proof of concept.

Cryptoassets are a daily reality

The prevailing market views seems to be that in the short to medium term, DLT will augment rather than replace RTGS. Interoperability remains a key challenge, as do the technological and energy requirements of a successful and permanent DLT-based payments system.

Nevertheless, it no longer seems fanciful to talk of cryptoassets forming a daily part of the mainstream payments system. They are no longer only the preserve of speculators, or of payors seeking anonymity. The number of transactions in cryptoassets continues to grow rapidly, and regulators are focused on managing their increasing role in day-to-day financial services. It will be fascinating to see how central banks and regulators continue to respond to the growth of cryptoassets, and where this sector will go next.

In another article entitled, ‘Fintech market enters a new stage of maturity‘, we review macro-developments in Europe.

 

Clive Cunningham
Clive Cunningham
Partner, London
+44 20 7466 2278
Wendy Saunders
Wendy Saunders
Senior Associate, London
+44 20 7466 2373
Richard Woods
Richard Woods
Senior Associate, London
+44 20 7466 2940

FCA calls for input on proposed Cross-sector Sandbox by 30 August 2019

New technologies, such as artificial intelligence (“AI“) and distributed ledger technology (“DLT“), continue to have a significant impact on the way in which firms, customers and regulators interact.  Firms introducing innovative business models whose products or services fall under the jurisdiction of different sectoral regulators can find themselves having to address competing regulatory expectations.

As these new innovative technologies and cross-sector business models begin to emerge, regulators have recognised a need to:

  • create a safe and encouraging environment for firms to develop positive innovations. At the same time, providing regulatory certainty;
  • ensure consumers are protected from new technologies still under development; and
  • ensure efficient and cost saving new technologies are made available to the public in a timely manner.

On 29 May 2019, the FCA issued a Call for Input seeking views on whether a single point of entry cross-sectoral sandbox would be useful in achieving these goals.  This is the first cross-sector sandbox proposed by a [global] regulator and reflects the UK’s desire to be perceived as a key centre for innovation and a thought leader on technology.

In a nutshell, the proposed cross-sector sandbox will allow firms to test innovative products, services and business models in a live market environment. Firms whose business span across different sectors (e.g. telecommunications, public utilities and banking) will be able to use this opportunity to obtain informal regulator input and guidance.  Products will be tested on a small scale and appropriate safeguards would be put in place to protect test participants.  The deadline for submissions to the FCA is 30 August 2019.

It appears that technology companies, telecommunication companies, public utility providers and financial institutions will be the most likely users of the cross-sector sandbox. Possible use cases include the launch of Orange Bank by the French telecommunications company, the launch of Ant Financial by the Alibaba Group, and the introduction of other “hyper platform” models by technology companies such as Tencent and Baidu (Open Edge).

We consider the FCA’s proposed cross-sector sandbox in more detail below.

Background

Traditional business models have largely been considered by regulators on an individual basis.  Where there have been areas of overlap, the FCA have relied on bilateral memorandums of understanding (“MoUs“) and existing fora to discuss cross-cutting issues.  However, there is currently no practical mechanism for multiple regulators to collaborate. With the development of more innovative and cross sectoral business models, regulators have recognised the need for a more focused and streamlined approach.  This is where the proposed cross-sector sandbox comes in.

The FCA’s suggestion of introducing a cross-sector regulatory sandbox is also consistent with the global trend of fostering innovation: at least 31 global financial services regulatory agencies now have a regulatory sandbox.  In addition, in January 2019, the FCA and 35 other financial organisations also launched the Global Financial Innovation Network (“GFIN”) to launch a cross-border testing pilot. The FCA’s current proposed cross-sector sandbox builds on the lessons learned from existing sandboxes and aims to leverage new opportunities brought by technological developments.

