HODL On: New HM Treasury consultation on cryptoassets and stablecoins

On 7 January 2021, HM Treasury (“HMT”) published its long-awaited consultation paper on the UK regulatory approach to cryptoassets and stablecoins (the “Consultation Paper”). This Consultation Paper was announced in the budget of March 2020 and has been eagerly awaited by the UK cryptoasset industry.

In summary, the consultation paper proposes to:

1. create a regulatory regime for “stablecoins”; and
2. request evidence for the future regulation of other types of cryptoassets.

Objectives

HMT has set out three key objectives and principles it has for its proposed cryptoasset regulation:

1. maintaining the current division of UK regulator responsibilities as far as possible and applying the principle of ‘same risk, same regulatory outcome’;
2. ensuring the approach is proportionate, focussed on where risks and opportunities are most urgent or acute; and
3. ensuring the approach is agile, able to reflect international discussions and aligned to the future government approach to financial services and payments regulation.

1. Expanding the regulatory perimeter

HMT sets out the keys risks it is concerned with in relation to stablecoins, which are:

1. risk to financial stability and market integrity;
2. risks to consumers; and
3. risks to competition.

In order to combat these risks, HMT proposes to introduce a regulatory regime for stablecoins which are used as a means of payments.

How is a “stablecoin” defined?

A clear definition of a “stablecoin” (referred to as a “stable token” within the Consultation) is not provided within the Consultation.

However, HMT states that the classification of a stablecoin will be agnostic to the technology underpinning its use. This approach seems to accord with the European Union’s recent approach in its new Markets in Crypto-Assets (MiCA) regulation and differs from our current approach within the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (“MLRs”) which only relates to tokens which use distributed ledger technology (“DLT”).

Which tokens will be in scope?

HMT intends to ensure that tokens which “could be reliably used for retail transactions or wholesale transactions” are subject to minimum requirements and protections as part of a UK authorisation regime.

This regime will cover the following types of tokens:

• stablecoins linked to a single fiat currency; and
• stablecoins not linked to a single fiat currency (e.g. gold or multi-currencies).

However, the regime will not cover the following:

• algorithmically linked stablecoins (i.e. stablecoins which use algorithms to control a market maker which buys / sells the tokens in order to control its price);
• unregulated exchange tokens;
• unregulated utility tokens;
• e-money tokens; and
• security tokens.

HMT also sets out some clear exclusions where it considers that the activities undertaken do not pose the same risks. For example, where services are provided to persons within a limited network of service providers or for acquiring a limited range of goods or service (e.g. store payment cards). This exclusion might be used by firms which implement their own private stablecoins (e.g. for accounting).

HMT is also considering whether a lighter regime should be implemented for smaller stablecoins with below a certain turnover, similar to the current regime available within payment services regulation.

Which activities shall be within scope?

HMT sets out that it shall apply the proposed new regime to firms carrying out the following functions / activities.

1. Issuing, creating or destroying asset-linked tokens – the activity of the token issuer in minting and burning tokens.
2. Issuing, creating or destroying single fiat-linked tokens – the activity of the token issuer in minting and burning tokens.
3. Providing custody and administration of a stable token for a third party – the activity of managing tokens on behalf of owners, including the storage of private keys.
4. Executing transactions in stable tokens – the activity of conducting transactions on behalf of another.
5. Exchanging tokens for fiat money and vice versa – the activity of purchasing/exchanging a stable token with fiat money.
6. Value stabilisation and reserve management – the activity of managing the reserve assets that are backing the value of a stable token and providing custody/trust services for those assets to ensure stabilisation of the stable token.
7. Validation of transactions – the activity of authorising or verifying the validity of transactions and records.
8. Access – the activity of providing services or support to facilitate access of participants to the network or underlying infrastructure.
9. Transmission of funds – the activity of ensuring the correct and final settlement of transactions while limiting counterparty and default risk.

However, activities 6 to 9 will not require authorisation by the FCA and shall only be regulated in certain circumstances, e.g. where the activity meets certain Payment Systems Regulator (“PSR”) or Bank of England (“BoE”) criteria (see Additional Requirements section below for details).

This will therefore include a broad range of firms which carry out activities relating to stablecoins including:

• issuers or system operators;
• stablecoin OTC providers;
• certain cryptoasset exchanges;
• certain merchant services providers allowing the acceptance of stablecoins; and
• wallet providers.

HMT states that it expects financial crime requirements, including in relation to anti-money laundering, will apply to all wallet providers and issuers, and that it will expect firms will be required to register under the anti-money laundering registration system for their activities relating to all cryptoassets (in addition to the stablecoin regime).

What will be the requirements for firms?

