UK regulatory approach to cryptoassets and stablecoins: consultation and response (2021-2022)

UK regulatory approach to cryptoassets and stablecoins: consultation and call for evidence (January 2021)

UK regulatory approach to

cryptoassets and stablecoins:

Consultation and call for evidence

January 2021

© Crown copyright 2021 This publication is licensed under the terms of the Open Government Licence v3.0 except where otherwise stated. To view this licence, visit nationalarchives.gov.uk/doc/open- government-licence/version/3. Where we have identified any third party copyright information you will need to obtain permission from the copyright holders concerned. This publication is available at: www.gov.uk/official-documents. Any enquiries regarding this publication should be sent to us at public.enquiries@hmtreasury.gov.uk

ISBN: 978-1-911680-25-3 PU: 3066

cryptoassets and stablecoins:

Contents

Foreword 2

Chapter 1 Cryptoassets and the current regulatory landscape 3

Chapter 2 Policy approach 9

Chapter 3 Expanding the regulatory perimeter 13

Chapter 4 Call for evidence on investment and wholesale uses 30

Chapter 5 Responding to this consultation and call for evidence 36

Foreword

In 2018 the government launched a cross-authority Taskforce with the aim of exploring the impact of a rapidly developing cryptoasset market. At the time the Taskforce found that distributed ledger technology (DLT) could have a significant impact across a range of industries, with the potential to deliver real benefits for financial services. It also judged that the cryptoasset market was at an immature stage of development, and that there was limited evidence of the current generation of cryptoassets delivering benefits.

Two years on, the landscape is changing rapidly. So-called stablecoins could pave the way for faster, cheaper payments, making it easier for people to pay for things or store their money. There is also increasing evidence that DLT could have significant benefits for capital markets, potentially fundamentally changing the way they operate.

But as will always be the case with a rapidly evolving landscape, these developments could pose a range of risks to consumers and, depending on their uptake, to the stability of the financial system. That is why, at the last Budget, the Chancellor announced that we would be consulting on our response to the challenges and opportunities posed by these innovations.

The UK has long been recognised as a world-leader in financial technology. We are committed to maintaining this position. In practice, that means creating a regulatory environment in which firms can innovate, while crucially maintaining the highest regulatory standards so that people can use new technologies reliably and safely. This is essential for confidence in the financial system more broadly.

This document marks the first stage in our consultative process with industry and stakeholders on our approach. The approach will be informed by evidence of potential take-up and where the most serious risks lie. In doing so, we will take an agile, risk-led approach to regulation, rooted in the principle of ‘same risk, same regulatory outcome’.

As the Chancellor recently set out, in the near-term our priority is to ensure the framework supports the safe use of stablecoins. The government will continue to actively monitor new and emerging risks as this market continues to mature. We will stand ready to take further regulatory action to ensure the market is working for the people and businesses who operate in it.

Your responses will help inform the government’s approach and ensure the UK’s regulatory framework is fit for the future.

John Glen MP, Economic Secretary to the Treasury

Chapter 1

Cryptoassets and the current

regulatory landscape

Introduction

1.1 Financial innovation has seen rapid change over recent years, accelerated

further by the impact of Covid-19. Cryptoassets, offering new ways to transact, invest and store funds, have been part of this trend and could play an increasingly important role in the future. However, as will always be the case with a rapidly changing technological landscape, they also present new challenges and risks.

1.2 New and emerging forms of cryptoassets, such as stablecoins, which seek to

stabilise their value, could be used as widespread means of payment, and potentially deliver improvements in cross-border transactions. At the same time, depending on scale and nature of use, these developments could pose similar financial stability and consumer risks as traditional regulated payment systems.

1.3 At present a large proportion of cryptoassets fall outside or are likely to fall

outside the regulatory perimeter. This means they may not be subject to the same consumer protections or safeguards found in other areas of financial services and payments.1This may prevent benefits from being realised and exposes consumers to potential harms and, depending on prevalence and value transferred, could pose financial stability and consumer risks.

1.4 In light of this, and reflecting the pace of change, the Treasury’s March 2020

Budget outlined two measures as part of the UK’s response to cryptoassets: • consulting on bringing certain cryptoassets into scope of financial promotions regulation to enhance consumer protection; and • consulting on the broader regulatory approach to cryptoassets, including new challenges from so-called ‘stablecoins’

1.5 HM Treasury’s consultation on cryptoasset promotions concluded on 26

October. Further detail will be set out in due course.

1.6 This consultation relates to the second commitment. It seeks views on how

the UK can ensure its regulatory framework is equipped to harness the benefits of new technologies, supporting innovation and competition, while mitigating risks to consumers and stability. It reflects advice from the UK’s

1 As noted by the Financial Policy Committee (FPC) in the December 2019 Financial Stability Report, “Absent additional regulati on, some stablecoins held to be used for payments may not offer similar protections to central bank or commercial bank money held to be used for transactions in traditional payment systems”.

joint Cryptoassets Taskforce,2 which was established in 2018 with a mandate to consider the risks and benefits posed by cryptoassets and distributed ledger technology (DLT) in the UK, and to advise on the appropriate regulatory response.

1.7 The government proposes a staged and proportionate approach to

regulation, which is sensitive to risks posed, and responsive to new developments in the market. This document represents the first stage in the consultative process and focuses on establishing a sound regulatory environment for stablecoins, where the government judges that risks and opportunities are most urgent. The government will strategically assess new and emerging risks as this market continues to mature. Future regulation of a potentially wider set of tokens and services will be informed by this analysis, taking into consideration the views of industry, consumers, and regulators.

1.8 The government invites views from a wide range of stakeholders, and

particularly firms engaged in cryptoasset activities. If the proposals are adopted, further consultations and guidance will be issued by HM Treasury and relevant UK authorities on implementation, including specific firm requirements (see chapter 4 for further detail on next steps and how to respond).

1.9 The consultation element of the document is structured as follows: chapter 1

sets out the landscape for cryptoassets and their current status in UK regulation; chapter 2 outlines the government’s proposed policy approach; chapter 3 sets out specific proposals with respect to cryptoassets used for payments purposes.

1.10 Finally, the call for evidence (chapter 4) seeks stakeholder views on a broader

range of questions in relation to cryptoassets used for investment purposes and the use of DLT in financial services. In particular, it asks about the benefits and drawbacks of adopting DLT across financial markets, whether there are obstacles to its adoption, and what further actions government and regulators should consider in this space.

What are cryptoassets?

1.11 A cryptoasset is understood to be a digital representation of value or

contractual rights that can be transferred, stored or traded electronically, and which may (though does not necessarily) utilise cryptography, distributed ledger technology or similar technology.3 The term ‘token’ is used interchangeably with ‘cryptoasset’ hereafter.

2 Membership includes senior representatives from the Bank of England, Financial Conduct Authority and HM Treasury. It is also attended by the Payments Systems Regulator. 3 This description is largely aligned to definitions used in the government’s proposed extension of financial promotions regulation and the UK’s Money Laundering and Terrorist Financing regulations (though in contrast, does not specify that DLT and cryptography are necessary features).

