UK moves to regulate 'stable tokens' with EU cryptoasset reform looming

The Treasury's plans, set out in a consultation on the UK regulatory approach to cryptoassets and stablecoins would maintain the Financial Conduct Authority's (FCA's) classification of cryptoassets but add to this a new form of regulated cryptoasset, the 'stable token' – commonly also referred to as stablecoin. In doing so it is seeking to improve certainty for stablecoin users and the market and to address risks likely to arise on the developing market if such tokens remain outside the regulatory perimeter.

The Treasury proposals in detail

Stablecoins, as the name suggests, are digital assets created with minimal price volatility in mind. They aim to achieve this either by backing the stablecoin with collateral, such as an asset or basket of assets or by using gold or a fiat currency, or doing so algorithmically so that issue and redemption of the token matches demand. 

The FCA has previously sought to classify cryptoassets into three categories: e-money tokens, which fall subject to regulation under the Electronic Money Regulations; security tokens, which are cryptoassets with the characteristics of specified investments and so are effectively regulated investments in digital form; and unregulated tokens, namely utility tokens used to access a service or exchange tokens, such as bitcoin, that can be used for payment.  The proposal to establish the new regulated stable token category would apply to tokens that seek to stabilise their value volatility by reference to other assets as well as other payment tokens and tokenised central bank money. 

Although many cryptoassets are currently underpinned by distributed ledger technology, the Treasury proposal is technology "agnostic" to ensure market and technological developments to this form of cryptoasset would not remove it from the scope of regulation.  The government is seeking views from the market on the need to balance "a more granular classification or taxonomy of tokens", while also seeking both to "future-proof" and retain flexibility for new developments in this space so they too would fall subject to regulation.

The consultation itself acknowledges the rapid pace of change in this area that has been accelerated not only by evolving technology and innovations but by changing consumer needs and expectations, including as a result of the coronavirus pandemic. This work sits alongside more practical day-to-day work by regulators in relation to heightening awareness of cryptoassets being used in scams and with the ongoing sandbox initiative which the FCA instigated as a controlled environment where such technological advances could be tested and fostered.

The consultation sets out the three objectives government proposes for approaching regulation of cryptoassets: financial stability and market integrity; consumer protection; and promoting competition and innovation. These are accompanied by three principles – ensuring the regulatory approach is proportionate in its focus on risks and opportunities, agile and applies a 'same risk, same regulatory outcome' approach. The expectation is the current division of responsibilities among the UK's regulators, the FCA, the Payments System Regulator and the Bank of England, would be retained.

As the consultation explains the focus here is to level the playing field, reduce arbitrage opportunity with regulators adjusting or adding to existing requirements to address resulting risks germane to this particular type of asset and activities connected to it. Where the regulatory perimeter lies would be set by government leaving the regulators filling in the detail for firms within the perimeter. The extent to which the UK's approach should take on board the approaches other jurisdictions are taking in this area is also an aspect on which government is seeking feedback. In this context, the consultation refers specifically to the EU's proposed Market in Cryptoassets regulation (MiCA).

In terms of setting the perimeter, the government's overall goals are risk management around use of tokens that can be used as a means of payment, while fostering responsible innovation alongside competition. The regulations should be flexible enough to accommodate new entrants to this category or new technological approaches such tokens might employ. However, the proposal currently up for discussion envisages leaving bitcoin and other tokens that are not currently regulated  but are used primarily for what government refers to as "speculative investment purposes" outside the perimeter for now.  Utility tokens would remain outside as well.

The stated government priority is to regulate those tokens that could be used for transactions "reliably" – namely those that are considered a sufficiently stable way to make payments because of their reference asset. There is a slightly layered approach as to which tokens are in scope. Because of the requirement for the token to be a reliable means of transactional payment for both retail and wholesale purposes, stable tokens referenced to fiat currency are most likely to achieve this required degree of stability but algorithmic stablecoin will not. They are considered more akin to unbacked exchange tokens, so proposals currently on the table for stable tokens will not apply to them. The proposal is that tokens that could be used for retail or wholesale transactions are to be subject to minimum requirements.  Tokens that would not satisfy the stability requirements could then be subject to restrictions on marketing or promotion.

Another key regulatory question to address is around the security of stable tokens' reserves. This is particularly acute where such a token is envisaged to be used in transactions on a systemic scale. The consultation also raises the question of location and whether a presence in the UK and UK authorisation should be a requirement for issuers of stable tokens and other service providers that market in the UK.

There would be a phased, two-step process for the introduction of regulation. First, the government has proposed that a regime would be introduced for stable tokens used for payment covering their issuers, and firms that provide services related to them to consumers.  In the second phase the government would consider whether to bring "a broader set of cryptoasset market actors or tokens into an authorisation regime". Such "actors" could include decentralised finance platforms and the activities connected with them and the currently unregulated exchange tokens being used in the retail market for speculative investment.

