A regulatory regime for stablecoin is coming: Here’s what we know

by Marcel Le Gouais

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With the UK’s financial watchdogs set to establish a regulatory regime for stablecoins, payment service providers must brace for stringent new standards in operations, redemptions, audits, and consumer protection.

Firms operating in the stablecoin market face stringent new regulations across the full gamut of operational standards, redemptions, independent audits and consumer protection as the financial watchdogs enact plans to create a regulatory regime for cryptocurrencies.

In the government’s latest moves to execute a phased strategy for crypto regulation, a Treasury policy statement preceded two discussion papers from the Financial Conduct Authority (FCA) and the Bank of England late last year, which set out proposals for all stakeholders including payment systems providers in the fiat-backed stablecoin space.

Piling on the onslaught of regulatory literature, the Prudential Regulation Authority (PRA) also issued a Dear CEO letter to banks on their use of deposits, e-money and regulated stablecoins.

Last year, the Treasury’s initial policy statement mapped out the broad direction of travel, stating an intention to define fiat-backed stablecoins in legislation by capturing stablecoins that hold (in part or wholly) a fiat currency as backing.

The Bank of England’s discussion paper, which closed on February 6, sets out a regulatory framework covering any payment systems that use stablecoins at a systemic scale. It focuses on sterling-denominated stablecoins only, as the bank believes these are most likely to become widely used for retail payments.

The FCA’s discussion paper (having closed on the same date) defines the standards that issuers and custodians of regulated stablecoins will have to meet, as well as payments system providers, once the regime comes into force.

The two financial regulators are proposing rules that have significant implications for operations, compliance, business structures, governance, backing assets, customer communications, and, ultimately, departmental budgets.

On a potential flipside, the proposals could help to open this market up. The regulators are considering changes to payments legislation to enable the use of fiat-backed stablecoins for retail goods and services payments. The law change would enable stablecoins issued both within and outside the UK to be used for this purpose.

The impact of allowing in foreign issuers is subject to debate; however, with The Payments Association informing the FCA, it’s likely no major global stablecoins would qualify for such a confined regime. Yet, this is just one proposal of a multitude that could evolve as the dialogue with the regulators gathers pace.

As for the relevant legislation used to enact a new regime, the issuance and custody of fiat-backed stablecoins will be regulated under the Financial Services and Markets Act 2000, while the use of stablecoins for payments will come under the Payment Services Regulations (PSRs).

Once the watchdogs assess the feedback, new rules will be drafted for consultation. The Treasury will then enact secondary legislation changes.

Essentially, this is still the beginning; a widening net of regulations through different phases will encompass more crypto stakeholders as the government moves forward.

In an immediate sense, the breadth of regulators’ activity here is vast. A framework is being established that extends their remit far beyond existing supervision of policies for anti-money laundering (AML) and counter-terrorist financing (CTF) in crypto.

The impact of allowing in foreign issuers is subject to debate; however, with The Payments Association informing the FCA, it’s likely no major global stablecoins would qualify for such a confined regime.

Preparations, if they haven’t already, will need to start imminently for those affected.

Crypto growth and an authorisation gateway

The FCA discussion paper provides some context on the estimated size and shape of the stablecoin market – and, therefore, the sprawling scale of the regime it needs to establish.

More than 200 cryptoassets are in existence, which purport to maintain a stable value against one or more fiat currencies, according to the regulator. The FCA also points to 2022 figures that show on-chain stablecoin transactions exceeded $7.5 trillion on the Ethereum blockchain alone.

The US dollar stablecoins issued by Circle and Tether exert something of a duopoly on the wider landscape. As of 12 October 2023, the FCA states, these had a combined market dominance of around 87% within a total stablecoin market capitalisation of $123.4 billion.

Against this backdrop, the FCA will have a vast in-tray of authorisations to wade through. Its discussion paper states that all stablecoin issuers will need authorisation to issue fiat-backed stablecoins in or from the UK.

Authorisation will come with requirements related to minimum capital held, AML rules and know-your-customer (KYC) checks, as well as accountability for directors through the Senior Managers Regime and where relevant, the Consumer Duty.

The FCA has a chequered history of processing authorisations on time, though it has made improvements during the past 18 months. The watchdog’s figures show that for Q2 2023/24, it did not hit its target to process new authorisations for payment services and e-money firms within the required timeframe.

Applicants in the stablecoin market may find their perseverance tested.

