What has happened?

On the 6 November 2023, the Financial Conduct Authority (FCA), the Bank of England (the Bank) and the Prudential Regulation Authority (PRA) published a package of documents on their proposed approach to regulating stablecoins, including two discussion papers (i.e. one from each of the FCA and the Bank), a letter from the PRA addressed to Chief Executive Officers of deposit-takers (e.g. banks) on the PRA’s expectations, and a joint roadmap paper explaining how the authorities’ regimes will interact.

Regulating stablecoins is the first phase in the UK Government’s plans to introduce a cryptoasset regulatory framework—this set of publications provides a helpful indication on the direction of travel in the development of the UK regime, as well as an opportunity for industry to voice its feedback. Below, we highlight what firms should bear in mind, the key takeaways from each of these important documents, and what comes next.

What should firms be thinking about?

The Bank’s discussion paper acknowledges a number of issues for existing firms arising from its proposals and encourages industry feedback. Issues include, for example, the challenges of estimating the proposed capital requirements due to the novelty of the industry and consequent absence of historical data, and operational challenges of implementing holding limits for each systemic stablecoin in light of the fact that users may be able to use multiple entities to access a given stablecoin.

The FCA’s discussion paper also welcomes feedback on a wide range of issues in order to inform its development of the specific rules in the future regime for fiat-backed stablecoins, such as whether backing assets should only be held in the same currency as the denomination of the underlying regulated stablecoin, as well as whether to permit the use of clients’ cryptoassets held under custody (for example to provide staking services or to hold cryptoassets as collateral).

More broadly, for a firm which is or intends to be providing services in the space of digital money or money-like instruments, such as tokenised deposits, e-money or stablecoins, it will be important to assess at a fundamental level which product category will be relevant to such firms’ activities. As this recent package of publications has highlighted, different instruments present different risks to consumers and to the stability of the financial market—accordingly, different regulatory requirements will apply. Where appropriate, firms should raise by way of feedback to the Bank and/or to the FCA any difficulties that firms may face in making such an assessment—for example, where there is insufficient clarity in the proposed definitions of such instruments.

Key takeaways

The Bank’s Discussion Paper

Among other things, the proposed regulatory regime for systemic payment systems using stablecoins and related service providers set out in the Bank’s discussion paper:

• focuses on sterling-denominated stablecoins because the Bank considers these are the most likely digital settlement assets to be used widely for payments. If necessary, the Bank will consider how the proposed regulatory framework would need to be adapted for non-sterling referenced stablecoins;
• is intended for business models that focus on payments-related activities and innovation within retail payments. Proposed holding limits, if used, would constrain wholesale use of stablecoins at systemic scale;
• would require issuers of systemic payment stablecoins to fully back stablecoins with non-interest bearing deposits at the Bank and to be set up in the UK as subsidiaries in order to carry out business and issuance activities into the UK and with UK-based consumers, both directly and through intermediaries (backing assets and the issuer’s capital would also need to be held in the UK);
• would keep the transfer function or payment system as the Bank’s ‘regulatory hook’, while aiming to be flexible with a view to accommodating different business models in which various functions are performed by different legal entities;

• would require that there is an entity within the payment chain that can be identified as the payment system operator (PSO), with responsibility for performing the transfer function and that—once recognised by HMT—would act as a ‘systemic risk manager’ across the entire payment chain (all in line with the Bank’s approach to the regulation of other systemic payment systems and with international standards);

• in the absence of backstop deposit guarantee scheme and resolution regime arrangements that are available for banks, would require other elements of the regulatory regime for non-bank systemic payment stablecoin issuers, such as backing and capital requirements, to be more robust than for banks to ensure the necessary overall level of protections.

The FCA Discussion Paper

The FCA’s discussion paper sets out a number of proposed requirements in relation stablecoins, particularly with regards to issuers and custodians of ‘regulated stablecoins’ (i.e. fiat-backed stablecoins issued in the UK and in accordance with FCA rules). Amongst other things, the discussion paper:

