Views from Hogan Lovells Global Digital Assets and Blockchain Practice

Overall, the Bank of England’s approach to regulating systemic stablecoins is welcomed. The discussion paper is thorough, and it is clear that the proposed regime follows careful considerations and deep thought with regards to how stablecoin arrangements work, and to the long-term role that stablecoins may potentially play in our financial ecosystem.

The core focus has been on preserving the ‘singleness of money’ – accordingly, the Bank’s focus has been on ensuring that, if stablecoins are to be a permanent fixture in the financial ecosystem, alongside cash or commercial bank money, they should be regulated to an outcome equivalent to that which applies to commercial bank money. To that end, the Bank has largely sought to apply existing regimes, with suitable adjustments made. Respondents to the discussion paper may wish to describe, by way of feedback to the Bank, the details of how stablecoin technology operates, the extent to which any regulatory outcomes that the Bank is seeking to achieve may already be built into a stablecoin arrangement by design, and to provide specific comments when assessing the appropriateness of the proposed rules.

The issue of ‘vertical integration’ has also been a focal point. The Bank’s approach to this is a pragmatic one – rather than imposing a ban, the Bank has proposed to ask for the risk to be managed by applying rules in line with the international Principles for Financial Market Infrastructure (PFMIs), such as by potentially requiring a multi-function entity to legally separate non-stablecoin services (to the extent that such services present a distinct risk profile) from the activities performed within the stablecoin payment chain. 

We note that the Bank’s current approach focuses on sterling-denominated stablecoins. However, the Bank has remained open to considering whether the proposed regulatory framework would need to be adapted for non-sterling denominated stablecoins – we consider this to be a sensible approach, particularly as the most popular stablecoins currently in circulation tend to be dollar-denominated (rather than sterling-denominated). It would potentially be in the Bank’s interest to extend its remit to non-sterling denominated stablecoins of systemic significance. This would also be in line with the UK’s aim to become a global hub for the cryptoasset industry.

We note also the timing of these developments. According to the UK authorities’ regulatory roadmap, the Bank intends to incorporate feedback on this discussion paper and to consult on the final rules by mid-2024, and, subsequently, to implement the regime by 2025. With other jurisdictions around the world seeking to implement stablecoin regimes in the near future, it will be important for the Bank to avoid significant delays to this timetable in order to uphold the UK’s reputation as a jurisdiction that welcomes and supports the safe development of innovative technology for use in financial services.

What’s the rationale for focusing on stablecoins when used as a means of payment?

Currently stablecoins are mainly used to settle transactions, or to store value, in cryptoasset markets. The FPC judges that direct risks to UK financial stability from cryptoassets and DeFi are limited due to their limited size and interconnectedness with the wider financial system. The Bank’s current assessment is therefore that existing stablecoins (eg USD Coin or Tether), or any new sterling referenced stablecoins similarly focused on transactions in cryptoassets or DeFi, would not be brought under the Bank’s remit, and would not be subject to the proposed regulatory framework set out in the discussion paper.

However, the Bank reasons that as stablecoins purport to have a stable value, and may offer advantages in terms of cost, convenience and functionality, many people in the UK could quickly start to use stablecoins for everyday payments. Given that the safety of payments and confidence in money are ‘fundamental to financial and economic stability’, the Bank therefore considers it sensible to prepare for this eventuality by setting out the regulatory framework that would be needed were stablecoins to become widely used as money for payments in the economy.

Brief overview of the proposed regulatory framework

The proposed regime:

• focuses on sterling-denominated stablecoins because the Bank considers these are the most likely digital settlement assets to be used widely for payments. If necessary, the Bank will consider how the proposed regulatory framework would need to be adapted for non-sterling referenced stablecoins; and
• is intended for business models that focus on payments-related activities and innovation within retail payments. Proposed holding limits, if used, would constrain wholesale use of stablecoins at systemic scale (see below for more on holding limits).

The Bank also considers that unbacked cryptoassets, or any other unbacked digital settlement assets, would not be suitable for widespread use in UK retail payments.

It is the Bank’s view that activities other than payments, such as lending or investment, pose risks that are better captured within other regulatory regimes.

Overarching elements of the proposed regulatory framework

The Bank’s proposed regime aims to address both types of risks presented by stablecoins, ie in their innovative use as a form of money or money-like instrument, and in their use as a means of payment in systemic payment systems.