HMT proposes the following high-level requirements for firms which are carrying out the activities which shall result in them needing to become authorised by the FCA (see Which activities shall be within scope? above for details):

1. Authorisation requirements with associated threshold conditions – the requirement to be authorised prior to operating;
2. Prudential requirements, including capital and liquidity requirements, accounting and audit requirements – requirements relating to effective management of capital and liquidity, to protect consumers and financial stability.
3. Requirements for the maintenance and management of a reserve of assets – obligation to have reserve assets underlying the token’s value and requirements to ensure the quality and safekeeping on those assets.
4. Orderly failure and insolvency requirements – requirements to ensure issuers and service providers are prepared for modified resolution or administration, or insolvency.
5. Safeguarding the token – requirements principally on wallets and exchanges to ensure those entities are appropriately protecting users' tokens and the privacy and security of keys to those tokens.
6. Systems, controls, risk management and governance – requirements relating to effective overall management of an issuer or service provider.
7. Notification and reporting – requirements relating to firms' disclosures to regulators and customers.
8. Record keeping – requirements relating to firms' internal record keeping processes.
9. Conduct requirements – requirements relating to the rights that firms must provide toward customers.
10. Financial crime requirements – requirements relating to proper implementation of anti-money laundering and counter-terrorist financing rules, among others.
11. Outsourcing requirements – requirements relating to safe outsourcing of key services to ensure continuous and adequate functioning.
12. Operational resilience, service reliability and continuity requirements – requirements to ensure business continuity in the event of physical, electronic, governance or other business failures.
13. Security requirements (including cyber and cloud) – requirements relating to safeguards against cyber security risks related to the technology and infrastructure used.

These requirements are similar to those required by payment services firms / electronic money institutions authorised and regulated by the FCA.

Additional requirements

HMT also proposes certain additional requirements for certain types of stablecoins.

The PSR regulates any “payment system” (i.e. system that enables persons to make transfers of funds). Where a stablecoin plays a similar function to existing payment systems, it may be appropriate for it to be regulated by the PSR. The PSR has the power to place requirements on any system designated as a “payment system”.

HMT also proposes that where a stablecoin arrangement reaches a systemic scale, the BoE may undertake an assessment in the same way that current payment systems and service providers are assessed, and decide whether it should fall within its scope. This assessment includes consideration of a firm’s ability to disrupt the UK financial system and businesses based on:

• current or likely volume and value of transactions;
• nature of transactions and links to other systems; and
• the substitutability and use by the Bank of England in its role as monetary authority.

It is also proposed that these criteria should be extended to stablecoins that perform a retail or wholesale payment function. HMT also notes that it is also possible for other service providers, e.g. wallet providers, to pose a systemic risk.

If the BoE decides a firm has reached a systemic scale, it will be subject to additional supervision and requirements imposed by the BoE, such as capital and prudential requirements in relation to assets-linked tokens.

What will be the territorial scope?

The territorial scope of these regulations is still under consideration. However, HMT is considering whether firms actively marketing to UK consumers should be required to (a) have a UK establishment and (b) become authorised in the UK.

The options under consideration are as follows:

1. requiring UK presence and UK authorisation for stable token issuers, system operators and service providers when marketed in the UK;
2. defining the activity conducted in the UK and determining whether UK authorisation is required as a result; or
3. no location requirements.

HMT is also considering location requirements for systemic stablecoin arrangements.

2. Request evidence for the future regulation of other types of cryptoassets.

Security token definition

HMT notes that the definition of security tokens are currently linked to the definitions of a “security” under the current Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (see our previous article on the topic for details), and has requested information on whether any further legal clarification is required in the future or whether this regime leads to specific obstacles, costs, or barriers for participation.

Distributed ledger technology in financial markets infrastructure

HMT notes that distributed ledger technology (“DLT”) can transform the financial markets infrastructure in the UK.

In this respect, it has set out a series of questions with the following aims:

• to understand the benefits and drawbacks of DLT in financial markets;
• what regulatory or legal barriers exist in relation to the adoption of DLT in financial markets;
• industry-wide incentives and challenges in adopting DLT across the financial market; and
• where government or regulator invention might be useful.

Other items

In addition to the above, HMT also sets out in its Consultation that it will be consulting on whether marketing cryptoassets should be considered a financial promotion (see our previous article on this topic for details).

Further, HMT also considers Decentralised Finance (“DeFi”) – a type of finance which is not run by any central authority. HMT states that it does not currently propose to bring DeFi activities into the scope of regulation but has asked for views on the benefits and risks posed by DeFi and whether these developments should be brought within the regulatory perimeter within the future.

Next Steps

The Consultation will close on 21 March 2021.

HMT has not specified when these responses to the Consultation will be considered and the date by which it expects to provide details on its new proposed policies. However, the Financial Stability Board in its recent report on global stablecoins has asked national regulators to deliver a regulatory regime in relation to stablecoins by July 2022.