The pending regulations of stablecoins

Posted: 26/07/2022

Introduction

There is currently no legislation in place as to how digital assets should be dealt with or regulated. The English High Court has for some time now accepted the UK Jurisdiction Taskforce’s views[1] that cryptocurrencies are classed as a type of property and should be treated accordingly[2]. A recent High Court ruling[3] also confirmed that non-fungible tokens (NFTs) are also a form of property and can, therefore, be protected in such a way.

The Law Commission[4] similarly reached the conclusion in November 2021 that no legislative reform is necessary for smart contracts, blockchain, distributed ledgers and cryptocurrencies and that the English common law is able to facilitate and support these emerging technologies.

Despite this, the lack of legislation and regulation has left many confused as to how to treat digital assets. Not only are many companies struggling to determine whether or not their activities and services relating to digital assets fall within the regulator perimeter, but many individuals are also falling victim to crypto or NFT scams and frauds with little to no protection and limited recourse.

The government has therefore considered the UK’s legislative and regulatory framework around this growing asset class and its underlying technology and is now moving to change the position to offer greater clarity and protection. This could not have come at a better time considering the recent ‘crypto winter’ that largely caused the crash of certain algorithmic stablecoins.

What is a stablecoin?

A stablecoin is a form of cryptocurrency whose value is pegged to fiat currency. As such, a stablecoin is, in theory, more stable than other cryptoassets and is more akin to traditional payment instruments in comparison to more traditional types of cryptocurrency such as Bitcoin, which are typically used for investment. Stablecoins are now being widely used as an entry into cryptocurrency. Depending on the way in which they are designed, stablecoins may already be subject to UK financial services regulation, although many are currently not in scope.

Background

A consultation and call for evidence were launched by the UK government in January 2021 to understand how the government and regulators could ensure that the UK’s regulatory framework is equipped to harness the benefit of new technologies and to support innovation and competition, while mitigating risks to consumers, market integrity and financial stability.

HM Treasury’s response to the consultation was published in April 2022, outlining the government’s intention to bring stablecoins, when used as a means of payment, into the regulatory permitter.

The Financial Services and Markets Bill

The UK government subsequently released the Financial Services and Markets Bill on 20 July 2022 for its first reading. The 335-page bill claims 'to make provision about the regulation of financial services and markets; and for connected purposes'. However, the part of the bill that is of crucial importance to the blockchain community and those using digital assets is its focus on imposing legislation and regulation about 'digital settlement assets' as this is a new concept that has not previously been defined in legislation.

The bill refers to 'digital settlement assets' (DSAs) which are defined as a digital representation of value or rights that - regardless of whether they are cryptographically secured or not:  

• can be used for the settlement of payment obligation;
• can be transferred, stored or traded electronically; and
• uses technology supporting the recording or storage of data (which may include distributed ledger technology).

The definition of a DSA is therefore very wide and goes beyond digital assets that are recorded on a blockchain, such as cryptocurrency and NFTs. As this type of asset class is nascent, the bill grants HM Treasury a power to amend this definition in the future as the underlying technology or the use of these assets continues to develop.

The UK government has planned to regulate this space on a staged basis. It currently seeks to bring activities facilitating the use of certain stablecoins, where used as a means of payment, into the UK regulatory perimeter primarily by amending the existing electronic money and payment system regulatory frameworks.

The bill therefore seeks to implement a regime which allows for the clear identification of the applicable regulatory requirements where a payment system using DSAs or DSA service providers is recognised as being systemic by HM Treasury.

The bill affords HM Treasury powers to make regulations connected with:

• (a) The regulation of payments that include digital settlement assets.
• (b) The regulation of:
  • (i) recognised payment systems that include arrangements using digital settlement assets;
  • (ii) recognised DSA service providers; and
  • (iii) service providers connected with, or in relation to, the systems and providers of (i) and (ii) above; and
• (c) making insolvency arrangements (including administration, restructuring and any similar procedure) in respect of the systems and providers mentioned in paragraph (b) above.

The breadth of the regulations that HM Treasury can make is also extremely wide to include:

• The regulation of electronic money and payments to DSAs.
• Insolvency arrangements and interactions between different arrangements to the systems and providers of those dealing with electronic money and payments to DSAs.
• Conferring powers on HM Treasury (including a power to legislate).
• Conferring powers on, or imposing duties, on a relevant regulator.
• Fees or other charges payable to a relevant regulator.
• Recognition orders and recognition criteria in part 5 of the Banking Act 2009.
• The enforcement of obligations arising under or by virtue of the regulations.
• Appeals in respect of decision made under or by virtue of the regulations.
• The sharing of information.

The bill also permits the regulations relating to the enforcement of such obligations to create criminal offences punishable on summary conviction with imprisonment of up to three months, a fine or both in England and Wales and similar in Scotland and Northern Ireland.

Before any such regulations are created, however, HM Treasury must consult with the FCA, the Bank of England and – to the extent that the regulations refer to them - the PRA or the Payment Systems Regulator.

In much the same way as the FCA’s Regulatory Sandbox operates, the bill also creates an environment in which a Financial Markets Infrastructure Sandbox can take place to assess the efficiency and effectiveness of the practices adopted in the issuance, trading or settlement of financial instruments, which could conceivably include digital assets.

HM Treasury said in a press release: 'In fostering these new innovations, the Bill will also enable the creation of Financial Markets Infrastructure Sandboxes – allowing firms to test the use of new technologies and practices in financial markets, increasing efficiency, transparency and resilience of new products.'

The bill may take some while to be implemented into primary legislation in the UK as it has only recently had its first reading, with the second reading due to come before Parliament on 7 September 2022. After the second reading, it will go to a committee to review and report upon before coming back before Parliament for the final third reading. Once completed, the process the repeats itself in the House of Lords before any amendments are considered and the bill (in whatever form) receives royal assent to become UK legislation, doubtless supported by secondary legislation which is yet to be prepared.

Conclusion

The regulation of stablecoins became a pressing priority following the market crash in May 2022 which led to the ‘crypto winter’. This was said to be largely caused by the crash of Terra, an algorithmic stablecoin, which then crashed the value of Bitcoin and the market more generally. Since then, various exchanges and crypto companies have gone into liquidation, with some of the largest, global exchanges pausing trading for a short time and having to make large numbers of their staff redundant.

The market is therefore likely to welcome some regulation of the riskier parts of the digital asset landscape to offer consumers protection, providing that it does not stifle innovation or seek to control the way in which blockchain and distributed ledgers work (ie by consensus, without one controlling party). How the regulation transpires and whether it ends up stifling innovation or undermining the very reasons why the DeFi community came together in the first place remains to be seen.

As explained above, however, the regulation of stablecoins is just the first stage of the UK government’s intended approach to this growing asset class and the wider industry. It intends to launch a further consultation on its regulatory approach to wider cryptoassets beyond stablecoins used for payments, including those primarily used as a means of investment such as Bitcoin or Ether later in 2022. So watch this space.

[1] See the Legal Statement on Crypto assets and Smart Contracts published by the UK Jurisdiction Taskforce in November 2019. 

[2] See, for example, AA v. Persons Unknown [2019] EWHC 3556 (Comm)

[3] Osbourne v. Persons Unknown and Ozone Networks Inc [2022] EWHC 1021 (Comm)

[4] In Law Commission Paper No 401 entitled 'Smart legal Contracts – Advice to Government'

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