FCA Consults on Stablecoin & Custody Rules... Confusion Looms On E-money

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.

FCA Discussion Paper On New Crypto Rules

Hard on the heels of the Treasury's proposed regulatory framework for cryptoasset activities in the UK, the Financial Conduct Authority published its own discussion paper on how it will supervise these activities within that framework. The FCA requested feedback by 13 June 2025. I will gradually add my thoughts on the discussion paper below, for information purposes. If you require legal advice on the plans and their impact, please let me know. 

The FCA's proposals are far reaching (including extra-territorial) and complex. Some areas are new, while others aspects attempt to include cryptoassets/activity into existing rulebooks. There are also some proposed restrictions on the type of customers that firms can deal with. 

The actual rules and guidance won't be available until mid-2025, when the FCA will publish a Consultation Paper on issuing a qualifying stablecoin, safeguarding qualifying cryptoassets and specified investment cryptoassets, along with the prudential framework (capital requirements) for qualifying stablecoins and safeguarding. There will be a further consultation on the wider 'conduct' standards, such as the Consumer Duty even later in 2025.

Operating a Qualifying Cryptoasset Trading Platform

This proposed new regulated activity is incredibly broad: 

[the operation of] ‘a system which brings together or facilitates the bringing together of multiple third-party buying and selling interests in qualifying cryptoassets in a way that results in a contract for the exchange of qualifying cryptoassets for any of: (a) money (including electronic money); or (b) other qualifying cryptoassets.

Any entity operating a trading platform for cryptoassets in the UK, or providing services to UK clients, will generally need to be authorised in the UK, except a firm operating an offshore trading platform for cryptoassets that is only serving professional investors in the UK.

One approach to authorisation for offshore firms would be to require both a 'branch' or local establishment for operating the platform and interfacing with overseas customers; and a UK subsidiary for client-facing functions (including for retail customers). Where an offshore firm is also regulated in its home jurisdiction, the FCA might be prepared to leave certain issues (e.g. capital requirements and systems/controls for trading operations) to the home regulator.

When dealing with retail customers, the FCA proposes that CATPs should:

• Disclose and clarify their own and their clients’ respective responsibilities. 
• Ensure that customers comply with the platform rules and relevant regulations (for example, not engaging in market manipulation). 
• Monitor trading activity to identify infringements of rules. 
• Set controls and limits for each type of customer profile. 
• Be able to revoke access or participation rights, or to suspend a customer.

Algorithmic trading and automated trading software: the FCA points out these are "highly prevalent in cryptoasset markets, with popular bot providers reporting up to 1 million users", including retail investors, requiring limited, if any, human intervention. "Trading platforms also provide dedicated access capabilities for algorithmic trading or [high frequency trading] HFT." Whether or not these will need to be authorised or registered somehow, CATPs will have to ensure fair and non-discriminatory access to trading, ensure orderly markets and eliminate or manage/disclose conflicts of interests between providers of algorithmic or automated trading software and the CATP operator.

Market-makers: the FCA is aware of anti-competitive and collusive practices between crypto trading platforms and market makers, artificially inflating trading volumes, giving unfair advantages for affiliated market makers, and market manipulation. Therefore, CATPs may need to identify those operating market making strategies on the trading platform; have appropriate contracts in place; and disclose potential relationships. Contracts would govern the market making scheme and including obligations for market makers posting simultaneous two-way quotes for a specific liquidity pool.

Trading & execution: Crypto trading service providers have different matching and execution protocols. Some exchanges combine discretionary and non-discretionary systems, and some trade in principal capacity on and off platform with their clients in ways that aren't clear who the counterparty is. The FCA will require CATPs to operate on a non-discretionary basis, treating all orders identically, according to a consistent set of rules, rather than using their judgement as to whether, when and how much of any orders to match. Where investors participate directly, CATPs might not be required to "take all sufficient steps to obtain the best possible order execution results for clients" (best execution requirements), so it would be up to investors to consider where best to trade on the basis of prices, fees and costs. Investors using an intermediary may benefit form investor protection rules and the intermediary's obligation to act in the investor’s best interest, including seeking best execution, though commission or other compensation would be charged.

