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).
Tag: HM Treasury
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.
The Financial Conduct Authority (FCA) has issued a ‘Dear CEO’ letter (the letter) with an update on key issues in light of COVID-19 to firms providing services to retail investors. In addition to the measures it has taken with the Bank of England (BoE) and HM Treasury (HMT), the FCA has considered many requests for forbearance and regulatory adaptations from firms and trade associations, some of which are discussed further below. The FCA has implemented a “significant package of reprioritisation and deprioritisaion of regulatory work” to allow firms to concentrate on their COVID-19 response efforts and protecting their consumers and has indicated that it will continue to update its approach in response the crisis.
The FCA will generally look favourably on forbearance requests for changes which support firms and consumers (some of which it will have the power to make immediately; others which may require co-ordination between the FCA and other UK Government or European agencies), and will only consider requests where there is a genuine need to help consumers or which, for example, would support the FCA’s response to the crisis.
Next steps for firms:
- In light of the impact of COVID-19 on firms’ operational resilience, the FCA re-emphasised its expectations for firms to focus strongly on supporting and serving consumers and small businesses during this time. The FCA also expects firms to be actively managing their own financial resources/resilience (and in particular liquidity), with firms notifying the FCA immediately if they expect to face financial difficulties.
- Where firms are re-directing resources due to reduced levels of staff, they should have regard to the FCA’s strong focus on consumer protection. Firms should consider documenting how these decisions are made, with the aim of allocating resources to achieve consumers protection as far as possible during this time.
- Firms should keep up-to-date with developments by regularly checking the FCA’s website to ensure they are aware of the regulations and rules which continue to apply to them. Firms should also remain vigilant of scams which are increasingly prevalent during the COVID-19 crisis; both the FCA and National Crime Agency have released warnings on rising fraud levels and firms have a responsibility to ensure that consumers are protected.
- Firms may also wish to consider making use of dialogue between trade associations and the FCA where appropriate to raise prevalent operational challenges with the FCA.
Key areas of focus:
In addition to the above, the FCA sets out in the letter its approach to a number of key issues to help firms manage their response to the crisis:
- Financial resilience – The FCA has already published guidance on financial resilience and prudential issues. Importantly, the FCA has clarified that government loans cannot be used to meet capital adequacy requirements as they do not meet the definition of capital. Firms therefore need to ensure that they have other appropriate funding available to meet their capital adequacy requirements, if necessary.
- Flexibility for client identity verification – Whilst firms must continue to comply with their obligations under the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs) to verify clients’ identities, they can be flexible with how they achieve this. The MLRs and Joint Money Laundering Steering Group guidance already provide that client identity verification can be carried out remotely, and outline appropriate safeguards and checks which firms can implement to assist with verification – some examples are given by the FCA. Firms can also consider seeking additional verifications once restrictions on movement are lifted.
- Flexibility over best execution reports – The FCA and the European Securities and Markets Authority (ESMA) have both published clarification for firms on best execution obligations in the current climate (the ESMA public statement is available here). The FCA expects firms to continue to meet their best execution obligations, including on client order handling, taking into account current market conditions when determining the relative importance of execution factors. Firms may wish to consider using different types or orders to execute client orders and manage risk during market volatility.
Following ESMA’s guidance, the FCA will not take enforcement action where a firm:
- does not publish its RTS 27 report by 1 April 2020, provided it is published no later than 30 June 2020; or
- does not publish RTS 28 and Article 65(6) reports, provided they are published by 30 June 2020.
- Flexibility over 10% depreciation notifications – Firms will not be required to inform investors in every instance where the value of their portfolio or leveraged position falls by 10% or more in value. Instead, until 1 October 2020, the FCA has confirmed that it will not take enforcement action provided that a firm:
- has issued at least one notification to retail clients within a current reporting period notifying them that their portfolio has decreased in value by at least 10%; and
- subsequently provides general market updates online, through other public channels, and/or generic, non-personalised client communications; or
- chooses to cease providing 10% depreciation reports for any professional clients.
In what is currently a highly volatile market, firms may wish to think about adopting this new approach which could ease the impact of repeated communications on consumers and the operational burden on themselves, or using email or phone calls to notify clients as opposed to written notifications.
- Pause on implementation of measures – The FCA’s policy statement on pension transfer advice has been delayed until Spring 2020 and follow-up work on assessing the suitability of retirement income advice has been paused. Rules on investment pathways and platform switching provisions have already been made; these have been referred to the FCA Board for further consideration. Ongoing work with firms providing defined benefit transfer advice will continue.