The FCA has been preparing to regulate 'stablecoins' for a lot longer than other types of cryptoasset, and is currently
consulting on the detailed rules for issuance/offer of qualifying stablecoins, the holding and management of the backing assets, and
key information that issuers will need to disclose.plan to consult separately on proposals for managing cryptoasset firm failure,
including qualifying stablecoin issuers. This (evolving) post is a summary for information purposes. If you would like legal advice on the potential issues and impact,
please let me know.
Terminology
"Qualifying Stablecoin" is defined in a new section 88G of the FSMA (Regulated Activities) Order (RAO) as:
a 'qualifying cryptoasset' [see s88F RAO - this excludes a cryptoasset that is already a specified investment of some kind, e-money, a fiat currency, a central bank digital currency or used in a limited network (similar to the exclusion from e-money/payment services] that:
(a) references a fiat currency; and
(b) seeks or purports to maintain a stable value in relation to that referenced fiat currency by the issuer holding, or arranging for the holding of:
(i) fiat currency; or
(ii) fiat currency and other assets,
irrespective of whether the holding of a fiat currency other than the one referred to in sub-paragraph (a) or other asset contributes to the maintenance of that stable value.
However, this will not include a tokenised bank deposit (we'll discuss the concept of 'tokenised e-money' below].
"Issuing" a qualifying stablecoin in the UK involves the issuer only accepting (a) money; or (b) other qualifying stablecoins issued by FCA-authorised firms, in exchange for qualifying stablecoins they issue. Where issued in exchange for money, it follows that the stablecoin they might also qualify as e-money; and this is pretty much how the FCA is treating them, albeit as a distinct form. Unlike [other] e-money, qualifying stablecoins
form a subset of qualifying cryptoassets; have a secondary market value [so does e-money, where it turns out too little cash is safeguarded], and the issuer can mint tokens before receipt of funds from token holders [like prepaid/smart cards?]. The FCA proposes to consult on guidance further clarifying the differences once legislation is passed.
"Creating" includes the technical design of a qualifying stablecoin on any form of DLT, including on private, public, permissioned or permissionless
blockchains. Issuers must identify and manage the risks associated with 'creation' (the design
and build of a qualifying stablecoin) before it is issued. This includes analysing the risks of
the underlying DLT and making sure they can manage potential disruptions
"Minting" a qualifying stablecoin such that it first exists as an identifiable asset on the blockchain in a transferrable form - an issuer must always hold backing assets in amounts equivalent to the value of the stablecoins that have been minted (1:1 in a single fiat currency, regardless of how the backing assets might perform in the markets for those types of assets). The jury is out on whether multi-currency stablecoins will be permitted, as they introduce FX and liquidity risks and the fact that 'par' would be judged against a basket of currencies, yet redemption could only be in one, thereby crysalising losses/gains.
"Burning" or permanently removing the stablecoin from circulation (on the blockchain).
Backing Assets
Only certain asset classes can be used to 'back' a stablecoin, including on demand deposits; and government treasury debt instruments that mature in one year or less. This is because the composition of the 'backing asset pool' must be able to meet requirements for redemption at all times and ensure that the qualifying stablecoin maintains stability.minimum ‘floor’, known as the on-demand deposit
requirement (ODDR), for the proportion of backing assets that must be held in bank
deposits that are available on-demand. The ODDR is set at 5% and will apply to all
stablecoin issuers - both those who only use core backing assets and those who opt-up
to use expanded backing assets (who would also need an appropriate backing asset risk management
tools and comply with the backing assets composition ratio (BACR) that has a core requirement (CBAR) and an estimated 'daily redemption amount (DRA) for each of the up-coming 14 redemption days, by reference to the experience over the prior 180 redemption-day period, with increases in the CBAR for each redemption day where the actual DRA is at least 110% of the forecast DRA. The intention is that core backing assets should be sufficiently liquid to meet
redemptions within the T+1 timeframe. Accordingly, in this context, short term deposits
must be repayable on demand or have an immediate break clause attached to them.
Issuers should ensure that they manage the portion of government debt instruments
used to meet the BACR in a way that meets their redemption obligations.