1.12 Cryptoassets could fulfil a diverse set of functions, ranging from the trading

of digital collectibles to raising capital for new projects. No internationally agreed taxonomy or classification of cryptoassets exists. In 2019 the Financial Conduct Authority (FCA) published its ‘Guidance on cryptoassets’ which described three broad categories of token in relation to how they fit within existing FCA regulation: e-money tokens, security tokens and unregulated tokens.4 • e-money tokens meet the definition of electronic money in the Electronic Money Regulations 2011 (EMRs) – broadly, digital payment instruments that store value, can be redeemed at par value, at any time and offer holders a direct claim on the issuer • security tokens have characteristics akin to specified investments, like a share or a debt instrument, as set out in UK legislation.5 Broadly, these are likely to be tokenised, digital forms of traditional securities. As with e- money tokens, these are already within the UK’s regulatory perimeter and therefore subject to FCA regulation • unregulated tokens are neither e-money tokens nor security tokens and include: • utility tokens: tokens used to buy a service, or access a DLT platform – this could, for example, include access to online cloud storage; and • exchange tokens: tokens that are primarily used as a means of exchange – this includes widely known cryptoassets such as Bitcoin, Ether and XRP.

1.13 The FCA’s guidance also makes clear that many tokens can take a hybrid

form and fall into different categories at different points in time – for example, they may initially be used to raise capital, then later be used primarily as a means of exchange.

1.14 High volatility has been a notable characteristic of many widely known

exchange tokens, making them less suitable for payment purposes and more attractive to some holders as a high-risk speculative investment. In March 2018 the UK’s Financial Policy Committee (FPC) noted that ‘their values are currently too volatile to be widely used as a currency or a store of value and, with transaction costs high and settlement times slow, they are an inefficient media of exchange’. The FPC also stated that ‘as assets, they establish no claim on any future income streams or collateral. They have no intrinsic value beyond their currently limited potential to be adopted as money in the future, and hence could prove worthless’.

1.15 So-called ‘stablecoins’ are an evolution of cryptoassets, which seek to

minimise volatility in value. Depending on design stablecoins can currently fall into any of the categories set out above – though are currently more likely to be unregulated exchange tokens or e-money tokens. Stablecoins aim

4 The definitions which underpin current payment systems regulation do not reflect the classification outlined in this section. Instead, systems are defined according to whether the arrangement facilitates the transfer of funds or money (alongside other relevant criteria). This is discussed in more detail in chapter three.

5 The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO)

to maintain stability in their price, typically in relation to stable assets such as fiat currency.6 Examples include Tether, Paxos or USD coin.

1.16 Design features vary, including how the stablecoin is backed or stabilised (for

example, with financial assets or using an algorithm to increase or decrease the supply as needed to maintain a stable price). Other design features include the existence and nature of the token-holder’s claims on any assets referenced (e.g. whether or not a holder has legal rights to assets in the reserve) and the population of users able to hold the coin.

1.17 A stablecoin arrangement can consist of a number of different entities in a

chain, conducting activities in relation to the issuance of tokens, redemption and stabilisation of the stablecoin, the exchange of the token, and the interaction with users. Opportunities and risks vary depending on these design features, scale of uptake and intended use.

1.18 The FCA’s classification of tokens above aimed to provide guidance on which

tokens may lie within the FCA’s regulatory perimeter and may be subject to its regulation. However different classification methodologies exist, for example by categorising tokens according to their economic function (for example, ‘payment tokens and investment tokens’), or other relevant characteristics, such as the rights they confer to users. Classifications have also evolved in line with the changing nature of the market.

1.19 To provide continuity and clarity for market participants, the government

proposes to maintain the FCA’s broad approach to classification as far as possible. However, to reflect the proposal to bring additional tokens and associated activities into regulation (as set out in chapter 2) the government is considering whether a new category of regulated tokens may be needed – stable tokens.

1.20 The regulated category of stable tokens would refer to tokens which stabilise

their value by referencing one or more assets, such as fiat currency or a commodity (i.e. those commonly known as stablecoins) and could for that reason more reliably be used as a means of exchange or store of value. The category would also include other forms of tokenised payment and settlement assets, as well as tokenised forms of central bank money. Further detail on tokens in scope is set out in chapter 3.

1.21 In considering this classification, the government and other Cryptoassets

Taskforce authorities recognise that whilst cryptoassets are typically underpinned by DLT, stable tokens could be designed using other types of technology. This classification is therefore agnostic on the technology underpinning its use (e.g. whether it relies on DLT or not).

1.22 The government recognises that a more granular classification or taxonomy

of tokens could have benefits, for example in providing clarity for consumers

6 The Financial Stability Board (FSB) offers the following differentiation: “Algorithm -based stablecoins: A stablecoin that purports to maintain a stable value via protocols that provide for the increase or decrease of the supply of the stablecoins in response to changes in demand; and Asset-linked stablecoin: A stablecoin that purports to maintain a stable value by referencing physical or financial assets or other crypto-assets.” Treatment of algorithm-based tokens is discussed in chapter 3 (3.16)

and businesses as to what type of cryptoasset they are using and the benefits and risks that derive from it. However, given the rapidly evolving market and hybrid (sometimes fluid) nature of many tokens it is also important that any classification is future-proof and sufficiently flexible. The government invites views and responses on this issue. Box 1.A: Questions for respondents

1 Do you have views on continuing to use a classification that is

broadly consistent with existing guidance issued by UK authorities, supplemented with new categories where needed?

2 Do you have views on the proposed new regulated category of

‘stable tokens’?

Actions taken by UK authorities and the

government

1.23 Since the Cryptoassets Taskforce’s 2018 report, the government and UK

authorities have taken a number of actions to address risks and support innovation arising from cryptoassets, including (but not limited to):7 • communicating minimum policy expectations for stablecoins (BoE, HMT) - these have been communicated through speeches and international reports,8 including the Financial Stability Board (FSB) report on stablecoin regulation and the G7’s global stablecoin working group report which stated that ‘no global stablecoin project should begin operation until the legal, regulatory and oversight challenges and risks… are adequately addressed, through appropriate designs and by adhering to regulation that is clear and proportionate to the risks’.9 They have also been set out by the UK’s Financial Policy

Committee (see box 3A)10

• clarifying the regulatory perimeter (FCA) – this sets out when tokens are likely to be a specified investment under the Financial Services and Markets Act 2000 Regulated Activities Order 2001 (RAO), including those that are a financial instrument under the second Markets in Financial Instruments Directive (MIFID II), or e-money captured under