‘Same risk, same regulatory outcome’ and singleness of money

• The proposed regime is guided by international standards, namely the CPMI-IOSCO Principles for Financial Market Infrastructures (CPMI-IOSCO PFMIs)) and the Financial Policy Committee’s expectations for stablecoins as money-like instruments.
• The principle of ‘same risk, same regulatory outcome’ applies, meaning that - among other things - as a new form of privately issued money, issuers of stablecoins used in systemic payment systems should meet standards that are at least equivalent to those applying to commercial banks (as commercial bank money now constitutes the majority of money used to make payments in the economy).
• This doesn’t mean that stablecoin issuers have to be regulated in exactly the same way as commercial banks. But they must be regulated in a way that ensures that stablecoins would maintain the same value as, and would always be fully interchangeable with, other forms of money – in line with the ‘singleness of money’ principle, ie that all forms of money should have the same value, be generally accepted as a means of payment and be interchangeable without loss of value with all other forms of money used in the economy.

Stablecoins to be backed with non-interest bearing deposits at the Bank and issuers of systemic payment stablecoins should be set up as UK subsidiaries

• Stablecoin issuers would be required to fully back stablecoins with non-interest bearing deposits at the Bank (see further ‘Requirements on backing assets’ and ‘Capital requirements’ under ‘Further details of the proposed regulatory framework’ below).

• It is also proposed that issuers of systemic payment stablecoins should be set up in the UK as subsidiaries in order to carry out business and issuance activities into the UK and with UK-based consumers, both directly and through intermediaries. The backing assets and the issuer’s capital would also need to be held in the UK.
• This is consistent with the PRA’s approach to supervising international banks, under which UK establishment is required where retail deposits exceed a certain threshold.
• For other non-UK elements of the payment chain, ie non-issuer systemic entities within stablecoin payment chains, the Bank will take an approach based on the framework applied to those FMIs it currently supervises.

Secondary market trading requirements

• Stablecoins are commonly traded in secondary markets. While the proposed regulatory regime would not ban systemic payment stablecoins from being traded on secondary markets, it aims to remove incentives for market participants to exchange systemic payment stablecoins at rates that depart from par (in line with the singleness of money principle).
• Issuers of sterling-denominated systemic payment stablecoins would be required to ensure that they can be exchanged at par – that is, without loss of value – for other forms of money, including a digital pound (if introduced), on demand. This is also consistent with the international CPMI-IOSCO PFMIs.
• The Bank recognises that further requirements might be needed to maintain the singleness of money. It welcomes views on this topic and will outline any further requirements in due course.

End -to-end financial and operational resilience

• The proposed regulatory regime would aim to adopt an end-to-end approach to ensure that risks in the payment chain are comprehensively assessed and controlled for, and do not disrupt the functioning of, the payment system.
• This means that the whole stablecoin payment chain, and the entities that comprise it, would be expected to demonstrate robust financial resources (see below ‘More robust backing and capital requirements’), risk management (including risks arising from the use of third parties), and governance.

More robust backing and capital requirements

• In order to meet the FPC’s expectations in the absence of backstop deposit guarantee scheme and resolution regime arrangements that are available for banks, other elements of the regulatory regime for non-bank systemic payment stablecoin issuers, such as backing and capital requirements, would need to be more robust than for banks to ensure the necessary overall level of protections.
• See the relevant sections on ‘Requirements on backing assets’ and ‘Capital requirements’ under ‘Further details of the proposed regulatory framework’ below for more details of the related proposals.

Addressing vertical integration risks

• In line with the CPMI-IOSCO PFMIs, the Bank considers that systemic payment systems using stablecoins would need to focus particular attention on certain aspects of their governance and risk management arrangements to address the risks posed by vertical integration.
• This may include legally separating the non-stablecoin services that a multi-function entity provides. In particular, the issuer may be required to form a legal entity that is sufficiently financially, operationally, and organisationally separate from other entities in the wider group, so that it is bankruptcy remote.
• The paper notes that the FCA will also give further consideration to the risks of vertical integration in the cryptoasset sector more broadly, and the Bank will engage with UK public authorities to consider how the regime for systemic payment stablecoins interacts with other parts of the framework (including the FCA’s regime).