• reiterates the FCA’s expectations that various aspects of the regime relating to regulated stablecoins (e.g. custody) would likely be mirrored in the future regulatory framework relating to other types of cryptoassets;
• highlights the need to ensure consumers’ rights to redeem stablecoins against the backing asset into fiat at par in a timely manner—in particular, the FCA would require regulated stablecoin issuers to ensure redemption by end of the next UK business day after receiving a redemption request;
• proposes using existing custody provisions in the Client Assets Sourcebook (CASS) as a basis to design bespoke custody requirements for cryptoassets. For example, custodians would be required to segregate clients’ cryptoassets from their own through recording of ownership and wallet labelling, and would be permitted to use an omnibus wallet structure provided that clients’ ownership rights are preserved;
• considers the application of the existing CASS regime in the context of a failure (e.g. an insolvency) of a regulated stablecoin issuer, a firm holding backing assets, or a custodian, and the relevant adjustments that would need to be made—for example, the FCA is exploring whether the DLT could be used to send electronic distribution notices directly to wallet holders;
• expands on HM Treasury’s proposal in its policy statement on the new activity of acting as a ‘payment arranger’ (i.e. the entity facilitating fiat-backed stablecoin payment services)—such payment arrangers would need FCA authorisation and would be regulated under the Payment Services Regulations 2017;
• proposes requiring overseas stablecoins to be approved by authorised ‘payment arrangers’ prior to being used in UK payment chains;
• considers applying existing systems controls requirements (e.g. the SYSC sourcebook) and conduct requirements (e.g. the Principles for Business) to regulated stablecoin issuer, custodians and payment arrangers, as well as a dedicated new prudential sourcebook for regulated stablecoin issuers and custodians (and, in time, other cryptoasset firms).

The PRA’s Dear CEO Letter

The PRA’s Dear CEO Letter addressed to deposit-taking entities (e.g. banks) in relation to innovations in deposits, e-money and stablecoins highlights the risks that may arise in relation to the availability in multiple forms of digital money or money-like instruments. Accordingly:

• the PRA expects deposit-takers to undertake certain measures in order to mitigate such risks, such as by using separate, non-deposit-taking and insolvency-remote entities to issue e-money and stablecoins;

• the PRA expects deposit-takers to be mindful of their existing obligations in a number of areas such as in relation to anti-money laundering and counter-terrorist financing, as well as under the PRA’s Fundamental Rules (e.g. to have effective risk management strategies), and to adjust their methodologies for identifying and addressing the relevant risks where novel digital money products are offered;

• deposit-takers should be assessing the risks of such new innovations in payments at a senior level within their organisations; 

• banks are encouraged to engage with their supervisor(s) with regards to any material developments in planned innovations in the use of digital money or money-like instruments and how they intend on meeting the PRA’s expectations.

The Regulatory Roadmap

The Bank, the FCA and the PRA’s cross-authority roadmap on innovation in payments delineates each regulator’s role in the current and proposed regulatory regimes in three key areas:

• E-money institutions (EMIs): Currently, EMIs are regulated by the FCA for prudential and conduct purposes under the E-Money Regulations 2011 and Payment Services Regulations 2017—as noted in HM Treasury’s recent Call for Evidence, the current e-money regime is likely to be amended. In the future, the Bank could also regulate systemic payment systems based on e-money.

• Stablecoins: The FCA will regulate (for prudential and conduct purposes) non-systemic UK-based issuers of stablecoins, while the Bank will regulate certain ‘systemic’ (as recognised by HM Treasury) payments systems and related service providers. Firms under the Bank’s remit may also fall within the FCA’s perimeter for conduct purposes, as well as within the Payment System Regulator’s (PSR) remit (e.g. as a designated payment system or service provider)—such firms will therefore be subject to requirements imposed under the relevant Bank, FCA and PSR regimes.

• Tokenised bank deposits: Banks will still be regulated by the PRA for prudential purposes and the FCA for conduct purposes. Where a bank also intends to issue e-money or stablecoins, and does so from a separate non-bank entity (in accordance with the expectations set out in the Dear CEO Letter), that entity would then be regulated under the regimes for stablecoins or e-money, but would also be subject to the PRA’s existing banking regulation as applied at consolidated-group level.

What’s next?

The deadline for responses to the two discussion papers is 6 February 2024.

The Bank plans to consider industry feedback to its discussion paper and to consult on the final proposed regime. It flags that the regime could be ‘adapted over time as the nascent industry evolves’. It is also considering the risks and benefits from innovations in wholesale settlement, including the use of stablecoins for wholesale purposes, and will set out its views on this in due course. Similarly, the FCA plans to engage a range of stakeholders in discussions and to consider industry feedback in developing specific policy proposals, and to draft appropriate new Handbook rules for consultation.

Banks should also consider whether there is a need to engage with and/or update their regulatory supervisors, in accordance with the expectations set out in the PRA’s Dear CEO Letter.

For additional insights on the future regime covering stablecoins, keep an eye out for our forthcoming ‘deep dive’ articles on the two discussion papers and the PRA’s letter—and for more digital content or to contact a team member, visit the Hogan Lovells Digital Assets and Blockchain Hub. Whether it's to find out the latest regulatory developments, or learn about new applications of the technology, we have you covered.

Authored by John Salmon, Christina Wu, Virginia Montgomery, and Alex Nicol