Matched Principal Trading: this is a form of trading where a person acts as a broker or central counterparty between the buyer and seller, making sure that the price and quantity is agreed on both sides before the trade is executed. The broker charges a fee rather than making a turn on the difference/spread between the buy and sell prices. The risks are that the CATP as broker trades against the clients on platform and/or takes on market risk (of counterparty default). which could create resiliency risks; conflicts of interest undermine the fair and non-discretionary operation of markets; and there may be other abusive or anti-competitive practices, such as wash trading and market manipulation. As a result, the FCA is not happy that "Exchanges often execute clients’ transactions back-to-back, by standing between the 2 trading counterparties" and want to explore some alternatives in light of the IOSCO Recommendations: neither the CATP operator nor any of its affiliates should never be allowed to trade in principal capacity on the CATP's own platform; and the CATP should not be allowed to do so even off platform, for trading activity not related to their CATP’s operation.

Issuing: the FCA may require legal or functional separation between the firm operating a CATP and the issuer of the cryptoassets admitted to trading on the CATP. Legal separation in particular could avoid credit and market risks exposures, capital risks, conflicts of interests and anti-competitive practices by the CATP against other issuers.

Market & Counterparty Credit Risks: the FCA wants CATPs to be "risk-neutral trading systems", without counterparty or credit risk to clients or products. CATPs could not act as a clearing house or directly manage or internalise risk exposures between counterparties on their platform; or provide credit lines or make credit arrangements with their clients.

Settlement: is the ‘irrevocable and unconditional transfer of an asset […], or the discharge of an obligation […] in accordance with the terms of the underlying contract’. The challenge with regulating settlement in cryptoasset markets is that CATPs don't control the underlying distributed ledger or 'blockchain' protocols (which the UK does not intend to regulate). CATPs often take on settlement responsibilities internally, creating risks for the CATP or its clients if a counterparty defaults in its own obligations. Generally, the FCA expects CATPs to have "satisfactory arrangements" for securing the timely and effective transfer of control over the cryptoassets traded on their platform, whether internally or by facilitating or arranging this through other service providers (including custodians).

Transparency & Reporting: the FCA has found that "cryptoasset market data is often unreliable and inconsistent", which undermines efficient pricing, creates unlevel playing fields, and creates "incentives in favour of minor, or illiquid, trading desks that do not offer the same level of transparency". In other words, this is how the pro's fleece the retail sheep. Therefore, the FCA wants to rely on CATPs to clean up and publish pre- and post-trade market data (presumably so a cryptoasset market data sector will grow up, just as other markets for financial data have evolved), including order and transaction data (while also retaining client identity information internally for 5 years).

Cryptoasset Intermediaries

These intermediary functions involve dealing as principal or agent; or arranging such deals in qualifying cryptoassets. Many CATPs undertake these functions as well as being an 'exchange'. Only 28% of users bought crypto through a distinct intermediary, paying higher charges and taking on a long list of risks (that also apply where the CATP is also acting as an intermediary, with additional conflicts of interest and opportunities for abuse). Chapter 3 of the Discussion Paper has more detail on the proposals to address these issues on a 'same risk, same regulatory outcome' basis as in traditional markets: 

• Facilitate UK investors’ access to global crypto markets through authorised entities. 
• Make sure UK markets remain internationally competitive, fair, orderly, transparent and liquid. 
• Fair and transparent conditions for trades executed for, or on behalf of, a client; executed in a way that serves the best interest of clients. 
• Intermediaries ensure that the price a customer pays for a product is transparent and reasonable compared to the overall benefits the customer gets from the product. 
• Firms compete to provide best execution. 
• Consumers protected from unfair or abusive practices. 
• Intermediaries manage conflicts of interest effectively. 
• Support growth of the UK intermediary market with clear and proportionate regulation.

The FCA Wonders Out Loud Whether UK E-money Is Really Redeemable at Par...

The 'decoupling drama' surrounding USDT stablecoins appears to be echoing in the UK e-money world amid news from the UK Financial Conduct Authority that it doesn't know whether UK e-money firms fully safeguard the cash corresponding to their customers' e-money balances. This bombshell comes with a commitment to change the safeguarding rules in ways that could bring further problems, casting serious doubt on whether UK authorities' really have a grip on the payments sector.

