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.

The Trouble With Categorising Cryptocurrencies As The Basis For Regulating ICOs

Securities regulators are trying to figure out whether and how to regulate Initial Coin Offerings (ICOs). In doing so, they are tending to focus on the economic function and purpose of the 'coins' or 'tokens' offered, to put them in categories that most stakeholders should understand. They are then proposing different regulatory treatments for the process of issuing the coins according to the different categories. The challenge is that tokens - like 'fiat' currencies (and barter goods, for that matter) - generally have multiple uses that are completely independent of the 'issuer' or protocol for issuing them, and which may vary from one 'holder' to the next. Therefore it is suggested that it should not be the economic function or purpose of the token itself that should drive the regulatory treatment, but the activities in which the issuers, holders and potential holders of the tokens are engaged. At any rate, before regulating or threatening the impact of existing regulation, we need to develop a much more comprehensive overview of distributed ledger technology; the role and use of 'tokens', 'coins' and 'cryptocurrencies'; and the participants and their activities. 

In its recent guidelines, the Swiss regulator (FINMA) categorises tokens into three types, although it admits hybrid forms are possible:

• Payment tokens are synonymous with cryptocurrencies and have no further functions or links to other development projects. Tokens may in some cases only develop the necessary functionality and become accepted as a means of payment over a period of time.

• Utility tokens are tokens which are intended to provide digital access to an application or service.

• Asset tokens represent assets such as participations in real physical underlyings, companies, or earnings streams, or an entitlement to dividends or interest payments. In terms of their economic function, the tokens are analogous to equities, bonds or derivatives.

FINMA says the resulting regulatory treatment may be flexible where a hybrid of the above is involved, e.g. anti-money laundering regulation would apply to utility tokens that can also be widely used as a means of payment (or are intended to be used that way in time).

The Malta Financial Services Authority says that these are all forms of "virtual currency" (i.e. digital currencies that are not backed by government - as opposed to e-money, which is the digital version of a country's 'fiat' currency). The Maltese definition of a virtual currency may also be wider, as the Swiss guidelines are only aimed at crypto-currencies - those issued or implemented using cryptographic or "distributed ledger technology".  The other differences seem to be in name only - the Maltese would refer to Swiss "payment tokens" as merely "coins" and prefer the name "securitised tokens" for the Swiss "asset tokens".

The MFSA says this approach to classifying types of “digital currency” reflects the Blockchain Policy Initiative Report of July 2017 (and an European Securities and Markets Authority statement from November 2017). 

But does it?

The crowd-sourced Blockchain Policy Initiative Report does not really give a succinct definition of 'cryptocurrency' and there is no mention of 'payment token' or 'utility token' according to my search of the pdf version. The report is a helpful, but long and discursive, explanation of distributed ledger technology (DLT).  It gives little insight into the uses of such technology beyond financial use-cases - which will likely be the majority in due course (if not already). In any event, with so many ICOs occurring so quickly, it's difficult to see how it could be comprehensive and therefore why it should be particularly reliable. It's even possible that there are initial coin offerings that are not presetned as "ICOs".

Consider "Filecoin", for example. Users can "earn" tokens for making available unused data storage capacity; the tokens become a "currency" for exchange with others; and the result is a means of those with flexible storage needs to manage their data storage costs and capacity. Couldn't this satisfy all three categories outlined above? Should a securities (or payments) regulator be involved in data storage capacity management? Should the transfer or sale of 'coins' representing storage capacity be seen as making a "payment" or "exchange" of "currency"? Consider that certain "carbon credits" or "emission allowances" are regulated securities... but why?

This underscores why we need to develop a much more comprehensive overview of distributed ledger technology; the role and use of 'tokens', 'coins' and 'cryptocurrencies'; and the participants and their activities, before regulating or threatening the impact of existing regulation. 

US Regulator Explains The Challenges For Registered CryptoFunds

The Maltese and Swiss securities regulators were not alone in focusing on cryptocurrencies over the Christmas break, as staff at the SEC were also at it in Washington DC.  Importantly, none of these regulators have poured scorn on the notion of ICOs or even funds holding cryptographic assets. All are merely concerned to signpost issues to be resolved.

