UK Government Responds to Submissions on Cryptoassets Regulation - Part 1

The UK Government has published three documents that expound on its plans for the regulation of certain cryptoassets, including fiat-backed stablecoins used for payments:

• Update on Plans for the Regulation of Fiat-Backed Stablecoins (the Update)
• Future Financial Services Regulation of Cryptoassets: Response to the Consultation and Call for Evidence (the Response)
• Managing the Failure of Systemic Digital Settlement Asset (including Stablecoin) Firms: Government Response to Consultation (the Systemic DSA Firm Paper)

Together, these releases advance understanding of the Government's approach. However, none of them respond fully to the calls for clarity and detail made by industry participants. Instead, they confirm the policy direction previously set out by the Government and the programme for secondary legislation and rule-making by the UK regulators. This information will be helpful to market participants, and there is much to commend the UK approach overall; however, firms establishing or growing cryptoasset businesses in the UK are likely to have questions about their regulatory position unanswered until draft legislation has been revealed.

The three main take-aways from the papers are that:

1. The UK approach to regulation is designed to be more flexible than the corresponding European Union (EU) rules under the Markets in Crypto-Assets Regulation (MiCAR). For example, the Government has highlighted avoid fragmenting liquidity through onshoring requirements.
2. The Government is not in a rush to set rules for the wider cryptoasset market. It intends to ease into regulation, starting with fiat-backed stablecoins and using the lessons learned to shape the requirements for other cryptoasset issuers and service providers. Further work by the Financial Conduct Authority and Bank of England is at the core of the project.
3. The Government is sensitive to the special features of cryptoassets as a novel asset class. Broadly, the incoming rules will be aligned with the framework established by, for example, the Financial Services and Markets Act 2000 (FSMA 2000); but it is recognised that the direct application of existing rules is not appropriate in every case.

It is important to note that the Government has previously set out a staggered approach to regulation of cryptoassets, which will focus on fiat-backed stablecoins used for payments in Phase 1 and on the activities of exchanges, custodians, and other intermediaries for other cryptoassets in Phase 2. The Government intends to lay secondary legislation for Phase 1 in early 2024 and Phase 2 later in the year.

This note is in two parts, which draw out the points that are made more certain by the Response and Update. In this first part, we consider the approach to fiat-backed stablecoins described in the Update and the scope of regulation set out in the Response and Systemic DSA Firm Paper. In the second part, we look at the other issues raised in the Response.

A. Treatment of Fiat-Backed Stablecoins

1. Issuance

Unlike the EU, which created separate categories of stablecoins under MiCAR for single-currency and multiple-asset backed stablecoins, the UK will focus, in the first instance, on stablecoins backed by one or more fiat currencies. The Government intends to regulate the issuance of these stablecoins in or from the UK through amendments to the Regulated Activities Order (RAO). Accordingly, issuers will need to have permissions under Part 4A of FSMA 2000. The product will be treated distinctly from other forms of digital money, such as e-money or tokenised deposits, which are subject to different rules.

The Update notes that the FCA will develop rules on the constitution and management of reserve assets used to back in-scope stablecoins, as well as the prudential obligations of issuers. HM Treasury will ensure that the FCA (and the Bank of England, as necessary) will have the power to require that reserve assets are held in a statutory trust for the benefit of the holders of the relevant stablecoin. Further consultation on these matters, as well as the redemption rights of stablecoin holders and distribution rules, is expected in due course.

In order to protect the interests of fiat-backed stablecoin holders on the insolvency of the issuer, the Government intends to extend the powers granted to the FCA under Part 24 of FSMA 2000 to participate in the insolvencies of authorised firms. Systemic issuers of digital settlement assets (DSAs; ie, a class of assets used for payment which includes fiat-backed stablecoins) will become subject to the Financial Market Infrastructure Special Administration Regime (FMI SAR). Special insolvency rules for non-systemic issuers remain under consideration.

2. Custody

The Government intends to add a new activity under the RAO of safeguarding, safeguarding and administering, arranging safeguarding, and arranging safeguarding and administering of UK-issued fiat-backed stablecoins. The FCA will make rules for their custody under secondary legislation. Based on the corresponding activity for securities and contractually based securities under Article 40 of the RAO, this will become the template for the custody of other relevant cryptoassets in Phase 2 of the Government's regulatory programme. Some changes are expected, as between Phase 1 and Phase 2 assets; but, given their similar features, custody of security tokens and UK-issued, fiat-backed stablecoins will be on the same basis and regulated in Phase 1.

As for UK-based issuers of fiat-backed stablecoins, the FCA will have powers, in the case of the failure of a custodian for the same assets, to participate in insolvency proceedings. The FMI SAR is intended to apply to the failures of systemic DSA custodians.

Custody arrangements for stablecoins used for buying and selling cryptoassets on exchanges are not included in Phase 1. They will be addressed in Phase 2, together with other cryptoassets.

3. Payments

Payment chains involving fiat-backed stablecoins will be brought within the Payment Services Regulations 2017 (PSR 2017) when they fit one of two patterns:

• "mixed stablecoin payments": on ramp = stablecoin -> converted to fiat -> off-ramp = fiat (or vice-versa)
• "pure stablecoin payments": on-ramp = stablecoin -> transfer of value = stablecoin -> off-ramp = stablecoin

In order to come within scope, the relevant payments would need to involve UK consumers, where at least one end of the payment is in the UK. Where UK firms are facilitating payments, the rules would apply, whether or not there was a UK end to the payment.

Peer-to-peer payments using cryptoassets, which are not on a commercial basis, would not be captured by the rules. Purchases of stablecoins using fiat currency are already captured by PSR 2017, so would not be subject to new requirements.