7 The Ministry of Justice are also funding the Law Commission to carry out a project exploring the legal status of digital assets. Primarily, the Commission will consider the issue of possession, and will provide recommendations for reform to ensure the la w is capable of accommodating digital assets. They aim to publish a consultation paper in the firs t half of 2021. 8 “Reinventing the wheel (with more automation)”, speech given by Andrew Bailey at the Brookings Institution virtual event, September 2020; “It’s time to talk about money”, speech given by Jon Cunliffe at the LSE, February 2020; “Seizing th e opportunities from digital finance”, speech given by Andy Haldane at TheCityUK, November 2020; “Payments after the COVID crisis” speech given by Christina Segal-Knowles at the LSE, June 2020. 9 G7 Working group report on “Investigating the impact of gl obal stablecoins”, CPMI October 2019; and FSB report on “Regulation, Supervision and Oversight of Global Stablecoin Arrangements”, October 2020. 10 The Bank of England’s August 2020 Financial Stability Report.

the EMRs. Depending on the activity that will be undertaken, FCA authorisation or registration may be required • implementing the Fifth Anti-Money Laundering Directive (HMT, FCA) – bringing custodian wallets providers and cryptoasset exchange providers into anti-money laundering (AML) and counter-terrorist financing (CTF) regulation • consulting on bringing a broader subset of cryptoassets within the FCA financial promotions regime (HMT) – if taken forward, this would apply to the promotion of relevant activities in relation to qualifying cryptoassets • banning the sale, marketing and distribution of derivatives and exchange traded notes that reference certain types of cryptoasset to retail consumers (FCA) – finalised rules come into force 6 January 2021, restricting the sale, marketing and distribution of contracts for difference, futures, options and exchanged-traded notes referencing unregulated, transferable cryptoassets • consumer warnings about cryptoasset scams (FCA) – as well as providing guidance on how consumers can protect themselves, the FCA also publishes a warning list of known firms running scams. In May 2019, the FCA (in conjunction with Action Fraud) reported that the number of reports of cryptoasset and forex investments scams tripled in 2018/19 (note, however, rising cryptoasset usage during this period) • support for DLT-based services through the FCA sandbox (FCA) - the FCA continues to support innovative financial services firms through its various initiatives. This includes its Direct Support function, which provides regulatory feedback to firms, and its Regulatory Sandbox, which offers the opportunity to test products in a live environment with FCA oversight. Particularly in the Regulatory Sandbox, DLT has been, and continues to be, the most popular technology tested, with roughly a third of all firms using it to facilitate their products and services. DLT-based solutions tested in the Sandbox include payments, tokenisation of financial instruments, Digital ID and insurance intermediation.

1.24 Building on these actions, the government judges that further regulatory

adjustments are required to enable the government and authorities to meet objectives discussed below.

Chapter 2

Policy approach

Objectives, principles and UK initiatives

2.1 HM Treasury and other Cryptoassets Taskforce authorities have identified a

series of objectives and principles to guide the government’s approach to regulating cryptoassets. These are as follows:

Objectives

Protecting financial stability and market integrity. This includes maintaining the appropriate regulatory standards, ensuring infrastructure is operationally resilient and that safeguards are in place to mitigate any risks to financial stability. Delivering robust consumer protections. This means ensuring consumers benefit from the same of level of protection they would when other regulated instruments are being used for the same purpose (e.g. payments). Promoting competition, innovation and supporting UK competitiveness. This means continuing to encourage and support UK fintech firms, and ensuring consumers and businesses have access to a variety of high-quality services and products.

Principles

Maintaining the current division of UK regulator responsibilities as far as possible and applying the principle of ‘same risk, same regulatory outcome’. In doing so, the government will remain technology agnostic, while also considering whether the technology used gives rise to additional risks or equally where its use may mitigate risks. This supports the government’s desire to ensure a level playing field and reduce opportunities for arbitrage. In practice, it means drawing on existing regulations and requirements insofar as they are applicable, with adjustments or additional requirements where needed to address specific characteristics or risks. The government will also seek to maintain as far as possible the current delineation of UK regulator responsibilities with respect to regulation of activities, including across the Bank of England, FCA and Payments System Regulator (PSR). Ensuring the approach is proportionate, focussed on where risks and opportunities are most urgent or acute. UK authorities should

avoid applying disproportionate or overly burdensome regulation to entities particularly where end users are aware of risks or the activities do not give rise to financial stability risks. The government is therefore proposing to take an incremental, phased approach to regulatory adjustments (see chapter 3 for further detail on the sequencing of regulatory changes). Ensuring the approach is agile, able to reflect international discussions and aligned to the future government approach to financial services and payments regulation. Given the cross-border nature of cryptoassets, the UK is committed to working with other jurisdictions and through the international standard-setting bodies to support harmonisation of treatment as far as is feasible. In doing so, the approach should allow for changes to reflect international discussions, including on equivalence where relevant. The government will also seek to ensure that the regulatory approach to cryptoassets coheres with the outcomes of the Payments Landscape Review and Future Regulatory Framework (FRF) Review, which are considering how the regulatory framework for financial services and payments need to adapt to be fit for the future.

2.2 The government recognises that there may be cases in which there is tension

between different principles, and they will need to be prioritised or balanced against each other.

Box 2.A: Questions for respondents

3 Do you have views on the government’s proposed objectives and

principles for cryptoassets regulation? Do you have views on which should be prioritised, or where there may be tension between them?

Overarching approach and related UK initiatives

2.3 The government is proposing an approach to cryptoasset regulation under

which firm requirements are designed and implemented by the independent regulators. This would involve the independent regulators using agile powers to issue rules or codes of practice, within a framework of objectives and broader considerations set by HMT and Parliament.

2.4 This has two key benefits: first, cryptoasset models continue to develop and

evolve rapidly, and this approach allows the regime to respond to developments. The government wants to ensure the regime can keep pace and adapt as new models or innovations emerge. Second, international work is in progress to develop appropriate global regulatory standards and review existing guidance. For example, international work is underway to assess the application of Principles for Financial Market Infrastructures (PFMIs) to stablecoins. The PFMIs are standards issued by the Bank of International

Settlements’ (BIS) Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO). The government wants to ensure it has the flexibility to update regulation to take account of the outcomes of this work.

2.5 In practice, this means that HMT will not seek to specify detailed firm

requirements through legislation (and therefore has not done so in this consultation). Instead, the government aims to define the scope of the regulatory perimeter and the objectives and principles applicable under that new regime. Reflecting this, the government is seeking views on those areas only in this consultation. The UK’s financial services regulators will consult on detailed firm requirements should the government adopt this approach. This could be subject to enhanced scrutiny requirements to ensure the regulators are appropriately accountable when setting firm requirements.

2.6 In July 2020 the government published a Call for Evidence to support a

review of the UK payments landscape. The Payments Landscape Review (PLR) is taking a holistic stocktake of the payments landscape and is considering changes needed to keep pace with new innovations. The government will set out more detail in response to the PLR call for evidence shortly. Changes under consideration through this consultation on cryptoassets are intended to support and align with the government’s broader approach to payments through the PLR.

2.7 HM Treasury and the Bank of England are continuing analytical work to

evaluate the possible opportunities and risks associated with a UK central bank digital currency (CBDC), and of CBDC initiatives being undertaken elsewhere. The government welcomed the Bank of England’s discussion paper in March 2020, as well as its important work with overseas central banks to share valuable experience related to CBDCs. HM Treasury and the Bank of England are now working together to consider next steps. The UK is taking a leading role in exploring this topic to understand the wide-ranging opportunities and challenges it could bring.