Redemptions at par

Once firms secure authorisation, one of the more taxing new regulations issuers and payments service providers will face relates to redemptions.

The FCA is proposing that all stablecoin issuers must ensure redemption at par to all holders of the regulated stablecoin by the end of the next UK business day after receiving the redemption request. There will also need to be more transparency around the fees charged.

In its consultation response, The Payments Association says there will be many situations where next-day redemption is operationally challenging, such as a mass run on a particular stablecoin.

There is also a cost element for the FCA to consider here; The Payments Association explains that if issuers are allowed to charge cost-effective fees for redemptions, this could disadvantage users wanting to redeem only small amounts.

From the regulator’s perspective, though, consumer protection is paramount, particularly during times of market turbulence. The FCA highlights the risk of stablecoin holders not being able to get par value for their coin on the secondary market during these periods or when an issuer collapses into insolvency.

For the industry, the FCA’s drive to transparency will undoubtedly have an impact.

The watchdog says that redemption restrictions are “rarely clearly communicated on corporate websites” and are “not always reasonable or proportionate”. It states that issuers commonly do not commit to specific redemption periods and reserve the right to pause or halt redemption at their sole discretion.

The Payments Association says in its consultation response that the FCA should require the publication of redemption policies on exchange websites to ensure users are fully informed.

The regulator’s principal aim here is to ensure holders can convert their stablecoin into fiat at par value at all times while the issuer is solvent. Acknowledging that holders can sell their stablecoins on an exchange at any time, the FCA believes this proposal will allow them to redeem with the issuer at par when the coin has de-pegged on the secondary market.

The FCA adds it is “aware this will be a significant change for issuers who currently seek to interact only with wholesale or institutional clients”.

Overseas stablecoins: Whose role to assess?

The Treasury’s plan to open up the market to stablecoins issued outside the UK, which is covered in the FCA paper, has one of the more significant implications for payments service providers.

Whitehall is considering whether to give the FCA powers within the PSRs to authorise payment arrangers, who would then assess overseas stablecoins against regulatory standards. Payment arrangers must provide evidence to satisfy the regulator they can assess and approve overseas stablecoins, along with information about any third-party assessors they propose to use. They must secure extra permissions under the PSRs to enact this role.

The FCA says that stablecoins introduced to the UK payment chain must be monitored weekly by the payment arranger to ensure they remain compliant. The regulator is considering whether further requirements, such as reporting and disclosures, should be made to ensure the smooth functioning of approved overseas stablecoins.

In its response, The Payments Association points out that payment approver conditions are likely to be operationally challenging and disproportionate due to the ongoing monitoring and the third-party auditing of assessments.

The association adds in its response that there is a” strong case for the FCA to play a more active role in this process, for example, by assuming the role of verifying assessments made by payment arrangers.”

Its response explains, “It appears that the FCA won’t hold a UK payments service provider responsible if the foreign stablecoin provider fails, as long as the UK payment services provider has followed the FCA rules. This is not fair for end consumers and is likely to create confusion.”

Reconciliations, governance and control

Another proposal that could have a material impact is a requirement for custodians to conduct reconciliations of each client’s cryptoassets on a real-time basis to identify and resolve discrepancies promptly. This would consider on- and off-chain internal and relevant external records.

Under the proposals as worded, custodians would have to cover any shortfalls if discrepancies are not resolved after reconciliations.

Once firms secure authorisation, one of the more taxing new regulations issuers and payments service providers will face relates to redemptions.

The Payments Association notes that technical controls and systems would need to be properly assessed to accurately assess holdings in an evolving market like crypto.

On a related matter, the FCA is considering requiring custodians that use sub-custodians and other third parties to comply with new requirements. These include undertaking due diligence in the selection, appointment and periodic reviews of the third party and ensuring that any custody assets deposited with a third party are identifiable separately from those belonging to the custodian.

Use cases, differentiation and compensation

Across its discussion paper, the FCA focuses largely on the retail use cases for stablecoin, but it’s seeking industry feedback on how to differentiate regimes for institutional and wholesale use cases.

The Payments Association says in its response that members are clear there should be differentiation between retail and wholesale, with retail including customer duty responsibilities, while the focus on wholesale should be on keeping their peg and financial stability.

“By differentiating them, institutions would be able to assess and accept risks better, and different backing assets could be used for both wholesale and retail,” the association’s response states.

This is one of many areas in the paper that will remain uncertain for now, though there’s some certainty on a separate topic. The FCA confirmed in its proposals that cover under the Financial Services Compensation Scheme would not apply to firms facilitating payments using fiat-backed stablecoins.