While the civil law Europeans were typically eager to be as definitive as possible in how they will treat ICOs (since they believe nothing is possible unless the government spells out how it can be done), the common lawyers in the US were more circumspect (as they abide by the maxim that the law must follow commerce), merely explaining "a number of significant investor protection issues that need to be examined before sponsors begin offering these funds to retail investors."

Yet similar issues arise in relation to ICOs as for funds investing in cryptographic assets, particularly those of "securitised tokens" or "asset tokens" which are analogous to equities, bonds or derivatives in their economic function, if not the rights that attach to them.

Specifically, the SEC's concerns relate to valuation, liquidity, custody, arbitrage for exchange traded funds (ETFs), potential manipulation and other risks. For instance:

• do funds have enough information to value their crypto assets each day, including accounting for events like 'hard forks' or differences in types of currency and potential for market manipulation?

• could open-ended funds support daily redemptions?

• how would a fund arrange custody and validate the existence, exclusive ownership and software functionality of private cryptocurrency keys and other ownership records?

• an ETF is required to have a market price that would not deviate materially from the ETF’s net asset value, so in light of the fragmentation, volatility and trading volume of the cryptocurrency marketplace, how would ETFs comply with this term of their orders?

• Although some funds may propose to hold cryptocurrency-related products, rather than cryptocurrencies, the pricing, volatility and resiliency of these derivative markets generally would be expected to be strongly influenced by the underlying markets, which feature substantially less investor protection than traditional securities markets, with correspondingly greater opportunities for fraud and manipulation. So:

• Would investors, including retail investors, have sufficient information to consider any cryptocurrency-related funds and to understand the risks?

• How would broker-dealers analyze the suitability of offering the funds to retail investors?

• Could investment advisers meet their fiduciary obligations when investing in cryptocurrency-related funds on behalf of retail investors?

Assuming the industry can solve these problems, we'll be in a strange new world.

Switzerland Explains How It Will Handle Initial Coin Offerings

Not to be outdone by Malta's announcements, the Swiss regulator (FINMA) has published its own ICO guidelines, which complement earlier Guidance. Unlike Malta, there is no specific regulation proposed at this stage. But FINMA has tried to clarify that, when assessing ICOs, it will focus on the economic function and purpose of the tokens issued by the organiser, and whether they are (or will be) tradeable or transferable.  FINMA categorises tokens into three types, although admits hybrid forms are possible:

• Payment tokens are synonymous with cryptocurrencies and have no further functions or links to other development projects. Tokens may in some cases only develop the necessary functionality and become accepted as a means of payment over a period of time.

• Utility tokens are tokens which are intended to provide digital access to an application or service.

• Asset tokens represent assets such as participations in real physical underlyings, companies, or earnings streams, or an entitlement to dividends or interest payments. In terms of their economic function, the tokens are analogous to equities, bonds or derivatives.

Malta says that these are all forms of "virtual currency" (i.e. digital currencies that are not backed by government - as opposed to e-money, which is the digital version of a country's 'fiat' currency). The Maltese definition of a virtual currency may also be wider, as the Swiss guidelines are only aimed at crypto-currencies - those issued or implemented using cryptographic or "distributed ledger technology".  The other differences seem to be in name only - the Maltese would refer to Swiss "payment tokens" as merely "coins" and prefer the name "securitised tokens" for the Swiss "asset tokens". 

On the basis of the function and transferability of the relevant crypto-currency), FINMA will treat Swiss ICOs as follows (see diagram on page 8 of the Guidelines):

• Payment ICOs: For ICOs where the token is intended to function as a means of payment and can already be transferred, FINMA will require compliance with anti-money laundering regulations. FINMA will not, however, treat such tokens as securities.

• Utility ICOs: These tokens do not qualify as securities only if their sole purpose is to confer digital access rights to an application or service and if the utility token can already be used in this way at the point of issue. If a utility token functions solely or partially as an investment in economic terms, FINMA will treat such tokens as securities (i.e. in the same way as asset tokens).