2.8 A number of other jurisdictions are considering or have implemented

legislative changes to bring cryptoassets and stablecoins into regulation. Approaches across different jurisdictions vary in terms of scope and substance. HMT and UK authorities are closely monitoring developments in this space, including the European Commission’s Market in Cryptoassets (MiCA) proposed regulation, which introduces a bespoke regulatory regime and applies it to a wide set of issuers and service providers. Other international approaches include outright bans or amendments to existing legislation (e.g. securities legislation) to bring tokens, and the service providers around them (e.g. exchanges, wallets), into scope. Box 2.B: Questions for respondents

4 Do you agree with the approach outlined, in which the regulatory

perimeter, objectives and principles are set by government and HMT, with detailed rules to follow set by the UK’s independent regulators?

5 What are your views on the extent to which the UK’s approach

should align to those in other jurisdictions?

Chapter 3

Expanding the regulatory perimeter

The first phase of legislative changes

3.1 In line with the government’s aim to ensure the approach to regulating

cryptoassets is proportionate, and to focus on where risks and opportunities are most acute, the government has considered how best to sequence any changes. This chapter sets out the government’s proposal and rationale.

3.2 At present, many cryptoassets and unregulated exchange tokens remain

highly volatile and cannot be reliably used as a means of payment or store of value. The FCA’s latest consumer research suggests that the dominant retail use case for cryptoassets is speculative investment: at present 47% of UK cryptoasset consumers said they bought cryptocurrencies ‘as a gamble that could make or lose money’ and 89% understood that they are not subject to regulatory protections.1 This suggests that at present consumer awareness of risks associated with the purchase of cryptoassets is relatively high.

3.3 The size of the UK cryptoassets market is still relatively small, but rapidly

growing. The government recognises that many firms engaging in cryptoasset activities are SMEs and start-ups. The government wants to ensure that any approach enables responsible innovation to occur, particularly where risks are well-communicated and understood. The government also wants to ensure that their use does not threaten stability and safeguards are in place to avoid their use in illicit activities.

3.4 The government is therefore considering an approach in which the use of

currently unregulated tokens and associated activities primarily used for speculative investment purposes, such as Bitcoin, could initially remain outside the perimeter for conduct and prudential purposes. At the same time, these would be subject to more stringent regulation in relation to consumer communications via the financial promotions regime (if adopted) and AML/CTF regulation. Utility tokens - those used to access a service - would also remain outside the authorisation perimeter.

3.5 At the same time, the use of stablecoins is rising; in June 2020, it was

reported that there was more value in transactions using stablecoins than in Bitcoin for the first time.2 Stablecoins aim to hold their value, typically

1 Cryptoasset Consumer research 2020, Research Note, 30 June 2020, https://www.fca.org.uk/publication/research/research -note- cryptoasset-consumer-research-2020.pdf

2 https://medium.com/akeo-tech/complete-guide-to-stablecoins-in-2020-1f37b7e11d9d

against a reference asset, meaning they can be more reliably used as a means of exchange or store of value, though they may also be used to facilitate investment or trading activities. This is supported by FCA research which found that stablecoins are the most likely to be used as a means of payment; 27% of stablecoin owners have used them to purchase goods and services.3

3.6 The government believes that, if appropriate standards and regulation can

be met, certain stablecoins would have the potential to play an important role in retail and cross-border payments (including settlement). This means they would have the potential to deliver benefits of DLT such as speed, efficiency and resilience. Some initiatives may have the potential to support financial inclusion and economic growth both domestically and on a cross- border basis. The Covid-19 pandemic has accelerated the use of digital forms of payments, which could increase the uptake of stablecoins for transactions and remittances in the future.4

3.7 The government believes that appropriately designed regulation can

promote innovation and industry growth, enabling responsible industry actors to innovate and supporting consumer confidence. However, in the absence of appropriate regulation and oversight, stablecoins could pose a range of risks. These include: • risks to financial stability and market integrity: where stablecoins are used widely as a means of payment, they may pose risks to financial stability and to the real economy. The ability of individuals and businesses to make and receive payments safely and smoothly with confidence is critical to financial stability. Disruption or outage within the stablecoin chain could lead to consumers being unable to access their money and make payments. Stablecoins could also be used to store value and, by design or use, constitute money- like instruments. Uncertainty about, or large fluctuations in, the value of the asset could give rise to similar risks to financial stability associated with the operational or financial failure of traditional payments systems. Reflecting this risk, in modern economies, private assets that function as money-like instruments are subject to high levels of protections that ensure that consumers can use them with confidence and exchange them seamlessly with other forms of privately issued money in widespread use. Most stablecoin arrangements seek to provide stability via some form of referenced asset such as a commodity or fiat currency. Depending on the nature of the reference assets and how the reserve is held and managed, the ability to provide stability and redeemability could come with additional risks (see Box 3.A for the FPC’s principles for stablecoin payments chains) • risks to consumers: these include, in the first instance, the risk that consumers could lose money through volatility of the value of the

3 https://www.fca.org.uk/publication/research/research-note-cryptoasset-consumer-research-2020.pdf

4 https://www.bis.org/publ/bisbull03.pdf

stablecoin or firm failure. Risks are likely to be increased where consumer protections are limited – for example, due to an absence, uncertainty or failure of a claim for redemption. Consumers may also not understand the product or service they are being offered and consumer data could be lost or misused. Consumer harm may also derive from models being too complex, or excessive prices, fees and charges. In addition, there are risks of fraud, financial crime, cyber- attacks or maladministration, with potential for consumer harm if services are vulnerable to operational and security risks leading to inaccessibility or inefficiencies • risks to competition: some initiatives could increase competition by challenging the market dominance of incumbent financial institutions. However, due to their ability to scale, and plug into existing online services, some stablecoin arrangements could quickly achieve market dominance, providing a similar service to a regulated service despite not yet not having the same regulatory and compliance obligations. This would create an unlevel playing field.

3.8 The FSB’s report ‘Addressing the regulatory, supervisory and oversight

challenges raised by “global stablecoin” arrangements’ sets out ten recommendations. This includes the recommendation that authorities have the necessary tools and powers in place to comprehensively regulate stablecoin arrangements. The FPC has also communicated two regulatory expectations for systemic stablecoins and its views on the need to adjust the UK regulatory framework to support appropriate regulation of these arrangements (see box below). It is within this context, and in light of the risks and opportunities discussed above, that the government judges that there is a strong case for bringing stablecoins into the regulatory perimeter.

3.9 The government therefore proposes to first introduce a regulatory regime for

stable tokens used as a means of payment. This would cover firms issuing stable tokens and firms providing services in relation to them, either directly or indirectly to consumers.