However, with permission and additional controls, public debt of a longer residual maturity; assets, rights or money held as a counterparty to a repurchase agreements or reverse repurchase agreements; and some limited money market funds might qualify as backing assets.firms to
determine their own compositions, based on factors including the redemption modelling
they undertake on an ongoing basis. An appropriate backing asset composition will
be driven in part by the maturity and liquidity of the underlying assets. This will be set
against the requirement for firms to place a payment order for redeemed funds by the
end of the business day following receipt of a valid redemption request
Statutory Trust Over Backing Assets
The FCA is still proposing a statutory trust over backing assets held by the issuer as trustee for the benefit of stablecoin holders as beneficiaries, so there would be a fiduciary duty between the issuer and stablecoin holders. This seems more consistent with a stablecoin being an investment instrument, rather than money-like, even though some rules are intended to redress this. It must also mean that the beneficiaries hold both a stablecoin and a beneficial interest in backing assets to the same value as that stablecoin - which surely adds up to two in economic/accounting terms?
The issuer must appoint an independent third party (not a group company), to safeguard the backing assets, which must be promptly segregated on receipt; and the third party must acknowledge in writing that safeguarded qualifying stablecoin backing assets are held on trust for the benefit of the stablecoin holders (rather than for the client issuer/trustee). This sounds like good news for the custody industry and expensive.
If an issuer issues more than one qualifying stablecoin it must ensure that the backing assets for each stablecoin product are held separately and under separate trusts for the benefit of each separate group of stablecoin holders for each corresponding qualifying stablecoin pool.
The issuer retains the obligation to ensure that each set of backing assets are managed appropriately and the qualifying stablecoins are backed 1:1 with the backing assets at all times.
There must be reconciliations of backing assets at least daily and
to ensure shortfalls are topped up and excesses removed, or that qualifying
stablecoins are minted or burned to ensure parity is maintained within 1 business day, failing which the issuer must alert the FCA the following business day (though the issuer won't be expected to publish or report the value daily, only monthly...). This is said to be in order to address the risk that any redemptions while the stablecoin has de-pegged would exacerbate the shortfall (potentially resulting in a 'run' on the issuer); and that issuers (or other investors) could speculate by buying the stablecoins below par and waiting for the issuer to restore parity. The fact that the rules could leave a window of 4 trading days (including a weekend) seems to have escaped the FCA's attention...
The issuer must redeem its qualifying stablecoins to all qualifying stablecoin holders at par, with no minimum redemption amount of stablecoin per redemption request, to an account in the name of the holder by the end of the business day following receipt of the request. Any redemption fee must be 'commensurate' with the operational costs incurred for executing redemption (not costs and losses arising from the sale of assets in the backing asset pool); and must not exceed the value of the stablecoins being redeemed. So the par value is the value of one unit of the reference currency, multiplied by the number of stablecoins being redeemed, irrespective of the value of the backing assets - so the redemption value should not fluctuate in line with the performance of the underlying backing assets (as is the case with a fund).
Issuers can retain interest on backing assets, but cannot pass interest or dividends/benefits on the backing asset pool to qualifying stablecoin holders (directly or indirectly), further distinguishing qualifying stablecoins from funds or other investment products.
The
draft RAO distinguishes 'issuing a qualifying stablecoin' from the operation or management of a Collective Investment Scheme (CIS) or
Alternative Investment Fund (AIF), of which Money Market Funds are a subset, but the FCA foresees the need to consult
on the differences in due course...
Stablecoins, E-money, Tokenised E-money and E-money Tokens
The FCA has always tried to adopt a technologically neutral and 'same risk, same regulatory outcome' approach to regulation. So crypto-tokens issued 1:1 in relation to the value of a single currency on receipt of funds and accepted as a means of payment by third parties have been treated as 'e-money tokens' and therefore e-money, such that the issuer would need to be authorised as an e-money institution under the E-money Regulations (EMRs). A reminder that e-money is defined as:
...electronically (including magnetically) stored monetary value as represented by a claim on the electronic money issuer which—
(a) is issued on receipt of funds for the purpose of making payment transactions;
(b) is accepted by a person other than the electronic money issuer; and
(c) is not excluded by regulation 3 [limited network, low value telecoms billing for certain things];
This remains baked into the proposed changes to the RAO, since to be a 'qualifying stablecoin', a cryptoasset must also be a 'qualifying cryptoasset', which excludes e-money.