Further details of the proposed regulatory framework

Requirements for the transfer function

Payment systems operator (PSO) as ‘systemic risk manager’

• While the regime aims to be flexible with a view to accommodating different business models in which various functions - including payment system/transfer, issuance of the stablecoin as the settlement asset, and customer interface/storage of stablecoins - are performed by different legal entities, the transfer function or payment system would remain the Bank’s ‘regulatory hook’.
• As with its approach to the regulation of other systemic payment systems, and in line with international standards, the Bank will require that there is an entity across the payment chain that can be identified as the PSO, with responsibility for performing the transfer function.
• That entity – once recognised by HMT – would be responsible for ensuring it can assess and control all risks that may arise across the entire payment chain (including from the form of infrastructure or ledger used) and that may disrupt the functioning of the payment system. The PSO would therefore act as a ‘systemic risk manager’.
• Importantly, the PSO would also be responsible for ensuring that the settlement asset it uses meets the FPC’s expectations and international standards. In practice, this means either issuing the stablecoin itself and being regulated against the Bank’s proposed requirements for issuers, or choosing another issuing entity that is regulated as a service provider (subject to HMT recognition) and which meets these requirements.
• The Bank recognises that there are elements of the transfer function of systemic payment systems using stablecoins that are innovative (ie do not feature in other payment systems), eg the use of external and distributed ledgers (as opposed to in-house ledgers with a centralised entity to record transactions). Consistent with the CPMI-IOSCO PFMIs, the Bank acknowledges that further supervisory guidance may be needed to give additional detail on how systemic payment systems using stablecoins may comply with the Bank’s requirements already applicable to systemic payment systems.

Governance requirements for systems using public permissionless ledgers

• Any systemic stablecoin payment system using public permissionless ledgers would have to assure the Bank that a legal entity or natural person could be held accountable and responsible for end-to-end risk management in the payment system and compliance with regulation. This is because the absence of centralised governance arrangements in permissionless ledgers makes it particularly challenging to address one of their core risks – namely, that settlement of transactions may not always be final (as set out in the CPMI-IOSCO PFMIs).
• The Bank acknowledges that such an entity may not be able to exercise the degree of control over public permissionless ledgers needed to meet international standards and the FPC’s expectations, and recognises that industry is already working actively on these issues. It would welcome views on how the necessary changes and/or solutions may be built in the future.

Recognised service providers to be regulated according to risk posed

• Similarly to the Bank’s ability to regulate service providers that provide critical services to other systemic payment systems, in addition to regulating the recognised PSO, the Bank will regulate recognised service providers in the light of the risks those entities pose to the functioning of the payment chain as a whole. These could include, for example, wallet providers, payment service providers, and issuers (if separate from the recognised PSO). These firms, once recognised by HMT, would be subject to all of the Bank’s powers as set out under the Banking Act 2009 and its supervisory regime once finalised.

Requirements on backing assets

• By contrast to the existing commercial banking regime, the proposed regime is intended for payment system business models that do not involve the payment system exposing itself to credit, liquidity or market risk, and which generate revenue from payment services rather than liquidity and maturity transformation. The stablecoins will therefore need to be backed by assets that do not generate the risks arising in commercial banking.
• Following the responses to its 2021 discussion paper on new forms of digital money, the Bank proposes that a 100% central bank deposits model is the most appropriate for systemic payment systems using stablecoins operating in the UK, in order to ensure that such stablecoins always maintain their value and the ‘singleness of money’. It would give coinholders greater confidence—in the absence of a deposit guarantee scheme or resolution regime—that their stablecoins can be redeemed in full at any time, minimising run risks.
• The Bank acknowledges that the proposed requirements on backing assets would require a different business model from those currently operated by stablecoins, which hold a variety of backing assets and receive a large proportion of their revenues from these assets. However, the idea is that this approach would support sustainable innovation in payment services by allowing for a ‘greatly simplified’ regime compared, for example, to the banking regime, and encouraging issuers and other firms to focus their business models on payments-related activities. It would also encourage investment in building the use cases for new technologies in payments, such as efficiency, cost and functionality, in order for issuers to generate revenue, and it would ensure that revenues are not vulnerable to interest rate changes.
• Stablecoin issuers that are recognised as systemic in the UK would need to meet the requirements for access to a deposit account at the Bank. In addition, the Bank would need to assess any operational risks that an issuer’s access to a central bank deposit account might pose to RTGS, and the UK’s wider financial system.
• The Bank’s preferred model meets the requirements of the CPMI-IOSCO PFMIs and the FSB High-level Recommendations for the Regulation, Supervision and Oversight of Global Stablecoin Arrangements (July 2023).