This post is for information purposes only. If you would like legal advice, please let me know.

Context

The FCA's consultation on proposed changes to the 'safeguarding' rules for non-bank payment service providers makes you wonder who's been responsible for supervising the 24 year old sector. The regulatory regime has been under the FCA's direct supervision since it took over from the beleaguered Financial Services Authority in 2013. The sector comprises over 1,200 firms and processed £1.9 trillion in payment transactions in 2023. Electronic money (basically prepaid stored value that's used for making e-payments to others) represents about £1 trillion of these volumes, issued by 250 firms. Some e-money balances, such as those relating to prepaid card programmes, are significant and held for long periods. 

E-money is supposed to be issued on receipt of funds, and to be 'redeemable' on demand, at 'par value'. So, if you pay £1 to the issuer, it should immediately credit your online payment account in its systems with £1 and that balance should continue to be 'worth' 1 GBP when you transfer, spend or withdraw it. You have the regulatory right to withdraw - or 'redeem' - your e-money balance on demand. 

But e-money balances (like other non-bank payment flows) are not subject to the deposit guarantee under the Financial Services Compensation Scheme that backs bank deposits (up to a limit of £85,000 for all your deposits with the one bank). Instead, the right to redeem your e-money at par is underpinned by a regulatory obligation on the issuer to safeguard the corresponding amount of cash in GBP in a designated bank account, separate from its own funds (or with insurance), so that the funds are available to pay out immediately on demand.

Other types of non-bank payment service provider (payment institutions) must also safeguard customer funds, but they're only supposed to hold funds for as long as it takes to execute/process the related payment order, rather than allow their customers to hold an ongoing balance, so the time during which the funds are 'at risk' of the PSP going bust or dissipating the funds should be shorter than for e-money balances.

What's the immediate problem (opportunity)?

The FCA admits in its consultation paper that it does not know whether firms are failing to fully safeguard funds corresponding to the payment transactions they process or the e-money they issue. Worse, it reveals that in the 5 insolvencies of e-money institutions from 2018-2023 only 20% of funds were available and it took over 2 years on average time for an administrator to distribute the first round of customers' balances...

This seems to echo what happened when the value of  Tether's USDT 'stablecoins' - which aim to trade at parity with the USD - de-pegged from the USD. The scenario presented traders with an arbitrage opportunity: some borrowed amounts in a rival stablecoin and bought USDT at a discounted rate, betting that if USDT returned to its 1:1 peg, they could sell their USDT at parity and repay their loans at a profit.

In principle, there may be little difference between a right to redeem an 'e-money' balance in an online account and a 'fiat-backed stablecoin'. Indeed, the EU regulates fiat-backed stablecoins in the same way that it regulates e-money, while the FCA suggests they should be regulated differently, as recently discussed on LinkedIn.

Could there be an 'arbitrage opportunity' between balances issued by different e-money issuers, based on the extent of their safeguarding and availability of the balances?

Why Doesn't the FCA Make Firms Reveal How Much is Safeguarded At All Times?

Alarmingly, the FCA says the problem arises from firms not understanding how to safeguard, as well as "challenges in supervision and enforcement": 

33. In some firm failures there has been evidence of safeguarding failings which put client funds at risk and resulted in shortfalls. The current light-touch regime around [FCA!] reporting requirements means that supervisors have insufficient information to identify firms that fall short of our expectations. This then prevents the FCA from being able to prioritise resources, be that support or enforcement, on firms that pose the greatest risk to clients prior to insolvency. 

34. In particular, we are concerned about 2 areas. First, regulatory returns do not contain sufficient detail to assess whether firms are meeting their safeguarding obligations. Second, the safeguarding audits provided for in the Approach Document do not have to submitted to the FCA, further limiting our oversight. 

35. Furthermore, the lack of clarity and precision in current provisions leads to difficulties in enforcement as firms may be able to contest findings. This can undermine the credibility of enforcement as a deterrence.