This is also reflected in the EU's Markets in Cryptoasset Regulations (MiCAR). In a recent opinion to delineate MiCAR and the Payment Services Directive (PSD2), the European Banking Authority has confirmed that a cryptoasset which aims to stabilise its value by referencing only one official currency is an "e-money token" (EMT); and Article 48(2) of MiCAR deems EMTs to be e-money, and therefore within the definition of ‘funds’ in Article 4(25) of PSD2. Article 70(4) of MiCAR then provides that cryptoasset service providers (CASPs) who provide PSD2 payment services related to their crypto-asset services, may either do it themselves or partner with a PSD2 firm, so long as either is authorised to provide the payment services. In addition, a custodial wallet that is held in the name of one or more clients and allows the client(s) to send and receive EMTs to and from third parties is a 'payment account' within the scope of PSD2. So, the following activities involving e-money tokens (EMTs) are also to be regarded as 'payment services' under PSD2:
- the transfer of cryptoassets as a payment service, where they entail EMTs and are carried out by the entities on behalf of their clients;
- the custody and administration of EMTs.
However, the UK seems to have diverged from this now in relation to qualifying stablecoins that "seek or purport to maintain their value by reference to a single fiat currency" (which I'll call 'single currency stablecoins'). The FCA seeks to explain this on the basis that such single currency 'qualifying stablecoins' are somehow different from e-money because they "have a secondary market value... the issuer can mint tokens before receipt of funds from token holders...and [due to] their use case in cryptoasset trading." This fails to acknowledge that the criteria for stored value to qualify as e-money were ordained by regulation that does not really negate such characteristics: recently, the FCA itself revealed that, in their experience of e-money institution insolvencies, only about 20% of funds corresponding to e-money balances are safeguarded, implying that UK e-money may have decoupled from sterling (just as stablecoins can). In addition, in order to reflect the custom that customers' payment accounts are credited instantly with e-money they purchase online or over the counter, the trigger point for the "receipt of funds" by e-money institutions has been inferred by the FCA as occurring earlier than when the funds themselves actually arrive in the firm's actual bank account: the e-money issuer must merely have become 'entitled to' those funds. And e-money can be used in the course of cryptoasset trading, as the EBA has confirmed.
Yet the FCA has also said that:
"we intend to regulate [qualifying stablecoins] as
money-like instruments rather than as investment products. This means we would
expect qualifying stablecoin issuers to offer all holders the right to redeem at par value,
and the redemption value should not fluctuate in line with the performance of the
underlying backing assets as is the case with a fund. We also propose to prohibit issuers
from passing interest on the backing asset pool to qualifying stablecoin holders, further
distinguishing qualifying stablecoins from funds or other investment products."
Note that while a qualifying cryptoasset need only "seek or purport to" maintain its value in a reference currency/asset in order to become a 'qualifying stablecoin', the FCA will then also require that the qualifying stablecoin maintain that value.
At any rate, there is now no mention at all of "e-money tokens" in the UK proposals for stablecoins or cryptoassets more widely. While a cryptoasset is not a 'qualifying cryptoasset' (and therefore could not be a qualifying stablecoin) if it is e-money (Art 88F(4), RAO), a new exclusion from the definition of "e-money" will also be added (via Reg 3ZA in the EMRs) to provide that the concept of “stored monetary value” is not to include:
(a) qualifying stablecoin;
(b) money or assets held as the backing assets or the stabilisation mechanism for a qualifying stablecoin;
(c) a cryptoasset comprising or representing a claim for the repayment of a sum of money received by way of deposit, within the scope of article 5 (accepting deposits) [in other words, tokenised bank deposits - which reflects the carve-out of tokenised bank deposits from the definition of a 'qualifying stablecoin in Art 88G RAO].
So, could a cryptoasset ever be considered "e-money" in the UK? Well, by analogy with the definition of a tokenised bank deposit, perhaps a cryptoasset that itself comprises or represents "e-money" could also be considered e-money, so long as 'the stored monetary value' is not itself a 'qualifying stablecoin' (while recalling that a to be a qualifying stablecoin, a cryptoasset must also be a qualifying cryptoasset, which excludes e-money; and around the circle we go...).
Of course, banks can issue e-money as distinct from 'accepting deposits'.
Not only is all this quite confusing, but having separate UK regulatory regimes for single-currency stablecoins and e-money also increases the jeopardy for getting the classification wrong at the outset (especially when opining on and operating under, say, the limited network exclusion) and addressing their uses and abuses in the market.
Are Pre-minted Tokens 'Qualifying Stablecoins'?
The FCA is concerned about the fact that issuers might "mint qualifying stablecoins" (the crypto-token that is not yet backed) before issuing them to the public and that if these tokens are not 'backed' from the time they are minted, there's a risk of unbacked qualifying stablecoins slipping into the market (as could a qualifying stablecoin that has been redeemed). I guess the simple answer to this risk is that neither a pre-minted (or redeemed) unbacked token is not yet (or any longer) a qualifying stablecoin, because it does not 'seek or purport to maintain' any value.