Key features of the FCA’s proposed cross-sector sandbox

The key features of the FCA’s proposed regulatory sandbox includes:

  • Restricted authorisation– the FCA will have a tailored authorisation process for firms accepted into the sandbox. Any authorisation or registration will be restricted to allow firms to only test ideas as agreed with the FCA;
  • Individual guidance– the FCA will explain how it will interpret the requirements in the context of a specific test;
  • Informal steers– the FCA can provide views on the potential regulatory implications of an innovative product or business model that is at an early stage of development;
  • Waivers– the FCA may be able to waive or modify an unduly burdensome rule, for a test. However, the FCA will not able to waive national or international law; and
  • No enforcement action letters–  if the firm deals with the FCA openly, keeps to the agreed testing parameters and treats customers fairly, the FCA accepts that unexpected issues may arise but it does not expect to take disciplinary action.

The FCA stated it will closely oversee tests and set specific safeguards for consumers. Sandbox tests are expected to have a clear objective (e.g. reducing costs to consumers) and be conducted on a small scale. Under the sandbox arrangement, firms will be able to test their innovations for a limited duration (up to 6 months) with a limited number of customers.

Perceived benefits

From a financial services perspective, the proposed cross-sector sandbox is expected to help:

  • Reduce time and cost of getting innovative ideas to the market (e.g. using DLT/ crypto assets as a payment mechanism for utility bills);
  • Facilitate access to finance and regulatory insight for innovators;
  • Enable products with potential or immediate cross-sector relevance to be tested and introduced to the market;
  • Ensure appropriate consumer protection safeguards are built into new products and services;
  • Allow regulators to share learnings from various tests and other sectors (e.g., on AI, DLT, Big Data and machine learning);
  • Allow regulators to create a common or harmonised regulatory and policy approach to the development and implementation of new technologies; and
  • Provide firms with complex new business models which span more than one regulator with a unique, coordinated single-point entry sandbox. Whilst the FCA has identified the possible use cases referred to above (Orange Bank, Ant Financial, Tencent and Open Edge), there will be greater use of more innovative business models as more and more technology and telecommunication firms diversify into traditional business areas, such as banking and public utilities, and vice versa.

Potential Challenges

The FCA has also identified some of the potential challenges a prospective cross-sector sandbox could face. They include:

  • Lack of demand– it is difficult to predict how many firms would submit an application that meets the eligibility criteria set by participating regulators.
  • Misunderstanding about the purpose of a sandbox– the FCA expects that participating regulators will set eligibility criteria and only accept applications from firms who have shown a “need for testing”. This, the FCA believes, will separate these genuine cases from those which simply wish to gain a regulatory seal of approval;
  • Firms do not improve own in-house knowledge – since regulatory feedback will be given, some firms (particularly smaller firms) may lose the incentive to develop in-house knowledge. As such, successful applicants to the cross-sector sandbox will need to show that they have an understanding of the regulatory framework in which they operate. Applicants will also need to provide reports of their findings and next steps.  Also, restrictions on firms will only be removed once the FCA is satisfied that a firm’s knowledge of the regulated market has sufficiently (i.e. when firms are able to operate without exposing markets and consumers to unacceptable harm);
  • Differing regulatory remits– given regulators have different mandates and objectives, they may arrive at different conclusions when looking at the same trial outcomes. Given different regulatory philosophies, there may also be situations where competing objectives conflict. For example, a new innovative business model that is prudentially sound may be approved by the PRA.  However, it may not receive the FCA’s blessing if it does not promote effective competition in the interests of consumers. However, the FCA is of the view that looking at tests concurrently with other regulators will help mitigate instances of uncertainty.  Although the sandbox should foster greater cooperation between regulatory bodies in the live testing environment, issues that are inherent in the various distinct regulatory frameworks may arise even after the product or offering has advanced into the formal marketplace. For example, a cross-sector product might fall within scope of several distinct dispute resolution mechanisms – different schemes, such as the Financial Ombudsman Service and the Energy Ombudsman, have different powers to, and parameters for, ordering redress and compensation.

HSF Comment

The proposed cross-sector sandbox is a further evolution of the FCA’s commitment to fostering innovation, and recognises that, even where sectors remain distinct, user behaviours and expectations are driving increased interaction between regulated sectors.  Innovators from sectors other than the purely financial should be encouraged to respond to the call for evidence.

 

Karen Anderson
Karen Anderson
Partner, London
+44 20 7466 2404
Vicky Man
Vicky Man
Senior Associate, London
+44 20 7466 3861