The proposal sets out a list of indicative regulated activities. The activities proposed to be regulated touch on the familiar areas from the current regulators' rulebooks but made bespoke to the specific requirements for stable tokens. So they would catch firms that issue, create or destroy tokens as well as those that validate or execute transactions in them, stabilise their value, transmit funds, provide custody or administration services for stable tokens for third parties in particular to address holding their private keys, or exchange stable tokens into traditional currency. There would also be requirements around such firms' conduct, record keeping, outsourcing, and with respect to operational resilience and financial crime. The proposal also envisages orderly failure and insolvency regimes and it will be interesting to see if learnings driving the special administration regime currently proposed for payment and e-money institutions, notably in light of the slow return of funds to customers under current insolvency arrangements, will have a bearing here. 

In whatever way the proposals are finalised it is clear increasing use of new payment technologies stimulated by the Covid-19 pandemic, alongside the nascent market for cryptoasset "investment" has given policy makers in the UK and beyond, added impetus to drive forward regulation in these areas.

Parallel developments in the EU

As part of a wider digital finance package, the European Commission set out proposals last autumn for legislation that would apply to all cryptoassets currently falling outside existing financial services legislation. The measures are aimed at protecting consumers and the integrity of the digital finance market.

The Commission is proposing to regulate entities issuing cryptoassets and those providing services in relation to them, such as custodian wallet providers, or those running cryptoasset exchanges or trading platforms. The Commission is also proposing rules to prohibit market abuse, such as insider dealing and market manipulation, on secondary cryptoasset markets.

The legislative package also includes a proposal for a regulation on distributed ledger technology (DLT) market infrastructures, which the Commission refers to as the 'pilot regime'. This would enable multilateral trading facilities (MTFs), and central securities depositories proposing to run DLT market infrastructure, to seek temporary exemption for up to six years from existing regulatory requirements that could impede them developing processes for transactions in cryptoassets qualifying as financial instruments. The insights gained from the pilot should help the Commission evaluate whether changes to the regulatory framework are needed and whether there is demand for a wider or permanent regime to cover this area of the market.

The business impact of regulation

The EU's focus is to create certainty for cryptoasset market participants and users on how all cryptoassets are to be regulated. This includes cryptoassets that are unregulated at the moment, such as utility tokens and stablecoins as well as those that are already within the regulatory regime as they are categorised as e-money or financial instruments. The proposals will also bring previously unregulated cryptoasset issuers and service providers into the EU's financial services regulatory arena. There are proposals for authorisation of such issuers and to impose a base-level of standards on their operations, as well as bring a degree of uniformity to their disclosure requirements.

Under the proposals in the MiCA regulation, cryptoasset service providers will be required to have a physical presence in the EU. They must be authorised by a national competent authority before commencing business activities and must satisfy capital requirements. Governance standards will also apply, IT requirements are proposed to prevent hacking and cyber theft, as are requirements for segregating client assets from those of the service provider.

For cryptoasset issuers the proposal would require them to publish a white paper containing information on the particular cryptoasset, describing the issuer and providing information on the project, the proposed use of funds raised, any applicable conditions, along with rights, obligations and risks. Issuers of asset-referenced tokens are also to be authorised under the proposals with rules proposed on governance, conflict of interests, disclosing their stabilisation mechanism, investment rules and requirements for the white paper.

The EU's proposals for cryptoasset service providers would result in such businesses complying with prudential and organisational requirements. There would also be rules for these businesses on safekeeping clients’ funds, handling complaints and conflicts of interest.

Importantly, the EU's package includes a passport – so cryptoasset service providers authorised in one EU member state would be able to operate throughout the single market in the EU. Supervision would be carried out by the competent authority where the service provider is based and divided between competent authorities in the member states where activities are carried on cross-border, of which one will be nominated as a single contact point.

Because of their potential risk to financial stability and consumer protection across member states, the European Banking Authority will supervise issuers of significant asset-referenced tokens – stablecoins.

A digital euro?

Since the Commission published its digital finance package, the European Central Bank (ECB) published its own report exploring the possibility of issuing a digital euro. In the report, the ECB set out criteria that a digital euro would have to meet to provide users with a safe form of central bank digital money and has recently closed its public consultation. A decision by the ECB on whether or not to start a digital euro project addressing design and technical issues relevant to a central bank digital currency in case one is to be launched, is not due until the middle of 2021.

The issuance of a central bank digital currency would represent a major shake-up. The ECB's stated intention is that a digital euro would sit alongside physical money and payment innovations from the private sector, but issuing a central bank digital currency could lead to a fundamental reassessment of how business and society as a whole thinks about money and transacts.