3.10 To a longer timetable, the government will consider the case for bringing a

broader set of cryptoasset market actors or tokens into an authorisation regime (see chapter 4). UK authorities and the government will continue to actively monitor the market, focusing on how services and products are used and the risks they may pose to consumers. The government will also seek to ensure its approach provides flexibility to enable new activities to be brought into the perimeter in the future in an agile way, subject to appropriate consultation and scrutiny. Should new risks emerge or if presented with evidence of significant consumer harm, the government will take further action.

Box 3.A: Financial Policy Committee (FPC) principles for systemic stablecoin payment chains In the December 2019 Financial Stability Report, the FPC observed that, in the future, digital tokens known as stablecoins might increasingly be used to make payments and that stablecoin-based payment chains pose additional issues for regulation. The FPC set out two expectations for stablecoin-based payment chains: 1: Payment chains that use stablecoins should be regulated to standards equivalent to those applied to traditional payment chains. Firms in stablecoin-based systemic payment chains that are critical to their functioning should be regulated accordingly. 2: Where stablecoins are used in systemic payment chains as money- like instruments they should meet standards equivalent to those expected of commercial bank money in relation to stability of value, robustness of legal claim and the ability to redeem at par in fiat.

Box 3.B: Questions for respondents

6 Do you agree with the government’s assessment of risks and

opportunities?

7 Do you have views on the proposed initial scope of UK cryptoasset

regulation as summarised above?

8 Do you agree that this approach best balances the government’s

stated objectives and principles?

Scope of regulation and requirements

3.11 The activities around tokens used for payments may be similar to existing

payment services such as the execution of payment transactions. However, the government also recognises that these tokens may also be used for other purposes than payments. For instance, today many are used as temporary stores of stable value for investors moving funds between cryptoassets without transitioning into fiat money.

3.12 Rules and requirements under the proposed regime would take relevant

aspects of the UK’s current approach to e-money and payments regulation, drawing on existing rules as far as possible. The main pieces of UK legislation governing payments regulation are the Electronic Money Regulations 2011 and Payments Services Regulations 2017. These provide powers to the FCA and PSR to regulate and supervise firms engaged in relevant payment activities.

3.13 In addition, the Banking Act 2009 and Financial Services (Banking Reform)

Act 2013 provide the Bank of England with power and responsibility for regulation of systemically important payment systems and service providers to those payment systems, and the Payments Systems Regulator (PSR) with power and responsibility for regulation of payment systems, respectively. HM Treasury anticipates both organisations would need powers over any system widely used for payments, and that their approaches will follow their respective remits.

3.14 In addition, the approach will draw on broader elements of financial services

regulation, for instance in relation to the protection of client assets, as well as specific requirements for stablecoins, such as safeguarding of the stablecoin and the means of accessing the stablecoin wallet with the associated private key.

Tokens in scope

3.15 The government’s priority is to ensure that tokens which could reliably be

used for retail or wholesale transactions are subject to appropriate regulation. The government considers that at present tokens that maintain a stable value based on their reference assets (e.g. fiat currency) are most likely to maintain a stable value and fulfil this function. Depending on legal structure and specific backing arrangements these tokens may have similar characteristics to e-money, which is subject to comprehensive requirements in UK financial services regulation.

3.16 The government proposes to seek therefore to ensure that tokens which

could be reliably used for retail or wholesale transactions are subject to minimum requirements and protections as part of a UK authorisation regime. The government is considering whether those tokens deemed out of scope from these minimum requirements should be subject to restrictions with respect to marketing or promotion for use in retail or wholesale payments activity.

3.17 Some tokens may not neatly fall within this category. For example, so-called

‘algorithmic stablecoins’ seek to maintain a stable value through the use of algorithms to control supply, without any backing by a reference asset. The government judges that these tokens more closely resemble unbacked exchange tokens and may pose similar risks in relation to their ability to maintain stability of value, so may not be suitable for retail or wholesale transactions. For this reason, algorithmic stablecoins are outside the scope of the proposals for stable tokens set out in the remainder of this chapter. The government invites views on this assessment and will consider this position based on responses received.

3.18 For the same reason, the government proposes that security tokens (as

defined in chapter 1) should be excluded from the scope of the proposals for stable tokens set out in this chapter. Utility tokens will also likely fall outside the scope of the proposals for stable tokens set out in this chapter.

3.19 Table 3.A sets out the tokens in scope of the government’s proposed regime

for stable tokens.

Table 3.A: Tokens in scope for proposed regime and payments use

Token type Definition In scope of first phase of

legislative changes?

Rules applying

Stable tokens:

Single-fiat

Value linked to a single

fiat currency (GBP, USD, etc.)

Yes FCA authorisation

regime based on payments regulation (see below)

Enhanced

requirements if systemic thresholds met Stable tokens:

Other asset-

linked

Value linked to an asset

other than a single fiat currency (e.g. gold or multi-currency)

regime (see below) –

Specific requirements

on backing asset(s)

requirements if systemic thresholds met5

Unregulated

exchange tokens

No backing

Primarily retail speculative

investments or means of exchange. May include algorithmic tokens. No – but may be subject to regulation in future

utility tokens

Used to access a current

or future service (e.g. access to a DLT platform), but may also be exchanged No – but may be subject to regulation in future

Security

tokens

Meets definition of

specified investment under the RAO and is subject to regulation No – but considering whether changes may be needed to provide clarity to support use in future (see chapter 4)

Subject to existing

FCA regulation

5 Bank regulation of systemic stable token payment systems and service providers to those systems, will be grounded in the FPC’ s expectations set out in Box 3A. For systemic asset-linked stable tokens this would imply significant capital and prudential requirements and other protections 6 If taken forward use of tokens would be subject to consumer disclosures via the financial promotions regime. Core entities facilitating their use also subject to AML/CTF regulation.

Actors, activities and requirements

3.20 As set out in chapter 1 a range of market actors can be involved in

facilitating the use and issuance of stable tokens. Key participants or entities are likely to include: • issuers or systems operators, responsible for managing the rulebook of a system, the infrastructure, burning and minting coins (among others)7 • cryptoassets exchanges, enabling consumers to exchange tokens for fiat money or other tokens • wallets, which may provide custody of tokens and/or manage private keys. Along with exchanges, these are often the main consumer interface.

3.21 The government’s view is that regulation would apply to the firms

undertaking the following functions or activities, either in terms of establishing the rules governing the activities or operating the infrastructure in relation to these activities.

• issuing, creating or destroying asset-linked tokens The activity of the token issuer in minting and burning tokens • issuing, creating or destroying single fiat-linked tokens The activity of the token issuer in minting and burning tokens • value stabilisation and reserve management The activity of managing the reserve assets that are backing the value of a stable token and providing custody/trust services for those assets to ensure stabilisation of the stable token • validation of transactions The activity of authorising or verifying the validity of transactions and records • access The activity of providing services or support to facilitate access of participants to the network or underlying infrastructure • transmission of funds The activity of ensuring the correct and final settlement of transactions while limiting counterparty and default risk • providing custody and administration of a stable token for a third party The activity of managing tokens on behalf of owners, including the storage of private keys

7 In some decentralised models there may not be a central entity responsible for issuing or burning tokens

• executing transactions in stable tokens

The activity of conducting transactions on behalf of another

• exchanging tokens for fiat money and vice versa The activity of purchasing/exchanging a stable token with fiat money. 3.22 These are partly aligned with the stablecoin activities identified by the FSB, adding further granularity and aligning activities with those used under UK law. The government considers that many of these activities bear similarity to currently regulated payment or e-money activities (for example executing payment transactions). However, others do not currently form part of traditional payment chains and may not be captured by analogous rules under existing payments regulation but could still pose risks to consumers and stability. This includes providing custody and administration of the token, a main aspect of which is the storing and protection of the private key.

