Regulated firms are increasingly interested in entering the (largely) unregulated cryptoasset market. In a coordinated set of statements, UK authorities have reminded firms of their obligations under existing prudential and conduct regulation when they do so. These statements also pave the way for an expansion of the regulatory perimeter, including through the regulation of systemic stablecoins, ahead of HM Treasury’s anticipated response to its 2021 crypto consultation.

Impact of crypto on financial stability

In recent years we have begun to witness a blurring of lines between the traditional financial sector and the crypto sector. This includes the growth in institutional exposure to unbacked cryptoassets like bitcoin and ether (in some cases indirectly, through derivatives or exchange traded products), as well as the rise of non-banks developing stablecoins backed by traditional asset classes.

The Bank of England and its Financial Policy Committee have for some time expressed measured concern over the potential financial stability risks. In a new report, the FPC reiterates a position we have heard several times before: the FPC considers that the direct stability risks posed by crypto and decentralised finance to the UK financial system are currently limited, but that they have the potential to grow and need to be monitored closely. The report outlines how the FPC intends to continue monitoring risks to systemic financial institutions; risks to core financial markets; risks from use in payments; and the impact on real economy balance sheets. 

As the markets grow, the FPC expects that enhanced regulatory frameworks will be needed, both at a global and domestic level. For now, it has welcomed statements from the Financial Conduct Authority and Prudential Regulation Authority reiterating firms’ existing regulatory obligations (as discussed below) as well as the government’s proposals to regulate stablecoins, including by bringing systemic stablecoins within the remit of the Bank of England (see our blog post: UK reveals plans to regulate stablecoins).

Treating crypto exposure

Published on the same day as the FPC report, the PRA has written to CEOs at banks and PRA-regulated investment firms to set out its views on exposures to cryptoassets.

In its latest letter, the PRA reminds firms to consider the full prudential framework when assessing and mitigating risks arising from cryptoasset exposures (including indirect exposures) or other activities (such as custody). Among other things, it suggests that its rules on market risk mean that a capital requirement of 100% of the current value of the firm’s position is likely to be appropriate for “the vast majority of cryptoassets”. The PRA says this is “particularly” the case for unbacked cryptoassets, while remaining somewhat vague in relation to digital assets backed by legal rights or interests.

The PRA also flags the need to manage operational risks. For example, firms that outsource the custody of crypto keys should understand their liability if the third party custodian fails and in that situation their legal and operational options for regaining control of the relevant assets.

The letter provides firms with guidance but does not propose changes to the existing regime. The Basel Committee on Banking Supervision is working on an internationally-agreed position on the treatment of cryptoassets (see our blogpost: Global banking regulator outlines proposals for the prudential classification and treatment of cryptoassets). The PRA does not suggest that it plans to pre-empt the BCBS by proposing a tailored crypto prudential regime before those talks are concluded.

The FCA has also issued a notice directed to all regulated firms with exposure to cryptoassets. The FCA reiterates that firms should be clear with customers about the extent of their business which is regulated. Firms are also advised to check whether the businesses they interact with are on the FCA’s list of unregistered cryptoasset businesses.

Regulating systemic stablecoins

Last year, the Bank of England published a discussion paper on new forms of digital money, including systemic stablecoins (see our blogpost: Bank of England papers on new forms of digital money). It has now published a summary of the responses along with planned next steps.

Among other things, respondents broadly agreed on the need to preserve cash; achieve interoperability between all forms of money; and have an appropriate risk-based regulatory framework for systemic stablecoin arrangements, including for private sector intermediaries.

The Bank had originally outlined four potential models for regulating systemic stablecoins in order to achieve the equivalent protections enjoyed by holders of commercial bank money. These models generated a mixed response among respondents. The FPC has advised that model 4, which contemplates stablecoins backed by commercial bank deposits, would introduce undesirable financial stability risks. The FPC also considered that any regulatory framework would need to mitigate the absence of a “backstop” (akin to the Financial Services Compensation Scheme and bank resolution arrangements) to compensate depositors in the event of a failure, as this type of state-backed arrangement would be difficult to replicate for non-banks. 

Next steps

In its letter the PRA says it will continue to monitor any expansion of firms’ crypto-related activities and expects firms to discuss proposed prudential treatment of crypto exposures with their supervisors. A PRA survey asks firms about their current and planned crypto exposures, including indirect exposure to crypto via derivatives. Responses to the survey are invited by 3 June 2022.

Before then, HM Treasury is expected to release more detail on the direction of travel for the regulation of cryptoassets in the UK, which is expected to include draft legislation introducing a regulatory framework for stablecoins (see our blogpost: UK reveals plans to regulated stablecoins). Building on this, the Bank of England intends to consult on its proposed regulatory model for systemic stablecoin issuers and wallets in 2023. 

The Bank of England and HM Treasury are also expected to launch a joint consultation on the case for introducing a UK CBDC in 2022.