Begging the question: in such circumstances, should the market continue to believe that UK issued/FCA-regulated e-money is really on par with GBP? 

New Rules...

The UK authorities' proposed remedy is to bring in more detailed rules, in two phases: supplementary rules under the current regulations "to reduce the incidence and extent of pre-insolvency shortfalls" (why so late?) and moving the e-money/payment services safeguarding regime under the FCA's wider 'client asset rules' (CASS) regime "to improve the speed and cost of distributing funds post-insolvency" - suggesting that the last attempt to improve the insolvency regime for non-bank payment service providers failed.

The interim rules will only echo current requirements, however, with only monthly reporting on the amount of e-money issued and corresponding cash safeguarded. Will the market be told? Even stablecoin issuers publish the amount of backing assets they hold (to prevent a 'run' on their stablecoins and a crash in the value). Maybe e-money issuers should start doing that, too? 

Among the eventual CASS rules will be an obligation to hold safeguarded funds under a statutory trust in favour of their e-money holders. This reflects the FCA's frustration at having already lost the argument in the case of Ipagoo in the Court of Appeal, which held that there is no statutory trust in favour of e-money holders under the E-money Regulations. The FCA is also pressing for a statutory trust over the cash which 'backs' fiat-backed stablecoins (while the EU has not). 

The statutory trust idea, in particular, raises a number of issues. 

The first issue is whether an e-money holder could have property rights in two distinct assets: the e-money balance (or the right to redeem it at par) and the beneficial interest in the pool of cash held by the issuer in the statutory trust (equating to the par value of e-money held)? If so, does the e-money holder simply have double the value of their e-money balance and/or could the value of these interests diverge?

Secondly, if the e-money itself gives the holder rights in the underlying cash in the statutory trust, why isn't e-money an investment instrument of some kind (the very thing that stablecoin issuers have structured their offerings to avoid, for fear of creating a regulated 'security')? Could it be traded on an exchange (or 'multi-lateral trading facility'), for instance? 

Thirdly, the requirement for the corresponding cash to be held in trust is no guarantee that an adequate amount will be held, or that the issuer won't somehow subvert the trust by, for example, failing to deduct 'own funds' (such as amounts owed in fees). What would such a failure mean for the value of the e-money balance itself (or the right to redeem it at par)?

There are likely other issues, such as those arising where an e-money holder has somehow granted an interest to a third party in either the e-money balance or the beneficial interest in the statutory trust. Currently, only the e-money issuer may have an interest in corresponding cash that is safeguarded. 

None of this is to suggest that there aren't answers in each case. The point is that the new concept of a statutory trust over the cash corresponding to e-money balances raises fresh uncertainty where the situation already appears grave under simpler rules; and without really solving the fundamental problems of potentially safeguarding too little and slow distribution on insolvency. 

More transparency and closer supervision would seem to be preferable.

Conclusion

The potential for new safeguarding rules is an almighty distraction from the critical uncertainty surrounding the integrity of the non-bank payment sector today.  

To ensure market confidence, e-money and payment firms may need to resort to publishing their safeguarding position on a daily basis, regardless of the FCA's requirements.

And new FCA rules will prove futile if the level of supervision remains the same.

This post is for information purposes only. If you would like legal advice, please let me know.

What is a "Stablecoin Used as a Means of Payment"?

The UK government is doing a lot of strange things with existing financial regulation, while trying to absorb new concepts, such as those relating to cryptoassets. Buried amidst the pile of economy-shrinking, post-Brexit deckchair rearrangement in the new Financial Services Bill (explanatory notes here) is an attempt to regulate 'stablecoins used as a means of payment'. This post tries to make sense of that. 

Existing UK regulatory view of stablecoins

In a previous policy statement, the Financial Conduct Authority explained its view that 'stablecoins’ (a.k.a. ‘stable tokens’) are cryptoassets that are structured in order to (try to) stabilise their value, e.g. by ‘pegging’ them to a fiat currency or different types of assets (including other cryptoassets (‘crypto-collateralised’)) or specified financial investments (regulated securities) or commodities (‘asset-backed’)).  