3.23 Considering the objective to manage the risks of tokens being used as a

means of payment whilst supporting innovation and competition, and reflecting the activities outlined above, the government judges that the following high-level requirements would be necessary. • authorisation requirements with associated threshold conditions

The requirement to be authorised prior to operating

• prudential requirements, including capital and liquidity requirements, accounting and audit requirements

Requirements relating to effective management of capital and

liquidity, to protect consumers and financial stability • Requirements for the maintenance and management of a reserve of assets – obligation to have reserve assets underlying the token’s value and requirements to ensure the quality and safekeeping on those assets • orderly failure and insolvency requirements Requirements to ensure issuers and service providers are prepared for modified resolution or administration, or insolvency • safeguarding the token Requirements principally on wallets and exchanges to ensure those entities are appropriately protecting users' tokens and the privacy and security of keys to those tokens • systems, controls, risk management and governance Requirements relating to effective overall management of an issuer or service provider • notification and reporting Requirements relating to firms' disclosures to regulators and customers • record keeping Requirements relating to firms' internal record keeping processes

• conduct requirements Requirements relating to the rights that firms must provide toward customers • financial crime requirements

Requirements relating to proper implementation of anti-money

laundering and counter-terrorist financing rules, among others • outsourcing requirements Requirements relating to safe outsourcing of key services to ensure continuous and adequate functioning • operational resilience, service reliability and continuity requirements Requirements to ensure business continuity in the event of physical, electronic, governance or other business failures • security requirements (including cyber and cloud) Requirements relating to safeguards against cyber security risks related to the technology and infrastructure used.

3.24 UK authorities are considering requirements in relation to the reserves held

for stable tokens (and related innovations), particularly where they operate at systemic scale. This includes, for example, how to ensure that regulation and requirements are appropriate for the risks taken in the reserve assets where stable tokens are intended for widespread use in retail or wholesale transactions. This also involves exploring what regulation might be necessary to enable issuers of systemic stable tokens to hold reserve assets in central bank accounts, commercial bank deposits or high-quality liquid assets to meet the FPC’s expectations. UK authorities will consult in due course on the impact of these options and how these options would be applied across systemic and non-systemic firms.

3.25 As set out in chapter 1, a subsection of tokens already falls within the

existing e-money regime (e.g. where, among other criteria within the EMRs, they provide users with a claim on the issuer and funds are redeemable at any time at par value). The government’s view is that where such tokens are subject to existing regulation, these requirements should continue to apply.

3.26 In practice, this means that some tokens, where they meet the criteria for e-

money, will be subject to e-money regulation and must be authorised by the FCA as such. To avoid scope for arbitrage and avoid confusion for consumers, the government is also considering whether stable tokens that are linked to a single fiat currency should meet the requirements applicable to e-money. Any stable tokens treated as e-money, which have significant potential to become systemic (see criteria below), would likely require enhanced regulation to meet the FPC’s stablecoin expectations. The government is considering how to ensure that this can be applied in a manner that provides an appropriate and clear framework to support innovation.

3.27 In line with other regulation, the proposed authorisation regime would also

allow for exclusions where, although an activity may fall within scope, the firm conducting that activity would not need to be authorised. This may

occur where the activity does not give rise to the same risks. For instance, services based on stable tokens used within a limited network of service providers (closed loop) or for acquiring a very limited range of goods or services (e.g. store payment cards) could be excluded. A lighter regime is being considered for smaller firms below a certain turnover, also akin to current payments regulation.

Stable token payment systems

3.28 The Payment Systems Regulator (PSR) is an economic regulator that regulates

payment systems designated to it by HM Treasury to achieve objectives in relation to protecting interests of users, promoting competition and innovation. A payment system is defined within the Financial Services (Banking Reform) Act 2013 (the FSBRA 2013), as a system that enables persons to make transfers of funds.

3.29 The government judges that stable token arrangements which play a similar

function to existing payments systems may be appropriate candidates for regulation by the PSR and is considering whether legislative adjustments are required to clarify this. Designation of a system for regulation by the PSR gives the PSR powers to place requirements or take action on the participants in that system. Participants are defined as system operators, infrastructure providers or payment service providers in relation to that system.

Systemic stable token payment systems

3.30 Where stable token arrangements reach systemic scale, the government

judges that existing systemic payments regulation which applies to the system and service providers in relation to the system should also apply. In the UK this is enforced by the Bank of England under powers contained within part 5 of the Banking Act 2009 (the BA 2009), following a recognition decision made by HM Treasury.8

3.31 The government judges that a systemic stable token arrangement could be

assessed for Bank of England regulation in the same way that current payment systems and service providers are (i.e. when potential disruption could lead to financial stability risks). Criteria under the BA 2009 for systemic payment systems includes consideration of their ability to disrupt the UK financial system and businesses based on current or likely volume and value of transactions, nature of transactions and links to other systems, as well as substitutability and use by the Bank of England in its role as monetary authority.

3.32 The government’s proposal is that these criteria should also extend to stable

tokens arrangements that perform a retail or wholesale payment system function. This would mean that a stable token with significant potential to be systemic at launch would need to be captured from launch by such

8 Link to HMT public document on recognition process -

https://webarchive.nationalarchives.gov.uk/20130102201246/http://www.hm - treasury.gov.uk/d/bankingact_guidancenote_040809.pdf

regulation. Appropriate triggers for treatment in this manner would include likely user base, likely transaction volumes and likely avenues for acquisition of customers (e.g. through widely used platform).

3.33 Issuers or system operators that reach systemic status, as well as critical

service providers as defined under the BA 2009, would be subject to regulation by the Bank of England and enhanced requirements grounded in the PFMIs against which they would be required to produce an annual compliance self-assessment. In line with powers to issue codes of practice and rules within current payments system and service provider legislation, the Bank of England would be given powers to specify enhanced requirements.

3.34 The Bank of England will be required to consult on the proposed supervisory

approach and enhanced requirements to be applied to systemic stable token systems and service providers. This will build on the PFMI and be grounded in the FPC’s expectations set out in Box 3A. To meet the FPC’s expectations, a systemic stable token arrangement would need to provide holders with a robust legal claim, ensure stability of value and enable users to redeem tokens at par into fiat. For asset-linked tokens, this would imply significant capital and prudential requirements and other protections. 3.35 Stable tokens bring together payment system activity, the issuance of a new, money-like asset and the storage of reserve assets. Current regulation for systemic payment systems applies to the recognised payment system operator as well as designated critical service providers in relation to a recognised system – for example information technology services or infrastructure providers.