Bank of England scope on systemic risks

The Bank of England’s purview on stablecoin will include payments service providers that are systemically important (as well as payments system operators) because, according to its discussion paper, they pose risks to the functioning of the whole payment chain.

That means these firms will be subject to the entirety of the bank’s powers, reflecting the regulator’s belief that payment systems for stablecoin should be under the same regime as commercial banks.

The lingering question here, however, is how the central bank defines systemic.

The Treasury determines which service providers should be recognised as systemic, and the Bank of England’s discussion paper doesn’t appear to be definitive in quantifying it. It states that a firm could be viewed as systemic in its own right (for example, a wallet that provides services to multiple non-systemic stablecoins) or because it provides essential services to a systemic payment system or a systemic service provider.

The Payments Association poses a set of questions to the bank on this, such as what the transition from a non-systemic firm to a systemic firm would look like and if a firm categorised as systemic can appeal that decision.

A range of service providers, including cloud outsourcing firms and security and encryption software specialists, could be caught by the central bank’s framework if their services are critical to the issuance, transfer, or custody of stablecoin.

Ultimately, The Payments Association asks for clarity on regulation scope between firms and for clear standards to be agreed to demonstrate where different organisations fall.

It also remains to be seen whether the Bank of England will live up to its pledge of a “flexible regime” that will accommodate different business models in this market.  

Separation of entities

As for specific proposals from Threadneedle Street, a notable element in terms of potential impact is on separation of legal entities among firms operating multiple functions in stablecoin.

The bank states in its paper that combining activities within the same group through vertical integration can lead to vulnerabilities, including “conflicts of interest, inadequate safeguarding of clients’ funds and assets, as well as complex and potentially reinforcing risk profiles.”

The regulator highlighted FTX’s collapse as an example.

While it may be a matter for a future scenario than the present, the bank is also proposing a rule that non-UK issuers of stablecoins must have a UK subsidiary.

The Payments Association has pointed out that if the government wants to make the UK a global hub for cryptocurrency, forcing systemic stablecoin issuers to be established in the UK may make this unworkable.

Another separate proposal will affect wallet providers. As the entities safeguarding holders’ means of control over their stablecoins, they must ensure that holders’ legal rights and ability to redeem the stablecoins at par in fiat are protected at all times.

Regulation, innovation and balance

Protecting consumers and ensuring financial stability are the principles undergirding the FCA and Bank of England discussion papers.

The Payments Association acknowledges in its response to the FCA that reduced consumer harm and increased competition could materialise from the advent of regulated stablecoins, while adding that the industry will know for sure only once several issuers are registered and their stablecoins are being used.

Its response added: “The key is to create a regulatory environment in which commercial gains for the issuers are possible to make it worthwhile for them to come into the market and to ensure the public are suitably educated to understand the benefits of regulated stablecoins.”

The government’s latent move on stablecoin could be perceived as another sign that the broader crypto market is undergoing a steeper trajectory of maturity.

A significant concern is that the FCA retains a balanced approach and doesn’t drive healthy competition out of the market by rendering profitability unfeasible for many firms.

The government’s latent move on stablecoin could be perceived as another sign that the broader crypto market is undergoing a steeper trajectory of maturity, with layers of consumer protection, oversight and operational standards being imposed that align a little closer to mainstream finance.

The direction of travel of the government’s phased strategy is also coming into view. In the near future, the Treasury intends to capture other activities such as “admitting a cryptoasset to a cryptoasset trading venue” or “dealing in cryptoassets as principal or agent”. Both of these will be subject to an initial consultation.

Perhaps the work on stablecoin is a litmus test to bring other cryptocurrencies under a mainstream regulatory regime. The fear is the extent to which the watchdogs will stifle the innovation and growth observed in crypto during recent years.

As the dialogue progresses with the regulators, the market will at least have a new tool to hold the watchdogs accountable for – their new regulatory duty to enable competitiveness.

If the FCA and PRA claim they will make efforts to engender economic growth and competitiveness within stablecoin while ushering in a new regime, they will have to prove it.

Read the entire Payments Review spring edition here

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UK financial regulators are advancing a comprehensive regulatory framework for stablecoins, focusing on operational standards, consumer protection, and market stability to facilitate secure retail and institutional transactions; new rules will have profound implications for compliance, governance, and operational costs. Subscribe to Payments Review to read the full article.

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