Cryptoassets in the Financial Services sector – increased consumer protection inbound?

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In February 2023, the UK Government announced its intentions to legislate  a forthcoming regulatory framework for cryptoassets in the financial services sector. The proposed strategy involved a step-by-step implementation, with the primary emphasis on fiat-backed stablecoins (stage 1) that could serve as a payment method, followed by the broader cryptoasset regime (stage 2). The Government described the changes as an opportunity to give cryptoasset firms the clarity to invest and innovate,  providing much needed protection for consumers.

What are fiat-backed stablecoins?

In October 2023, the Government published the response to its February 2023 Consultation and call for evidence, as well as a Policy Update on how it intends stablecoins to be regulated. HM Treasury indicated in its Policy Update that it will define fiat-backed stablecoins as a cryptoasset that seeks or purports to maintain a stable value by reference a fiat currency and by holding fiat currency, in whole or in part, as backing.  

The Treasury is also contemplating amendments to payments legislation to facilitate retail transactions for goods and services using fiat-backed stablecoins. This involves exploring the possibility of permitting certain stablecoins issued outside the UK (overseas stablecoins) for payment purposes.

The FCA’s involvement

In line with the Government’s proposals, the FCA will oversee the issuance and custody of fiat-backed stablecoins under the Financial Services and Markets Act 2000, and regulate the use of stablecoins for payments, under the Payment Services Regulations 2017 (PSRs).

The FCA’s Discussion Paper, published in November 2023, was aimed at supporting the development of its regulatory regime for fiat-backed stablecoins.

The Discussion Paper is one component of a publication package alongside the Bank of England’s Discussion Paper and the Prudential Regulation Authority’s Dear CEO letter, which focuses on innovative applications of deposits, e-money, and regulated stablecoins.

To accompany these releases, the FCA has concurrently published a joint ‘Roadmap paper’ with the Bank and Prudential Regulation Authority, which aims to explain the FCA’s proposed regulatory frameworks and outlines the approach to dual regulation. It affirms that regulation will incorporate all non-systemic UK-based issuers of stablecoins and custodians (including those who provide custody services in the UK and to UK-based customers). It indicates that the Treasury is looking at how coins issued outside of the UK can be incorporated into UK payment chains (under a regime aimed at “payment arrangers”).

Why is there a need for regulation? The perceived risks and harms associated with stablecoins

In its Discussion Paper, the FCA states that the risks associated with stablecoins encompass several key areas. Firstly, concerns arise from the lack of transparency regarding the backing assets of stablecoins, with information often being incomplete or opaque. This opacity poses a challenge for market participants in assessing stability and the availability of backing assets, potentially leading to risks for consumers if assets are insufficient or unavailable. The interconnectedness of stablecoins with traditional finance further accentuates these concerns.

Redemption issues are notable, as most issuers restrict redemption to wholesale users, leaving retail consumers reliant on secondary market trading, which may result in losses during depegging events (i.e.  where the stablecoin loses value relative to its “pegged value”, which is usually an underlying fiat currency).

Custody-related risks may stem from poor safeguarding arrangements, leading to potential loss, hacking, and delayed returns. Additionally, stablecoins may attract money launderers seeking stability and an off-ramp to fiat currency, while consumer risks include misunderstandings, fraud, and scams. As stablecoins are considered for wider usage in payments, concerns include the assurance of funds reaching merchants efficiently, transparency in transactions, and potential risks in the payment chain, necessitating clear accountability and conduct requirements.

The new stablecoin regime

The Treasury has outlined its intention to regulate certain fiat-backed stablecoins to facilitate their use in everyday transactions, with the aim of mitigating observed market risks, establishing consumer protections, enhancing market integrity, and addressing risks associated with backing assets. It wants to see stablecoins with appropriate backing assets, that are always safeguarded, and are redeemable in fiat at par value by the holder. It seeks regulation that will ensure positive outcomes for consumers using stablecoins, establish a resolution regime for failing cryptoasset firms, maintain stablecoin value, adopt innovation within a secure legal framework, and align with recent policies on cryptoasset financial promotions to provide transparent and fair information to consumers.

Regulating payments using stablecoins

The Treasury is considering amendment to payments legislation, to accommodate the use of stablecoins as payment instruments in the UK. While the PSRs regulate the transfer of funds, including electronic money, they do not currently cover transfers involving cryptoassets like stablecoins, unless defined as electronic money.

As a result, hybrid business models have emerged, integrating traditional payment services with stablecoins for converting cryptoassets into fiat. Stablecoins are primarily used within cryptoasset exchanges rather than for real-world payments. The proposed regulatory framework aims to secure positive outcomes for consumers using stablecoins for payments, ensure the safety of stablecoin payment services, and adapt a level playing field for competition and innovation. The suggestion is to extend the PSRs to cover two stablecoin payment models: the hybrid model involving fiat transfer through traditional payment services, and the pure stablecoin model, where both parties transact in stablecoin.

Peer-to-peer stablecoin transfers without a commercial basis are excluded from regulation, while transactions involving other cryptoassets remain unregulated or partially regulated depending on fiat conversion.

Conclusion

The FCA’s Discussion Paper outlines the proposals for how the regulatory framework will work and what issuers and custodians can expect under the new regime. The Treasury and the FCA’s primary goal is to mitigate the identified risks and harms in the market, while ensuring consumer protections and upholding market integrity.

The Discussion Paper sought feedback to understand the potential impact on existing business models, market dynamics, associated costs, and any overlooked market developments or unintended consequences.  The consultation closed on 6 February 2024, with further consultation likely to take place prior to any final rules being adopted. The regulators’ roadmap currently anticipates final implementation of new regimes in 2025.

If your business requires assistance or further information about the future of cryptoasset regulation, please get in touch with our Financial Services team.