Stablecoin Redemptions
The FCA proposes that a redemption must be for money (not other assets); and starts when a holder makes a formal request to redeem; and ends when "a payment order for the redeemed stablecoins has been submitted to the holder's desired [bank or payment] account." These rules will need to be tightened up. Of course, the payment order in this case would be submitted by the issuer to the safeguarding custodian to pay the fiat currency to the holder's account. The issuer does not submit a payment order directly to the holder's account. Equally, 'placing a payment order' begs the question of when the payment order is to be executed. It is possible to place a future-dated payment order...
There would also be exemptions, e.g. where redemption would breach a legal requirement (e.g. AML check, as the stablecoin has been transferred from the original recipient) or court order; or where a currency exchange is required (in which case the issuer should disclose the timing of when such requests can be executed, along with redemption fees that are 'commensurate' with the operational costs incurred (excluding costs/losses from selling backing assets).
Redemptions could be suspended "in exceptional circumstances" where necessary to protect the rights of holders or the integrity of the stablecoin: due to a failure in the underlying blockchain/infrastructure; insolvency of the issuer; or a sudden loss of confidence in the value of the stablecoin (a 'run'). The FCA wants "at least 5 working days' notice" of restarting redemptions, which means the suspension could last at least 6 working days.
Use of Third Parties
An issuer can use third parties to sell or redeem qualifying stablecoins and manage the backing asset pool, on its behalf. In each case, there are requirements to minimise the risk on the third party's failure. It must be clear when a third party is carrying out any issuance activity.
Communications/Disclosure
Issuers must publish the number of stablecoins issued and the backing asset composition at least once every three months (why not daily?); obtain independent verification annually of any statements they've made about the 1:1 ratio in the previous 12 months; along with e.g. technology used, third parties outsourced service providers and the redemption policy/process.
Custody
Taking custody of a cryptoasset usually means taking control over it by holding or storing the means of accessing it (the private key) on behalf of the customer, but that doesn't mean it holds the customer's private key to the customer's own wallet. Instead, the custodian receives a transfer of the cryptoasset from the customer's wallet to its own wallet to which it has access with its own private key.
Customers often leave the cryptoasset with the exchange they bought it on, which then also acts as a custodian.
In a cryptoasset custody arrangement, the stablecoin holder may therefore have both legal and beneficial title, only beneficial title or just a right for the return of the stablecoin. There is no registration of ownership in some kind of central register, as there is for traditional securities, for example, under Article 40 of the RAO. While there's a record of transactions on the blockchain, that is not a definitive record of ownership. There is some reliance, therefore, on the custodian's records and service terms that might defeat ownership interests or render customers only unsecured creditors of the custodian.
Therefore, custodians will have to segregate client assets from their own and ringfence them from other creditors' claims. This could be done in individual or omnibus wallets. Reconciliation must be done each business day; and the results held independently of other records (with notification to the FCA if this is not possible or there is a shortfall (in which case the client must also be notified).
The custodian would also have to hold the cryptoassets in a (non-statutory) trust for the clients, as a bare trustee on receipt, recording the name of the client beneficiary in the firm's internal records that state the type of asset, quantity, the address where it is held, the nature of the client's claim to it and the identity of any third party that has capacity/control to effect a transfer.
Whether such a trust persists in the event that the customer wants the cryptoassets put to a different use in some way (e.g. staking) remains to be consulted upon.
The CASS 7 rules will apply to any cash that is held for clients.
The FCA also wants to avoid the insolvency of crypto custodians altogether, by ensuring they wind-down in an orderly fashion:
Where necessary, we propose amendments to existing CASS provisions, to ensure
we accommodate the unique characteristics of cryptoasset custody outlined above.
We have considered feedback from DP23/4 and other publications. These include the
IOSCO Policy Recommendations for Crypto, the Law Commission’s final report on
digital assets and the Property (Digital Assets Etc.) Bill which clarifies that certain digital
assets, such as crypto-tokens, can be recognised as property even if they do not fit into
the two traditional categories of personal property in the law of England and Wales.
Other internal controls must also be maintained; and custodians will only be able to use third party service providers under strict conditions, including that the appointment must be "in the best interests of the client, and necessary for safeguarding, which firms must evidence in a written policy."
Custodians may be held liable for negligence, breach of contract and breach of FCA rules.
Specific disclosure requirements are being considered, but not Proof of Reserves (a cryptographically proved, independent audit process). Audit standards will also be consulted upon, along with regulatory reporting rules.