Restrictions on remuneration

• The Bank proposes that issuers should not receive interest on their central bank deposits or pay interest to coinholders, in line with the principle that stablecoins used in systemic payment systems should be primarily used for payments.
• The Bank points out that the ban on interest payments to coinholders would align the treatment of systemic stablecoins with cash, e-money, and a potential digital pound.
• However, it also notes that existing payments providers provide incentives for usage, such as points or rewards linked to transaction volumes. It will consider further whether this practice would be permitted for stablecoins used in systemic payment systems.

Other requirements for the issuance of money used in systemic payment systems

Legal claim for the value of stablecoins used in systemic payment systems and redemption arrangements

• The Bank proposes to require systemic stablecoin issuers to:
  • ensure that there are no undue restrictions or conditions that would prevent coinholders from redeeming their stablecoins;
  • process redemption requests by the end of the day on which a valid redemption request is made, and in real time wherever possible (in line with CPMI-IOSCO guidance); and
  • demonstrate to the Bank how they intend to manage redemptions both in normal times and in stress, and both during and outside of the operating hours of payment systems they use to process redemption requests.
• Redemption fees would either be prohibited or there would be a requirement that any redemption fees charged to coinholders reflect the cost incurred by the systemic stablecoin issuer or any other entity providing the redemption service.
• In the event of a failure of any participant in a systemic payment system using stablecoins, the Bank expects issuers and other relevant entities to cooperate with the appointed administrator or other insolvency official of the failed participant to facilitate redemption/payout.
• Issuers would be required to maintain a recovery and administration plan to be able to fulfil redemptions in the case of a failure of any firm in the payment chain and/or to facilitate a faster payout to coinholders in the case of failure of an issuer.
• The Bank would reserve the right to require, or allow for, a temporary pause on redemption for financial stability reasons, for example through a direction to the systemic stablecoin issuer.

Safeguarding

• The Bank proposes that there should be a safeguarding regime to protect coinholders’ legal claims and to ensure that coinholders can redeem their stablecoins at par value at all times.
• The two key features of the safeguarding regime would be: (a) statutory trust, where the backing assets are held for the benefit of coinholders (drawing on the FCA’s Client Assets Sourcebook (CASS)); and (b) safeguarding rules. Again, this is in line with both the FSB High-Level Recommendations and the CPMI-IOSCO PFMIs.
• The Bank notes that the FCA is also proposing to adopt a trust model in its regime for the backing assets of non-systemic stablecoins. This means that transition costs for non-systemic stablecoins that are later recognised as systemic payment systems using stablecoins would be reduced.
• The safeguarding rules would govern the segregation of backing assets, the reconciliation of these assets with issued stablecoins, the organisational controls over the issuance, transfer, and holding of these stablecoins, and reporting on issuers, stablecoins, and backing assets. .
• In relation to issuers’ use of so-called ‘treasury wallets’ (i.e. where issuers hold their own stablecoins in proprietary wallets, and such stablecoins would be ‘unbacked’, unlike other stablecoins in circulation), the Bank’s current view is that issuers of systemic stablecoins should be required to comply with safeguarding rules such that the stablecoins held in treasury wallets are also fully backed, . However, the Bank is open to industry feedback on alternative solutions to mitigate the risk of these ‘unbacked’ stablecoins diluting the pool of backing assets available to support coinholders’ redemptions.

Capital requirements

• The Bank proposes that issuers of stablecoins used in systemic payment systems should hold additional capital against other risks that may result in a shortfall in the backing assets or that can threaten the firm’s ability to operate as a going concern. The key risks are operational and general business risk, and distribution costs (ie costs of distributing the proceeds of backing assets to coinholders in the event of distress).
• The proposal is to use existing international standards (the CPMI-IOSCO PFMIs) as a baseline for calculating capital requirements, with some modifications to mitigate the risk of a shortfall in backing assets (notably a requirement for issuers to hold a ‘shortfall reserve’ on statutory trust for the benefit of coinholders in a similar legal structure to that proposed for the backing assets).
• There is acknowledgement that, due to the novelty of the industry and consequent unavailability of historical data, estimating the capital requirements may be ‘challenging’.