• Asset ICOs: FINMA regards asset tokens as securities, which means that there are securities law requirements for trading in such tokens, as well as civil law requirements under the Swiss Code of Obligations (e.g. prospectus requirements).

This may be flexible where a hybrid of the above is involved, e.g. anti-money laundering regulation would apply to utility tokens that can also be widely used as a means of payment (or are intended to be used that way in time).

Malta's Proposals On Regulating Virtual Currencies, ICOs etc - Updated

The Malta Financial Services Authority, like other regulators, is in the process of consulting on the policy it proposes to adopt for regulating virtual currencies, the process of issuing them ("Initial Coin Offerings" or "ICOs") and the service providers involved. The MFSA has proposed new legislation that would extend create an additional regime beyond the scope of existing securities and investment regulation, to cover virtual currencies that are not deemed to be financial instruments and therefore already caught by existing laws.

The MFSA published a “Discussion Paper On Initial Coin Offerings, Virtual Currencies And Related Service Providers” in November 2017 and consultation ended on 18 January 2018. The MFSA is yet to finalise its policy or any proposed statute.

The MFSA clearly wishes to support innovation and new technologies for financial services, while ensuring effective investor protection, market integrity and financial stability.  

It’s proposed approach to classifying types of “digital currency” reflects the Blockchain Policy Initiative Report of July 2017 and an European Securities and Markets Authority statement from November 2017.  This contrasts “virtual currency” with “E-money” which is the digital representation of a fiat currency; and defines three types of virtual currency (any of which might also be cryptographic currencies operating on distributed ledger technology or DLT): 

• “utility tokens” (providing only platform or application utility rights or access rights);

• “securitised tokens” (embedding an underlying asset/commodity or rights, like quasi-shares or bonds); and

• “Coins” (that are intended to be, or have become, a means of payment). 

The MFSA is proposing to seek the adoption by the Maltese Parliament of a Virtual Currencies Act to regulate virtual currencies:

• that constitute “financial instruments” (under a test to be devised), by confirming they are subject to existing EU and national financial services regulation; and

• those that do not qualify as financials instruments, by making them subject to new “similar high level regulatory principles on transparency and merit-based regulation as those currently applicable to securities seeking a listing on a regulated market” – although they will be deemed “complex instruments” so their regulatory treatment will be akin to how such instruments are regulated under MiFID. 

Persons involved in activities related to virtual currencies would need to be "'fit and proper', have the competence, sufficient knowledge and expertise, experience, business organisation and systems necessary in the field of information technology, VCs and their underlying technologies, including but not limited to DLT."

Providers of investment services will need a separate licence to provide services in support ICOs etc in relation to virtual currencies that do not qualify as financial instruments under existing laws; and will need to set up a dedicated subsidiary for that purpose. 

All persons subject to the Act would also be subject to anti-money laundering requirements. 

There are specific proposals to regulate issuers, exchanges and investment funds (and other collective investment schemes) that deal in virtual currencies that do not qualify as financial instruments. 

Banks and payment service providers would be permitted to extend their activities to such virtual currencies, but only for clients and under a separate subsidiary licensed under the Act. 

But reinsurers, insurers and pension schemes would still be prohibited from dealing in virtual currencies for their clients or their own account. 

Update 22.02.18: The Maltese government has published a further consultation in response to submissions received on the MFSA discussion paper, which "presents a conceptual framework through which DLT Platforms can be subject to certification in Malta" which will extend to issuers of ICOs and certain service provides dealing in virtual currencies. Consultation responses are due by 9 March 2018.

Three new pieces of legislation are proposed:

• The MDIA Bill will provide for the establishment of an Authority to be known as the Malta Digital Innovation Authority.

• The TAS Bill will set out the regime for the registration of Technology Service Providers and the certification of Technology Arrangements.

• The VC Bill will set out the framework for ICOs and the regulatory regime on to the provision of certain services in relation to VCs. The intermediaries subject to the VC Bill include brokers, exchanges, wallet providers, asset managers, investment advisors and market makers dealing in VCs.