HM Treasury publishes stablecoin response

On 4 April 2022, the UK government published a consultation response (the Consultation Response) to their initial consultation paper and call for evidence on a UK approach to the regulation cryptoassets and stablecoins.

Today, the most well-known cryptoassets are likely to be exchange tokens such as Bitcoin and Ethereum. However, a first look at the decentralised finance (DeFi) space reveals the increasing importance of stablecoins, and the exchanges and wallets which seek to disrupt the financial services industry. We summarise the key points in the proposed rules and analyse how they may affect UK companies seeking to operate in the Web 3.0 and DeFi space.

Background to the UK consultation response

HM Treasury initially consulted in January 2021 on a UK approach to the regulation of cryptoassets, regulating stablecoin issuers and bringing cryptoassets within the UK financial promotion regime (the Consultation).

Stablecoins underpin or help operationalise many of new DeFi and Web 3.0 projects, with use cases ranging from staking, providing liquidity for other tokens on an exchange, or even have use cases in leveraged borrowing of cryptoassets. Considering the importance of stablecoins and the increasing volume and complexity of uses of stablecoins, it is therefore not surprising that global regulators see systemic risks, prudential regulatory gaps, and market abuse risks, linked primarily to stablecoins. The UK government is therefore seeking to bring stablecoins within the regulatory perimeter, primarily through amendments to the Electronic Money Regulations 2011 and the Payment Services Regulations 2017.

The government has also proposed to further regulate custodial wallet providers, having correctly identified that wallet providers play a prominent role in the provision of decentralised financial services. Wallet providers are currently only subject to registration requirements under the money laundering regulations (although firms are currently finding even this registration requirement difficult) and bringing them within the existing e-money and payments regimes.

The Consultation Response outlines three key changes to the regulatory ruleset affecting crypto-asset firms, being as follows:

• firstly, the government proposes to require issuers of stablecoins referring to fiat currencies (specifically, issuers of ‘payment cryptoassets’) to seek authorisation from the FCA;
• secondly, the government also intends for custodial wallet providers to also require authorisation from the FCA;
• lastly, the government will extend Part 5 of the Banking Act 2009 to systemic stablecoin payment systems, capturing arrangements that control or facilitate the transfer of ‘digital settlement assets’. This will enable the Bank of England (as lead prudential regulator) and the FCA to directly supervise certain stablecoin payment systems if they are deemed to pose systemic risks.

Regulating stablecoins referring to fiat – ‘payment cryptoassets’

The government has stated that it will likely develop a definition for payment cryptoassets, being cryptoassets which are a digital representation of monetary value, stabilised by reference to one or more fiat currencies and/or issued and used as a means of making payments transactions. This confirms that they will continue the approach set out in the initial consultation and stablecoins referring commodities or stabilising ‘algorithmically’ would be excluded from the scope of the definition (noting, however, that cryptoassets which stabilise their value may already fall within the regulatory perimeter by virtue of being specified investments).

As set out in the Consultation, in-scope firms will become subject to authorisation requirements and certain compliance requirements. The compliance requirements will be onerous, drawing from existing payments and e-money regulation. This includes prudential requirements, requirements in relation to maintenance and management of reserves, safeguarding, systems and controls, conduct of business requirements

Bringing custodial service providers in scope of regulation

Wallet providers have been correctly identified by the UK government as being a key feature in cryptoassets, unlike for example in relation to e-money – the government notes that customer interaction with a stablecoin often takes place through a third-party wallet provider or an exchange. Therefore the government has proposes that custodial activity in relation to stablecoins will be regulated and will also require authorisation under the e-money and payments regimes.

The changes are broadly in line with the expectations set in the Consultation. However, it is noteworthy that the government only proposes to regulate exchanges in as far as they provide or arrange for custody of payment cryptoassets. Therefore, unlike in the Consultation, operating an exchange would not in of itself require authorisation – this is a significant change from the prior approach as an exchange could fall outside of scope of regulation by simply not providing custodial services (e.g. only allowing interactions through another wallet provider, such as Wallet Connect or MetaMask).

This puts the UK in sharp contrast to the EU’s approach in relation to exchanges in the draft Markets in Cryptoassets Regulation (MICAR), which proposes to take an approach to cryptoasset exchanges and trading platforms not dissimilar to the approach taken under the recast Markets in Financial Instruments Directive (MiFID II). Nevertheless the government has noted that it intends to consult later in 2022 on a regulating a wider set of cryptoassets, including exchange tokens.

Taking it all together – what will be regulated?

In their initial Consultation, the UK government had set out a useful framework which summarises which kinds of activities will be regulated. The Consultation Response only provides limited confirmation of the below approach, but we expect that the government’s draft rules, once published, should broadly be aligned to the table set out below.

Territoriality

Unhelpfully, the government’s new proposal is silent on the territorial scope of these new licensing requirements. The Consultation initially took a more expansive view of territoriality, consulting on whether firms which issue stablecoins and actively marketing to UK customers should be required to have a UK presence and authorisation. This was a departure from the traditional approach (being the characteristic performance test) that UK regulator typically adopt (as opposed to what is known as the “targeting test”). Given the UK government’s recent stated intention to make the UK a global cryptoasset hub it would be surprising to see a targeting test make it into the draft rules. That said, the characteristic performance test is not easily applied to cryptoasset firms – a preferrable approach would be for the government or the FCA to provide specific guidance, as firms have been struggling with conflicting approaches and multi-jurisdictional complexity when seeking to provide services cross-border into the UK and the EU.

Firms should also note that the changes above should not be considered in a vacuum and that existing activities may already be regulated. The above changes focus on issuers of stablecoins and wallet providers. However, changes the regulatory ruleset notwithstanding, the government and the FCA are of the view that the existing ruleset already covers activities of existing cryptoasset firms, for example in relation to entering into credit agreements (e.g. staking or lending cryptoassets), issuing e-money (e.g. certain stablecoin issuers), or operating collective investment schemes (e.g. certain DAOs).

Given the increasing regulatory scrutiny on stablecoins and crypto firms generally, players operating in this space should consider a review of existing arrangements and carefully consider their licensing requirements and structuring of any new products, with due consideration to upcoming regulatory changes in the UK and beyond.

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