3.36 The government’s view is that it is possible other service providers or core

entities that form part of a stable token chain could pose systemic risks (e.g. wallets). It is therefore considering, for stable token arrangements, whether Bank of England systemic regulation grounded in the PFMIs and FPC expectations should also apply to service providers or entities within a chain where these pose systemic risks. For example, the government judges that certain wallets used to safeguard or exchange customer funds could pose systemic risks if used at scale because of the potential wider impact of any disruption (e.g. of consumers’ ability to withdraw funds) and their potential role in fulfilling critical functions in the chain.

3.37 In applying this assessment approach, the bar for systemic importance and

Bank regulation would remain high, as it is for payment systems and service providers to those systems at present. Within a competitive and diverse landscape, it is not clear that many service providers will attain systemic importance to require such enhanced regulation. However, the dynamic and nascent nature of the market requires ensuring the adequate powers are in place, subject to the recognition process, should they be needed now or in the future.

Location requirements

3.38 For firms carrying on payment services, the requirement to be authorised or

regulated by the FCA applies in relation to activities that are carried on by way of regular occupation of business activity in the UK. Whereas, powers in relation to recognised payment systems under BA2009 apply on an extra- territorial basis. Due to the digital, decentralised and cross-border nature of stable tokens, the government and UK authorities are considering whether firms actively marketing to UK consumers should be required to have a UK establishment and be authorised in the UK. Options include: requiring UK presence and UK authorisation for stable token issuers, system operators and service providers when marketed in the UK; defining the activity conducted in the UK and determining whether UK authorisation is required as a result; or no location requirements.

3.39 The government and UK authorities are also considering the case for location

requirements for systemic stable token arrangements under BA2009.

Box 3.C: Questions for respondents

9 Do you agree that the activities and functions outlined above are

sufficient to capture the activities that should fall within the scope of regulation?

10 Do you agree that the government should primarily use existing

payments regulations as the basis of the requirements for a new stable token regime, applying enhanced requirements where appropriate on the basis of mitigating relevant risks? What other existing legislation and specific requirements should also be considered?

11 Do you agree with the high-level requirements outlined? Do you

consider that any additional requirements are needed?

12 Do you have views on whether single-fiat tokens should be required

to meet the requirements of e-money under the EMRs, with possible adaptation and additional requirements where needed?

13 Do you have views on whether exclusions to the authorisation regime

are needed in relation to the stable tokens regime, in light of the government’s objectives? If so, which activities do you think should be excluded?

14 What are your views on the appropriate classification and treatment

of (unbacked) tokens that seek to maintain a stable value through the use of algorithms?

15 Do you agree Part 5 of the Banking Act should apply to systems that

facilitate the transfer of new types of stable tokens?

16 Do you have views on potentially extending Bank of England

regulation of wider service providers in the stable token chain, where systemic?

17 Do you agree that Part 5 of FSBRA 2013 should apply to payment

systems facilitating the transfer of new types of stable tokens?

18 Do you have views on location and legal entity requirements?

Authorisations regime for token issuers and service

providers

3.40 As set out, the government’s proposal is the FCA would authorise and

supervise firms – both stable token issuers and relevant service providers – where they carry on certain regulated activities, an indicative list of which is set out below. The table also indicates where firms undertaking certain activities may be subject to BoE and/or PSR regulation.

Table 3.B: Anticipated activities, entities and requirements

Anticipated regulator roles

Activity (in relation to in-

scope tokens)

Entities likely to

be conducting activity

Requirements likely to apply

FCA regulated? PSR regulated? Bank regulated?

Issuing, creating or

destroying tokens

Token issuers Authorisation

Prudential requirements

Requirements for the maintenance and management of a reserve of assets

Orderly failure and insolvency

Systems, controls, risk management and governance

Reporting (including notifications requirements, e.g. if value of reserve falls below par) and record keeping

Conduct requirements

Outsourcing requirements

Operational resilience, service reliability

Security requirements

Financial crime requirements

If systemic, PFMIs would apply with some modifications and significant requirements to address specific characteristics and risks

Yes If activity

meets PSR designation criteria

If activity

meets Bank recognition criteria

Issuing, creating or

destroying single fiat tokens

Token issuers Authorisation

PSRs and EMRs would likely apply – with modifications of requirements and additional requirements to address specific characteristics and possible different risks

If systemic, PFMIs would apply with some modifications and possible additional requirements to address specific characteristics and risks

meets PSR designation criteria

meets Bank recognition criteria

Value stabilisation and

reserve management

Token issuers or

payment system operators

No authorisation regime

If systemic, PFMIs would apply with some modifications and possible additional requirements to address specific characteristics and possible different risks

Yes (as a

requirement for the issuer)

If activity

meets PSR designation criteria

meets Bank recognition criteria

Validation of

transactions

Depends on

design, but may include token issuers

No authorisation regime

If systemic, PFMIs would apply with some modifications and possible additional requirements to address specific characteristics and possible different risks

No If activity

meets PSR designation criteria

If undertaken

by asset issuers,system operators, or specified service providers, and if activity meets Bank recognition criteria

Access Providers

focused on

No PSR has

powers with

If activity

meets Bank

facilitating access to network or technology If systemic, PFMIs would apply with some modifications and possible additional requirements to address specific characteristics and possible different risks

Fair and open access to potential participants: criteria are proportionate, objective, non-discriminatory regard to system access recognition criteria

Transmission of funds Designated

dealers, payment system operators, wallets

No authorisation regime

If systemic, PFMIs would apply with some modifications and possible additional requirements to address specific characteristics and possible different risks

No If activity

meets PSR designation criteria

meets Bank recognition criteria

Providing custody and

admin of token for a third party

Wallets, some

exchanges where applicable

Authorisation

Prudential requirements

Orderly failure and insolvency

Safeguarding the stablecoin and key

Safeguarding of customer funds / custody of client assets

Systems, controls, risk management and governance

Reporting and record keeping

Conduct requirements

Financial crime requirements

Outsourcing requirements

Security requirements

Yes If activity

meets PSR designation criteria

Potential

If systemic, PFMIs would apply with some modifications and possible additional requirements to address specific characteristics and possible different risks

Executing transactions in

a token – making payments Token issuers, wallets and exchanges

As above Yes If activity

meets PSR designation criteria

Exchanging tokens for

fiat and vice versa Token issuers, wallets and exchanges

meets PSR designation criteria

HM Treasury expects financial crime including anti money laundering requirements will apply to all wallets and issuers and that these will also have to register under AML registration for their activities in relation to all types of cryptoassets. The AML registration may not cover issuers; we would expect issuers to be subject to AML requirements in line with other regulated entities.

