The UK has already made some important strides to regulate the cryptoasset sector over the last few years, focusing on consumer protection and anti-money laundering initiatives. Advancing to the next stage, the UK aims to bring cryptoassets within the 'regulatory perimeter' of its licensing regime. Anticipated legislation slated for this year is expected to mark the beginning of a new era in cryptoasset regulation.

How will fiat-backed stablecoins be brought into the UK’s regulatory framework?

The legislation that empowers HM Treasury to bring fiat-backed stablecoins and other cryptoassets within scope of the financial services regulatory perimeter is the Financial Services and Markets Act 2023 (FSMA 2023), which received Royal Assent on 29 June 2023. Since then, HM Treasury has set out its final proposals on how it intends to proceed in relation to the regulation of fiat-backed stablecoins.

In summary, HM Treasury wants to bring forward secondary legislation in the coming months to bring various activities relating to fiat-backed stablecoins within the regulatory perimeter. This includes regulating:

• the use of regulated stablecoins as a means of payment: new legislation will amend the UK’s Payment Services Regulations 2017 so that they apply to fiat-backed stablecoins used in UK payments chains. Firms involved in these payments would need to seek authorisation or registration as a payment service provider from the FCA. Plans to allow stablecoins issued overseas to be used for payments in the UK need fleshing out. One option is for the “arranger” of the payment using an overseas stablecoin to be appropriately licensed and held responsible for making sure that the stablecoin meets the FCA’s standards.
• the issuance and/or custody of regulated stablecoins: the issuance and custody of fiat-backed stablecoins (regardless of whether they are used in payments) will become regulated activities and subject to FCA supervision. This will be achieved by amending the Financial and Market Act 2000 (Regulated Activities Order) 2001 (RAO).

In addition to the above, the scope of systemic regulation is also being expanded to provide for stablecoins. FSMA 2023 allows for payment systems and service providers using digital settlement assets to be recognised or designated by HM Treasury and so become subject to supervision by the Bank of England and/or the Payment Systems Regulator. This means that potentially systemic stablecoins would be regulated like a traditional payment system. A special administration regime prioritising the return of customer funds will also apply in the event of an insolvency.

What requirements will apply to regulated stablecoin issuers and custodians?

In November 2023, the FCA unveiled proposals regarding the regulatory requirements anticipated for firms that issue or provide custodial services for fiat-backed stablecoins. The proposed framework will seek to apply several existing regulatory standards, that currently already apply to many FCA-authorised entities, to the realm of stablecoin activities.

This includes, by way of example, adherence to the FCA’s overarching ‘Principles for Business’, compliance with the Consumer Duty, and observance of rules within the FCA’s Conduct of Business sourcebook such as those concerning inducements, client categorisation, and the disclosure of costs and charges.

Furthermore, the existing conflict of interest rules, operational resilience requirements, and the senior managers and certification regime should also apply.

The primary challenge here, for both the FCA and regulated stablecoin providers, lies in adapting and applying these established rules to the novel operational models and inherent challenges of stablecoin issuance and custody.

For instance, the FCA notes in the context of inducements that if a stablecoin issuer holds stablecoins itself then, in the event of market turbulence, the issuer may be incentivised to consider its own interests ahead of those of clients. This raises the question of whether the FCA needs to draft any specific rules or guidance to tackle this issue.

Beyond the existing regulatory provisions, the FCA is considering specific rules tailored to the unique nature of stablecoin issuers and custodians. The two principal expectations for issuers are to ensure that their stablecoins consistently maintain their value relative to the designated reference currency (or currencies) and that holders can promptly redeem their value at par.

To achieve this, the FCA proposes that issuers will be required to hold backing assets that are not only stable in value but also sufficiently liquid, allowing for quick redemption by consumers. The FCA has set out more granular proposals concerning (amongst other details) the management, composition, and safeguarding of these backing assets and the redemption rights for holders.

For custodians of stablecoins, the FCA’s proposed regulations underscore the importance of asset protection. This includes a proposal to apply certain core components of the FCA’s Client Assets sourcebook (CASS). This would include segregating client stablecoins from the custodian’s own assets, maintaining records to clearly establish asset ownership, and implementing effective organisational controls to mitigate the risk of loss or diminution of clients' custody assets – for example, due to misuse, fraud or poor administration.

In scenarios where custodians engage third parties or sub-custodians, they would have to conduct thorough due diligence and establish contractual arrangements that ensure stringent controls and governance over client stablecoin holdings are maintained.

The FCA’s proposals also set out their envisaged prudential sourcebook for regulated stablecoin issuers and custodians, which will cover the potential scope of the new prudential requirements, the sorts of capital and liquidity requirements that may be appropriate for these businesses and the need for regulatory reporting of prudential matters. The working title of the new sourcebook is ‘CRYPTOPRU.’

What is the expected timing on the finalisation of this new regulatory regime?

In October 2023, HM Treasury noted that it intends to bring forward secondary legislation as soon as possible and by early 2024, subject to available parliamentary time.

After the feedback period for its November proposals ended on February 6, 2024, the FCA is expected to publish draft rules for cryptoasset issuers and custodians later in the year for consultation.

Looking beyond 2024: What is ‘phase 2’ of the UK’s plans?

Beyond the initial focus on stablecoins, the UK Government is preparing for a more comprehensive ‘phase 2’ of cryptoasset regulation. This ambitious next step aims to establish new regulated activities that encompass the issuance, exchange, investment, risk management, lending, and custody of a wider array of cryptoassets, extending beyond the scope of fiat-backed stablecoins alone.

Following a consultation in February 2023 on the future financial services regulatory framework for cryptoassets, the Government published its response in October. This document refined and adjusted the original proposals, taking into account the industry feedback received.

Draft legislation for this broader regulatory sweep is anticipated for 2024. However, with an election impending and the current focus on establishing regulations for fiat-backed stablecoins, the timeline for these measures may be subject to change. 

The commitment to a more fully regulated cryptoasset sector is clear, but the exact trajectory will depend on the legislative calendar and the prioritisation of these extensive regulatory developments.

A version of this article was originally published by Finextra.