In the aftermath of the recent collapse of TerraUSD, a prominent USD-pegged “stablecoin”, the UK government is consulting on new measures to bring systemic “digital settlement asset” firms within the special administration regime applicable to traditional systemic payment systems. The proposals raise a number of questions, particularly in relation to scope and objectives. Stakeholders have until 2 August 2022 to respond.

Regulatory response to collapse of TerraUSD

Last month, a highly prominent algorithmically maintained USD-pegged “stablecoin”, TerraUSD, went into freefall, along with its sister cryptocurrency Luna. The incident sent shockwaves across the crypto markets and reinforced the concerns of many regulators around potential contagion risks. In the UK, the Financial Conduct Authority promptly put out a reminder to consumers of the risks of investing in cryptoassets. There followed much speculation as to if and how the government might respond, in light of its recent efforts to present the UK as open for crypto business. The government has now published a consultation paper outlining proposals intended to mitigate financial stability risks by bringing systemic “digital settlement asset” firms within the Financial Market Infrastructure Special Administration Regime (FMI SAR).

What is the FMI SAR?

The UK has certain “special administration regimes” to deal with the insolvencies of entities like banks and financial market infrastructures, where the usual administration process does not best serve the public interest. Traditional payment systems which are recognised as systemic fall within the FMI SAR. If such a payment system fails, the FMI SAR requires the administrator to pursue an objective of service continuity (i.e. continuing to deliver the failed firm’s services), even if that is not in the best interests of the creditors. This is designed to mitigate the risk of severe disruption to the wider financial sector. The Bank of England has oversight and powers of direction over administrators of entities that fall within the FMI SAR.

Proposals to extend and amend the FMI SAR

The government is proposing to pass legislation (i) to establish that systemic (non-bank) digital settlement asset firms will generally fall within the scope of the FMI SAR and (ii) to make amendments to the FMI SAR regime in order to introduce an additional objective for administrators in these cases (as discussed further below). The proposal contemplates that the Bank of England will be the lead regulator but will have an obligation to consult with the FCA, given the potential for regulatory overlap.

What constitutes a “digital settlement asset” and a “systemic DSA firm”?

The consultation paper defines “digital settlement asset” in rather vague terms. What is clear is that this concept is intended to be broader than the category of “payment cryptoassets” which are to be regulated under the e-money and payment services regimes. The government has previously said that that category will not include algorithmic stablecoins. In contrast, the term “digital settlement assets” is said to include “wider forms of digital assets used for payments/settlement” alongside payment cryptoassets.

The term “systemic DSA firms” is stated to refer to “systemic DSA payment systems and/or an operator of such a system or a DSA service provider of systemic importance”. The paper notes that “[a] payment system may be designated as systemic where deficiencies in its design or disruption to its operation may threaten the stability of the UK financial system or have significant consequences for businesses or other interests.”

The additional objective for administrators of systemic DSA firms

While continuity of service is intended to remain an important objective in the administration of a systemic DSA firm, the government wants to introduce an additional objective “covering the return or transfer of funds and custody assets”. This is intended to reflect the fact that, unlike traditional payment firms, DSAs may allow users “to store value which is then used for the movement of funds between cryptoassets without transitioning into fiat money”. This raises a lot of questions. In particular, in the case of an algorithmic stablecoin which has no (or subpar) market value and which is backed by no legal rights or interests in respect of fiat money, what “funds” are intended to be “returned or transferred”, and by whom? The consultation paper provides little insight into these types of issues.

What’s next?

The consultation remains open for comment until 2 August 2022.