That interpretation means that stablecoins may currently fall within existing e-money/payments regulation and/or securities regulation (as a derivative, a unit in a collective investment scheme/fund, a debt security, or another type of specified investment) provided they meet all the applicable critieria, regardless of the fact they are issued using 'distributed ledger technology' or on a 'blockchain'. Those regulatory criteria vary depending on the nature of the underlying assets, the rights granted by such tokens and other relevant 'arrangements' or other activities, like whether advice is given. 

The FCA has said that 'algorithmically stabilised tokens' or stablecoins which attempt stabilisation through algorithms that control the supply of the tokens to influence price, for example, should only be regulated to the same extent as other (financially) 'unregulated' tokens are. Examples of unregulated cryptoassets or tokens include 'bitcoin' (classified as an 'exchange token' rather than as a means of payment) or 'utility tokens' that merely grant access to a game or system, for example.

Aside from stablecoins and other cryptoassets that trigger existing regulation, the FCA explained that it needs new statutory powers to regulate cryptoassets.

The new approach to Stablecoins - DSAs

The new Financial Services Bill itself makes no reference at all to 'cryptoassets' or even 'stablecoins', but the explanatory notes do. 

Of course, this instantly expands the lawyers' playground of unintended consequences, so I'm not really complaining professionally. 

The explanatory notes essentially recite the earlier FCA consultation [although the notes ominously refer to Bitcoin as an example of "cryptoassets used primarily as a means of investment" rather than 'exchange', perhaps signalling a shift in the government's approach to the regulation of cryptoassets and related activities more widely, due to be announced later in 2022.]

In relation to stablecoins, the explanatory notes say that the Bill empowers the Treasury to: 

• establish an FCA authorisation and supervision regime, drawing broadly on existing electronic money and payments regulation, to mitigate conduct, prudential and market integrity risks for issuers of, and payment service providers using, stablecoins; 

• regulate (via the Bank of England) any systemically significant stablecoin-based payment system, in a similar way that Visa, Mastercard and a range of other designated "payment systems" are controlled by the Payment Systems Regulator (PSR);

• empower the PSR to regulate payment systems using stablecoins, following designation by the Treasury, to address issues relating to competition innovation, user interests and access; 

• apply the Financial Markets Infrastructure Special Administration Regime (FMI SAR), which is a bespoke administration regime for recognised payment and settlement systems and recognised service providers, to stablecoin firms that have been recognised by HM Treasury, with appropriate modifications. This will ensure appropriate tools are in place to mitigate the risks to financial stability associated with a systemic stablecoin firm’s failure; 

• Amend or disapply existing financial regulators' rules to avoid systemic stablecoin firms being subject to conflicting requirements in areas relating to financial stability. 

For these purposes, however, the Bill uses the term "digital settlement asset" instead of 'stablecoin':

""digital settlement asset" [or "DSA"] means a digital representation of value or rights, whether or not cryptographically secured, that— 

(a) can be used for the settlement of payment obligations, 

(b) can be transferred, stored or traded electronically, and 

(c) uses technology supporting the recording or storage of data (which may include distributed ledger technology)."

For most purposes a DSA "includes a right to, or interest in, a [DSA]." This reflects the definition of "cryptoasset" in the Money Laundering Regs.

The Bill gives the Treasury power to regulate DSAs by applying e-money/payments and payment systems regulation to them, including the power to change the statutory definition itself! 

The Bill creates the concept of "DSA service providers" which includes anyone directly involved in: 

• issuance/creation of DSAs, 
• safeguarding or safeguarding and administration (custody) of the DSAs including the private cryptographic keys (or means of access) [not clear whether this service must include the keys/means of access, or would be satisfied if the provider only safeguarded the keys/means of access];
• exchange or arranging the exchange of DSAs for money and/or other DSAs or vice versa ("digital settlement asset exchange providers" is defined pretty much like cryptoasset exchange providers under the Money Laundering Regs), 
• rule/standards-setting; and 
• any service that facilitates, or supports, a transfer of money or digital settlement assets to be made using the payment system, including any infrastructure provider in relation to the system.

Unintended consequences?