Supervision including failure of issuers

• The Bank is proposing to apply its existing approach to the supervision of financial market infrastructure firms, including systemic payment systems, to issuers of stablecoins used in systemic payment systems.
• It proposes to use its powers under the Banking Act 2009 to identify weaknesses and intervene early or pre-emptively where an issuer is experiencing stress or failing.
• It states that supervisory measures may take various forms depending on the risk assessment.
• Issuers would be required to maintain a credible plan to enable a successful wind down.
• If solvent-exit options or solvent wind-down are impractical or unsuccessful and an issuer fails or is likely to fail, the Bank may seek to apply to the courts to place the issuer into special administration under the FMI Special Administration Regime (FMI SAR), as modified by HMT. See this article for more on the October 2023 HMT response to its previous consultation on the application (with modifications) of the FMI SAR regime as the primary regime to be used in the event of a failure of an operator of a recognised systemic DSA payment system, a recognised DSA service provider to such payment systems and a non-systemic service provider to such payment systems.
• The Bank makes particular note that the modified FMI SAR is not a resolution regime, meaning that the FMI SAR will not have the same range of tools to facilitate continuity of service as the resolution regimes do for the largest banks and recognised central counterparties. The timeliness of payout by issuers will also be dependent on the speed with which administrators are able to effect such payout, so may not be as rapid as, for example, payouts under the Financial Services Compensation Scheme (FSCS) for covered bank deposits.

Limits on holdings of systemic stablecoins

• The Bank welcomes feedback on the use, calibration and practicalities of limits on holdings of systemic stablecoins, which (similarly to its proposed approach for the digital pound) it considers likely to be necessary to mitigate financial stability risks from large and rapid outflows of deposits from the banking sector, and risks posed by newly recognised systemic payment systems as they are scaling up.
• The limits would be raised, or removed completely, if the Bank believes the risks to financial stability have been mitigated.
• For the digital pound, the Bank previously consulted on an individual holding limit of between £10,000 and £20,000, and sought views on a lower limit, such as £5,000. The Bank states that any stablecoin limits would be set at a level that is consistent with, and no higher than, those set for the digital pound, if introduced.
• The Bank also suggests that firm-specific limits could further mitigate risks posed by systemic payment systems using stablecoins while they are launching and scaling up. It points out that similar processes are currently applied to some new systemic payment systems and banks.
• There is acknowledgement that implementing holding limits for each systemic stablecoin may be operationally challenging, given that users may be able to use multiple entities to access a given stablecoin. The Bank welcomes feedback on the practicalities of implementing such limits, including potential technological solutions.

Requirements for wallet providers

• As the entities safeguarding coinholders’ means of control over their stablecoins, wallet providers would need to ensure that coinholders’ legal rights and ability to redeem the stablecoins at par in fiat are protected at all times.

Custodial wallets

• As the FCA is developing a regime for the custody of stablecoins issued in the UK, based on its Client Asset Sourcebook (CASS), and the existing regime for custodians of other financial assets, the Bank does not, in general, expect to regulate stablecoin custodians directly.
• Instead, it will seek assurances from the firms within its supervision that: (i) activities performed by wallet providers do not threaten the ability of the payment system operator to perform payment transactions; and (ii) coinholders are able to exercise their legal claim on the issuer to redeem the full value of their stablecoins.
• However, the Bank may consider that a custodial wallet provider should be recognised by HMT as a service provider. The Bank would then – subject to HMT recognition - regulate the recognised entity directly. The Bank would take into account other regimes that might already apply to a systemic stablecoin custodian before applying any direct requirements.