These rules would apply to UK-issued fiat-backed stablecoins; the issuance of which is subject to authorisation under the RAO. The use of ex-UK issued fiat-backed stablecoins will be the subject of further deliberation and consultation. The Government is considering an approach that will require a UK-based payment arranger (eg, the provider of cash-point systems to take payments in non-UK stablecoins) to be FCA-authorised and to ensure that any non-UK stablecoin facilitated by it meets the requirements of the UK regulatory system. Although other cryptoassets may continue to be used in payment systems, this will be on an unregulated basis. The Treasury and FCA are considering the communications to be given to consumers about the risks of such unregulated payments.

4. DSA Payment Systems and Service Providers

The Bank of England is expected to issue a discussion paper that will address matters specific to the operators of systemic payment systems for DSAs, along with service providers to them (eg, issuers, exchanges, and custodians) and systemic DSA service providers. These matters have been added to its competency through the Banking Act 2009, and the scope includes both UK- and ex-UK issued stablecoins. The Payment Systems Regulator will also acquire similar powers for DSA payment systems. A paper on effective co-supervision, in circumstances where an FCA-authorised fiat-backed stablecoin firm has been designated as systemic by HM Treasury and lead supervision responsibility has passed to the Bank, is also expected.

In the Systemic DSA Firm Paper, the Government confirmed its intention to use the FMI SAR as the primary insolvency regime for systemic DSA firms. A new objective, requiring the return or transfer of client assets, will be added through legislation, along with an accountability framework for the Bank. In parallel, the Government is looking at changes to the Settlement Finality Regulations 1999, in order to extend their provisions to systems involving the transfer of DSAs.

B. Response to Consultation and Call for Evidence

1. Scope of Regulation for Cryptoassets

Distinction Between Financial Instruments and Cryptoassets

The UK Government does not intend to treat cryptoassets as if they are, as a whole, financial instruments. To the extent that cryptoassets represent digital forms of specified instruments, financial instruments, or e-money, they are to be regulated on the same basis; albeit, with appropriate changes. Some amendments to existing rules will be made through the upcoming Digital Securities Sandbox, which will allow financial market infrastructures (eg, trading platforms and central securities depositories) to support trading of in-scope security tokens while the relevant legislation is recalibrated as necessary.

Unlike the EU, which created a bespoke framework for the regulation of cryptoassets in MiCAR, the UK intends to make incremental reforms to existing laws. Through changes to FSMA 2000, implemented by the Financial Services and Markets Act 2023 (FSMA 2023), the Government has already acquired broad powers to regulate activities involving cryptoassets. Its Phase 2 regulation will address issuance and intermediary activities for a wider category; building on the work done for fiat-backed stablecoins.

By amending the definition of "specified investments" in Part III of the Regulated Activities Order, the Government intends to require firms undertaking cryptoasset activities by way of business to obtain authorisation under Part 4A of FSMA 2000. The new Designated Activities Regime (DAR), brought in by FSMA 2023, will allow for rules to be made that are more suitable for cryptoasset-related activities than the existing framework for financial instruments. Firms that have registered under the UK's anti-money laundering regime will need to consider whether they will need to obtain Part 4A permissions.

Investment Advice and Discretionary Investment Management

The Government sought evidence on the need for the regulation of investment advice and discretionary portfolio management involving cryptoassets. Although there was sentiment in favour of bringing these activities within the regulatory perimeter – as the EU has done with MiCAR – the Government has opted to keep this question under review.

Investment vs Gambling

In May 2023, the Treasury Select Committee suggested that the Government ought to treat the purchase and sale of unbacked cryptoassets as a form of gambling. The Government replied by pointing to the confusion that would be created by treating cryptoasset investments as bets. In the Response, it has maintained its view that cryptoasset trading would be best addressed through the application of a set of rules that is aligned with that applicable to financial instruments.

Permissioned vs Permissionless Distributed Ledger Technology

The Government has opted to take a technology-neutral approach to regulation, so far as practicable. In relation to permissionless blockchain systems, the preferred approach is to require any associated risks to be addressed and disclosed by intermediaries in Phase 2, rather than to impose restrictions. Some limitations are still possible, when risks are identified by regulators that are unacceptable.

Geographical Scope

The rules proposed by the Government generally will apply when a regulated activity is undertaken in or to the UK by a person by way of business. Given the global nature of many cryptoasset businesses and DLT systems, this creates a concern about the possible fragmentation of liquidity between UK and non-UK participants. The Government is opposed to opening the overseas persons exclusion (OPE) to include cryptoasset-related activities. It does, however, recognise that there may need to be time-limited arrangements to facilitate market access before any mutual recognition (ie, equivalence) arrangement is in place with another jurisdiction. It defers to the FCA to look at how this could be set up (eg, through branching into the UK of trading venues operated overseas by UK firms, for the purposes of trade matching and execution only).

Vertically Integrated Business Models

Although the development of vertically integrated business models (eg, exchanges with custody functions) has been questioned, the Government is not minded to impose structural requirements on such operations. Instead, it points to the need to meet the requirements prescribed for each particular activity, as well as an over-arching need to address conflicts of interest – particularly with respect to tokens issued by the integrated firm. The position will be kept under review.

Asset-Referenced Tokens and Algorithmic Tokens

The Government had sought views on the treatment of two types of stablecoins that are not fully backed by fiat currency – asset-referenced tokens and algorithmic tokens. Its view is that these are both best addressed within the framework for general cryptoassets, rather than under a specialised regime.

NFTs and Utility Tokens

Two other types of cryptoasset, non-fungible tokens (NFTs) and utility tokens, are expected to fall within the FSMA regime only when they are being used for investment purposes. This functional approach asks how the cryptoassets are being used, rather than how have they been designed or marketed.

To continue reading part 2, please click here.