Right now your brain should be fizzing with other things that could be DSAs; and even whether any existing components of payment systems or services could qualify as DSAs or DSA services and therefore require a currently unregulated/unauthorised service provider to become authorised as a "DSA service provider".

It is also worth watching the evolution of "data objects" as a new class of personal property with distinct rights and remedies.

Trouble At The FCA's Perimeter

The UK's Financial Conduct Authority is often charged with an apparent failure to act amidst a 'scandal' of some description. Its usual defence is that the activity in question lay outside the scope or 'perimeter' of what the FCA is empowered to supervise. The FCA also publishes a "Perimeter Report" pointing out issues that it sees outside the perimeter that it considers it should be given powers to address. Needless to say, that's a lot like having your cake and eating it, but so it goes. Anyhow, aside from the usual suspect of dodgy financial advice through appointed representatives, two areas leapt out at me among those identified in the latest Perimeter Report:

Financial promotions/marketing: The FCA believes that the exemptions for unauthorised persons to market investments to 'high net worth' and 'sophisticated' investors under the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (SI 2005/1529) (FPO) are no longer fit for purpose, so there need to be significant changes - including the nature of the thresholds for consumers to qualify and self-certify that they qualify as either high net worth or sophisticated. 

Cryptoassets: The FCA is seeing the evolution of 'complex business models' presented as ways for customers to generate returns from cryptoasset holdings, which its believes may need further regulatory or legislative action to address. I'd say that's the understatement of the century, given the recent shriek of alarm from the Bank of England about the threat to financial stability from cryptoassets. I'd say investors are more likely to understand that 'unbacked' cryptoassets (e.g. bitcoin) are very high risk investments, but vulnerable to being misled to believe that a cryptoasset is somehow "backed" by other assets (i.e. 'stablecoins') or somehow include rights to other assets or income.

The problems identified here are likely to have arisen from investigations or complaints where the FCA would particularly like to have acted but didn't immediately have all the powers it would have liked. Therefore, it also seems likely that these areas will be the subject of future enforcement if those powers are forthcoming...

Proposed Extension of UK Cryptoasset Regulation

The UK Treasury is consulting until 21 March 2021 on its approach to extending financial regulation to 'cryptoassets'. This is intended to build on the FCA's previous guidance on the UK's regulatory approach to cryptoassets, which divides them into regulated 'e-money' and 'security' tokens and unregulated 'utility' and 'exchange' tokens. Any token could fall into multiple categories, with 'stablecoins' being a prime example that will likely be regulated in their own right. Certain types of service provider will become subject to the full weight of FCA authorisation and regulation. A 'technology neutral' approach means that any asset which replicates the features of a regulated cryptoasset will also be regulated as one ('same risk, same regulatory outcome'). The goal is to protect the 'regulated financial system' not consumers or investors, so speculation in unstable 'exchange' tokens, such as Bitcoin, will remain unregulated (but subject to anti-money laundering checks and, potentially, rules on financial promotions). A key challenge for some existing cryptoassets is that some authorisation requirements would need to have been addressed at launch but were not. Due to the digital, decentralised and cross-border nature of cryptoassets, the government is considering whether firms actively marketing regulated tokens to UK consumers should be required to have a UK establishment and be authorised in the UK.

Extending the concept of 'cryptoasset'

The Treasury takes a broader view of cryptoassets than authorities have done to date, defining them to be 

"a digital representation of value or contractual rights that can be transferred, stored or traded electronically, and which may (though does not necessarily) utilise cryptography, distributed ledger technology or similar technology."

The term ‘token’ is used interchangeably with ‘cryptoasset’. This means that the government's proposals go beyond the proposed extension of financial promotions regulation and the scope of the UK’s anti-money laundering regulations (implementing the EU's 5th Money Laundering Directive).

It is proposed that stablecoins - or 'stable tokens', as the Treasury refers to them - should receive a distinct regulatory status but this will affect assets designed to similar effect that are not based on distributed ledger technology.

FCA research published in June 2020 estimated that 4% of the UK population use or invest in cryptoasset, of whom:

• 47% of UK cryptoasset consumers said they bought cryptocurrencies ‘as a gamble that could make or lose money’; 
• stablecoins are the most likely to be used as a means of payment; 
• 27% of stablecoin owners have used those tokens to purchase goods and services.
  
