December 2023
In early November, the FCA and Bank of England (BoE) published sister discussion papers on proposals for the regulation of, respectively, non-systemic and systemic fiat-backed stablecoin (FBS) payment systems. These proposals reveal important differences between the two regimes, which have significant implications for developing business models in the space.
Overview
As described in our previous article, HM Treasury (HMT) plans to bring FBS within the regulatory perimeter by amending the Payment Services Regulation 2017 and creating two new activities — issuance and custody — under the Regulated Activities Order 2001 (RAO). That article considered, in detail, the FCA's discussion paper (PDF 1.4 MB) (DP) on rules related to both activities.
The BoE has now published a further discussion paper (DP) on the regulatory framework for FBS systems deemed systemic (or likely to become systemic). The BoE and Payment Systems Regulator (PSR) already regulate operators of traditional systemic payment systems (and service providers that provide `essential services') once recognised or designated by HMT. Legislative changes (under FSMA 2023) expanded this remit to include operators that transfer `digital settlement assets' — which includes FBS.
In the context of FBS, the BoE's remit can capture operators of systemic payment systems using FBS, systemic service providers (e.g. issuers, wallet providers, exchanges) or related service providers. The latter two categories could be recognised as systemic in their own right or systemic because they provide essential services to a systemic system or systemic service provider.
The BoE's DP is specifically scoped to address systems that are:
- Payments-focused — i.e. FBS systems that are widely used for payments in the UK.
- Retail-focused — i.e. FBS systems used by households and non-financial businesses. The BoE will set out its views on wholesale settlement “in due course” — it has alluded to potentially updating the RTGS system so that it can connect with a wider range of ledgers.
- GBP-denominated — however, the BoE will monitor non-GBP denominated FBS that are being widely used and consider whether the regime requires amending.
Designation as systemic
The DP notes that HMT is responsible for designating `systemic' status where “any deficiencies in design of system, or disruption to operation, would likely threaten stability of, or confidence in, the UK financial system, or could have serious consequences for business or other interests in the UK”.
The BoE must be consulted as part of HMT's decision and will consider:
- The number and value of the transactions passing through the system.
- The nature of the transactions — e.g. criticality, currency denomination and risk profile.
- Whether the transactions could be handled by other systems — i.e. substitutability and continuity.
- The relationship with other systems — e.g. connectedness with systemically important FMIs, institutions and governments.
- Whether the system is used by the BoE in its role as a monetary authority.
With a particular eye on Bigtech firms, the BoE may also recommend designation as systemic where a system is not currently operating at systemic scale but is likely to do so in the future (“systemic at launch”).
Once recognised as systemic, a relevant entity (or entities) would be subject to the BoE's powers to (i) obtain information, (ii) issue principles and binding codes of practice, (iii) make directions and (iv) issue enforcements.
The BoE will work with HMT and other regulators to allow for a smooth transition into the systemic regime and minimise regulatory overlaps. This co-operation will be set out in an MoU which is reviewed annually.
Interestingly, the BoE has said that it would not deem existing stablecoins (which are mainly pegged to USD) or any new sterling equivalent similarly focused on “transactions in the crypto world” systemic.
Leveraging the Principles for Financial Market Infrastructures (PFMIs) (PDF 296 KB) as a starting point, the BoE has proposed the following:
BoE | FCA |
FBS should be fully backed with central bank deposits. | Non-systemic FBS should be fully backed by short-term government debt instruments and cash deposits. |
No interest should be paid on the central bank deposits and no interest to coin-holders.
| Non-systemic issuers should be permitted to retain interest revenue from backing assets, but not pass this on to customers. |
There should be a robust safeguarding regime for backing assets:
| Aligned to the FCA’s proposed non-systemic regime. |
There should be additional capital requirements to mitigate operational risks and distribution costs.
| Overall capital requirements for non-systemic issuers to be prescribed by a new prudential sourcebook — CRYPTOPRU. |
Systemic issuers should have a UK presence (i.e. be set up as subsidiaries).
| The FCA’s proposed non-systemic issuer scope is already limited to FBS issued in or from the UK. |
All coin-holders should be able to redeem their stablecoins at par (minus any fees) and on demand (i.e., at minimum by end of day).
| Aligned to the FCA’s proposed non-systemic regime. |
Individual holding limits may be needed.
| No holding limits in the FCA’s proposed non-systemic regime. |
The BoE is considering legally separating non-stablecoin services from vertically-integrated business models.
| The FCA’s non-systemic regime is also considering vertical disintegration more broadly. |
Application of the modified FMI Special Administration Regime (FMI SAR) would be used for firm failure.
| The FCA has proposed that failure of non-systemic issuers be dealt with under standard corporate insolvency procedures (for the time being). |
BoE | FCA |
Systemic payment systems should identify a legal entity or natural person as the ‘payment system operator’ (PSO) — that can be held accountable for end-to-end risk management and regulatory compliance:
| Not included in the FCA’s proposed non-systemic regime. |
BoE | FCA |
Hosted wallets should protect coin-holders’ legal rights (and ability to redeem at par in fiat) at all times:
| Aligned to the FCA’s proposed non-systemic regime. |
Requirements exist for exchanges providing wallet services:
| Not in scope of FCA proposed non-systemic regime. |
Risks of off-chain transactions should also be addressed:
| Not in scope of FCA proposed non-systemic regime. |
BoE | FCA |
Depending on the activity performed and the risks posed, these service providers may come into the BoE’s remit in various ways:
| Not in scope of FCA proposed non-systemic regime. |
What does this mean for firms?
The proposals have significant implications for developing stablecoin business models, for example:
- Firms with a large user base may be recognised as systemic at launch. Other firms may begin to operate as non-systemic and later have to navigate the transition onto the BoE's systemic regime. Where such firms are already regulated by the FCA (e.g. as an issuer) they would also become regulated by the BoE and, where relevant, the PSR. Close engagement between the industry and regulators is needed to enable firms that are close to reaching systemic levels to prepare for, and thus mitigate the costs of, transition.
- If an issuer transitioned onto the systemic regime, it would need to entirely convert its backing assets into central bank deposits. Moreover, it would lose the ability to retain interest on these assets. The BoE encourages firms to build revenue-generating use cases in payments (such as efficiency, cost and functionality) rather than rely on interest rates.
- In order to quell BoE concerns about chains operating in a fully decentralised manner, systemic systems would need to identify a PSO to operate as an accountable `central entity'. Firms would need to determine solutions for how the PSO could ensure overall compliance as well as attest to the quality of the system's infrastructure and settlement assets.
- Firms could be caught under new location requirements. Systemic issuers would automatically be subject to UK subsidiarisation while other entities might also be caught under the BoE's powers of direction.
- Firms may need to determine how to implement holding limits for customers which could prove operationally difficult to enforce due to the multiplicity of entities within the blockchain (e.g. issuers, wallets, exchanges).
More clarity is expected once the BoE and FCA DP feedback deadlines pass in February 2024, and they move into the consultation phase. KPMG in the UK can support firms with the wide range of challenges stemming from these developments. If you have any questions or would like to discuss further, please get in touch.