Non-custodial or unhosted wallets

• Transfers to and/or from unhosted wallets could be left unchecked, making them difficult to track and therefore potentially attractive tools for money laundering and terrorist financing purposes.
• The FCA’s proposed regulatory regime for stablecoin issuers will require regulated stablecoin issuers to carry out customer AML checks, including when redemption requests are received from unhosted wallet owners.
• However, the Bank notes that these additional checks may not be sufficient to ensure the integrity of day-to-day payments and transfers, as customers may not always redeem their stablecoins from the issuer, or redeem stablecoins at all (i.e. if customers are transacting with other unhosted wallets). As such, it is still exploring the risks associated with unhosted wallets and their suitability to be used at systemic scale for payments in the UK.

Exchanges providing wallet services

• If an exchange provides custodial services to coinholders and therefore performs the store of value function in a systemic stablecoin payment chain, it may be recognised by HMT and would be captured by the Bank’s regime for systemic stablecoin payment chains – more specifically the requirements that custodial wallet providers should meet.
• See also above ‘Addressing vertical integration risks’ for more on the risks from, and the Bank’s approach to, the vertical integration of multiple activities into single entities like exchanges.
• Regarding exchanges that perform trading activities for speculative purposes, the Bank expects this to be beyond its remit for systemic payments systems. But if an exchange performs the activity of settling payment transactions at systemic scale, it could fall within the Bank’s remit and - subject to HMT recognition - be regulated as a systemic payment system.

Addressing the risks of off-chain transactions

• The Bank’s initial position in relation to off-chain transactions (ie those occurring outside the main blockchain network and which are recorded on a separate off-chain ledger) is that, were entities like exchanges and custodial wallet providers to develop their own off-chain ledgers on a systemic scale, the Bank may regulate them directly either as a payment system operator or as a systemic service provider, subject to HMT recognition.
• The Bank points out that the privacy element of off-chain transactions raises similar anonymity concerns to those raised for unhosted wallets (see above ‘’Non-custodial or unhosted wallets’).

Requirements applicable to other service providers

• The Bank may regulate other service providers that are critical to the delivery of the issuance, transfer and/or store of value functions without directly performing them (eg technology providers like cloud outsourcing providers, privacy, security and encryption software providers, or firms providing the infrastructure to enable operation of the ledger), to ensure they do not threaten the ability of firms in systemic stablecoin payment chains to deliver against regulatory expectations. This will depend on the scale of the risks posed and activities performed.
• For example, where they provide services to a wider set of financial services firms they may be captured by the proposed regulatory regime for critical third-parties, subject to HMT designation. Alternatively, the Bank may recommend that the service provider be specified by HMT as a critical service provider to a firm already recognised by HMT in the systemic payment chain, or recognised as a systemic service provider in its own right. Here, the Bank would expect to apply its approach to critical service providers (subject to any necessary adjustments to the supervisory approach).
• At this stage, the Bank is not proposing requirements for other ancillary activities that exchanges may also provide, such as brokerage, market-making, staking, and other decentralised finance operations, although as set out above at ‘Exchanges providing wallet services’, exchanges may be regulated as a service provider or payment system operator (subject to HMT recognition).

Overlap with other regulators’ remits

• The Bank acknowledges that some stablecoin entities – those that are recognised by HMT as being systemically important – may be regulated by the Bank (for prudential purposes), the FCA (for conduct purposes), and the PSR (for competition purposes).
• It states that the regulators will provide clarity on how the regulatory framework for firms that fall within multiple regimes will work in practice in due course. Work in this area will include revisiting the existing Memorandum of Understanding between the Bank, the PRA, the FCA and the PSR. In addition, as part of FSMA 2023 HMT may, via secondary legislation, make provisions relating to the regulation of recognised DSA payment systems and service providers, for example to clarify how dual regulation of systemic stablecoin entities will work in practice.

Next steps

The deadline for responses to the discussion paper is 6 February 2024. According to the cross-authority roadmap on innovation in payments that has also been published, the Bank will then consider industry feedback and consult on the rules for the proposed regime by mid-2024. Implementation of the regime is currently planned for 2025. The Bank flags that the regime could be ‘adapted over time as the nascent industry evolves’.

The Bank also states that it is considering the risks and benefits from innovations in wholesale settlement, including the use of stablecoins for wholesale purposes, and will set out its views on this in due course.

The Bank also mentions that it will ‘shortly’ publish a response to its February 2023 consultation paper on the digital pound. For more on the consultation, take a look at this article.

Authored by John Salmon, Lavan Thasarathakumar, Virginia Montgomery and Christina Wu.