• 89% understood that cryptoassets are not subject to regulatory protections. 

The government is therefore considering an approach in which the use of currently unregulated tokens and associated activities primarily used for speculative investment purposes, such as Bitcoin, could initially remain outside the perimeter for conduct and prudential purposes, while subject to more stringent regulation in relation to consumer communications via the financial promotions regime (if adopted) and anti-money laundering regulation. 

Utility tokens (used to access a system or service, for example) would also remain outside the authorisation perimeter. 

The issuance and use of stablecoins concerns the government more than rampant speculation in cryptoassets by consumers, partly in light of 10 recommendations from the Financial Stability Board of the Bank of England in December 2019. 

In other words, the more likely that a cryptoasset could be reliably used for retail or wholesale transactions, the more likely it will be subject to a UK authorisation regime. 

Yet investors should be left unprotected in relation to tokens that are not suitable for retail or wholesale transactions. These include ‘algorithmic stablecoins’ that seek to maintain a stable value through the use of algorithms to control supply, without any backing by a reference asset, as they are judged to pose similar risks to unbacked exchange tokens and in their ability to maintain stability of value. You're free to lose your shirt, just so long as it does not affect the 'system'.

Likely scope of authorisation

Key regulated participants are likely to include: 

• issuers or systems operators, responsible for managing the rules of a system, the infrastructure, burning and mining/minting coins (among others);
• cryptoassets exchanges, enabling the exchange of tokens for fiat money or other tokens;
• wallet providers, who provide custody of tokens and/or manage private keys and are often the main customer contact point, along with exchanges. 

Regulation would apply to such firms where they undertake the following functions or activities:

• issuing, creating or destroying asset-linked tokens 
• issuing, creating or destroying single fiat-linked tokens 
• value stabilisation and reserve management 
• validation of transactions 
• facilitating access access of participants to the network or underlying infrastructure 
• transmission/settlement of funds 
• custody and administration of a stable token for a third party, including the storage of private keys 
• executing transactions in stable tokens 
• exchanging tokens for fiat money and vice versa 

The following high-level requirements would be necessary for authorised firms:

• meeting certain gating criteria and threshold conditions prior to operating;
• capital, liquidity, accounting and audit requirements;
  
• maintenance and management of a reserve of assets underlying the token’s value and ensuring the quality and safekeeping on those assets;
  
• orderly failure and insolvency requirements;
  
• safeguarding requirements, principally on wallets and exchanges to ensure those entities are appropriately protecting users' tokens and the privacy and security of keys to those tokens;
  
• systems, controls, risk management and governance;
  
• notification and reporting;
  
• record keeping;
  
• conduct requirements toward customers;
  
• financial crime requirements;
• outsourcing requirements;
  
• operational resilience, service reliability and continuity requirements; and
  
• security requirements (including cyber and cloud).
  

Systemic Stablecoins

The government is considering requirements in relation to the reserves held for stable tokens (and related innovations), particularly where they operate at systemic scale (intended for widespread use in retail or wholesale transactions). Issuers would need to hold reserve assets in central bank accounts, commercial bank deposits or high-quality liquid assets.

Arrangements similar to existing 'payments systems' may need to be regulated by the Payment Systems Regulator as system operators, infrastructure providers or payment service providers in relation to that system. 

A systemic stable token arrangement could be assessed for Bank of England regulation in the same way that current payment systems and service providers are when potential disruption could lead to financial stability risks. Criteria include consideration of their ability to disrupt the UK financial system and businesses based on current or likely volume and value of transactions, nature of transactions and links to other systems, as well as substitutability and use by the Bank of England in its role as monetary authority. 

This would mean that a stable token with significant potential to be systemic at launch would need to be captured from launch by such regulation. Appropriate triggers would include likely user base, likely transaction volumes and likely avenues for acquisition of customers. 

Issuers or system operators that reach systemic status, as well as critical service providers, would be subject to regulation by the Bank of England and would be required to produce an annual compliance self-assessment.