Chapter 4

Call for evidence on investment and

wholesale uses

Security Tokens

4.1 The use of tokens to facilitate securities transactions is an important

development for the financial sector. The representation of traditional securities, such as equities or debt, on a distributed ledger (the ‘tokenisation’ of assets) could have substantial implications for the way assets are traded or capital is raised. Security tokens that exist and are traded exclusively on the distributed ledger (and are therefore ‘digitally native’) are also playing an increasing role across markets. Existing examples of security tokens include Santander’s ‘blockchain bond’ issued on the Ethereum blockchain.1

4.2 Security tokens can sometimes be distributed through initial coin offerings

(ICOs) which enable businesses to raise capital for their projects, by issuing digital tokens in exchange for fiat currencies or other cryptoassets, e.g. Bitcoin or Ether. ICOs are viewed as high risk,2 but where used safely, could be used as an alternative funding tool for new and innovative business models, products and services, while the use of DLT could make the capital raising process more streamlined, faster and cheaper and facilitate global interconnectedness of markets.

4.3 As part of the FCA’s Regulatory Sandbox programme, firms have compliantly

issued equities, bonds and structured products on the Ethereum blockchain. These small-scale tests showed the potential of DLT-based systems to deliver securities issuances more efficiently; faster and cheaper when compared to traditional issuances, while increasing the transparency of ownership.

4.4 However, the government recognises that existing regimes were not

originally intended to support the use of cryptoassets or DLT-based innovations. It would therefore like to understand what changes may be necessary to remove obstacles and enable the use of these new technologies.

4.5 For instance, there is no legal definition of a security token or tokenised

security in the UK. The FCA has described them as providing rights and obligations akin to specified investments, like a share or a debt instrument or units in a collective investment scheme – this would mean that in the UK

1 https://www.santander.com/en/press-room/press-releases/santander-launches-the-first-end-to-end-blockchain-bond

2 https://www.fca.org.uk/news/statements/initial-coin-offerings

such tokens meet the relevant definitions in the RAO. If a token is negotiable on the capital markets (for example because it can be transferred from one person to another who then acquires legal title of the token), then it might be considered a transferable security under this framework.

4.6 The government would like to understand whether further legal clarification

is required in the future, or whether the application of existing rules under this regime leads to specific obstacles, costs or barriers for participants.

Box 4.A: Questions for respondents

19 Are there any areas of existing regulation where clarification or

amendments are needed to support the use of security tokens?

DLT-based financial market infrastructures

4.7 Distributed ledger technology (DLT) could potentially transform financial

markets and the infrastructures that underpin them. The representation of assets on distributed ledgers could in theory deliver benefits such as more efficiency, improved liquidity, enhanced transparency and greater security. It may fundamentally alter the structure of the current market ecosystem, which is currently characterised by several different financial market infrastructures (FMIs) and intermediaries performing separate functions, from trade management processes, through to clearing and settlement, and on to post settlement activities such as custody and asset servicing.3

4.8 However, the adoption of DLT across financial markets may face a number

of challenges and hurdles. The ability to overcome these challenges, and the way in which they are overcome, could be important in determining whether the benefits of DLT will be realised. This section of the consultation therefore aims to gather views about the potential of DLT to transform financial markets, what steps would need to be taken to fully realise this potential, and what barriers stand in the way of adoption.

4.9 In the first instance, the government wants to understand more about what

the benefits of DLT may be to financial markets. In particular, the government would like to understand what the specific advantages are to adopting DLT in different parts of market value chains including whether DLT could lead to more efficient trading, clearing or settlement, and if so what the nature of the efficiencies realised would be (for example reduced settlement times or lower costs). The government would also appreciate views on where the benefits of DLT may go beyond efficiency and cost-

3 In this paper the term ‘FMI’ includes multilateral systems across all parts of the market value chain, including at the tradi ng level as well as clearing and settlement.

effectiveness, particularly to security and transparency, and where it may spur innovation by changing the way markets operate.

4.10 Conversely, the government also invites industry views on the possible

drawbacks of DLT if adopted across financial markets. For example, the creation of new intermediaries could create greater fragmentation within the existing FMI ecosystem, particularly if new DLT FMIs are not interoperable with each other or existing FMIs. This could potentially result in more complexity, less efficiency, and a reduction in the ability of supervisors to ensure regulatory compliance. It is possible that DLT FMIs make markets less, rather than more, transparent to market participants, depending on how they are specified.

4.11 Views would also be welcome regarding areas where the benefits of DLT for

FMIs may be overstated- for example, it may be that incremental reform of existing market practices, or the further development of existing technology, will improve the performance of existing FMIs, rather than the adoption of DLT. Consideration should also be given to whether the optimal route is for increased take-up of DLT by existing FMIs, rather than DLT solely being utilised by new entrants.

4.12 The government is also seeking feedback regarding what regulatory or legal

barriers exist that currently limit the adoption of DLT in UK financial markets. In particular, the government would like views as to whether existing UK legislation is adequate for capturing DLT-based FMIs, and whether the current legislation or regulation makes creating and operating a DLT excessively burdensome. It would be useful to hear feedback regarding how DLT will interact with existing rules around transfer of title, settlement finality, financial collateral, shareholder rights and corporate actions, and whether there is a need to optimise legislation across these areas to better accommodate DLT FMIs while safeguarding stability and security.

4.13 More broadly, industry views around the wider incentives and challenges in

adopting DLT across financial markets and the potential solutions to these, would be valuable. Feedback could cover technical challenges, but also issues around industry incentives to implement DLT in a way that benefits UK markets collectively.

4.14 It is possible that a degree of coordination/collective action by market

participants is required to achieve the benefits of DLT FMIs, while ensuring that innovation is not stifled. An example of where this may be needed is to ensure DLT FMIs are interoperable either with each other or with existing FMIs, so as to avoid or mitigate the new layers of intermediation and fragmentation that may otherwise be created, as noted above. The outcome in this instance could be the development of a basic set of standards that ensure the interoperability of DLT FMIs. Feedback to this consultation could consider other areas where it may be useful for the market to develop standards (such as cybersecurity, transparency, confidentiality and governance arrangements), as well as other approaches for overcoming barriers to adoption across markets.

4.15 The government is also seeking views over where government or regulator

intervention may be useful. For instance, the government would welcome

industry feedback regarding initiatives that could be taken forward for trialling or testing DLT FMIs. This could entail making use of existing schemes, such as the FCA Sandbox, or developing new propositions, such as an initiative for testing the operation of a DLT FMI in the market. The government would have to carefully consider the impact of any proposals given the systemic importance of FMIs to the financial system and would need to work closely with the Bank of England given their role in regulating and supervising FMIs.

4.16 As noted above, market coordination may be required to deliver the benefits

of DLT in the FMI space. The government would therefore appreciate views on whether regulators or government have a role to play in convening market participants. Alternatively, respondents may feel that any initiatives should be best left to the market. Given FMIs are important for international markets, specific UK rules could create conflicts with rules in other jurisdictions, meaning it may be preferable to take forward rules at global level first before adoption in the UK.

Box 4.B: Box title

20 What, specifically, are the potential benefits of the adoption of DLT

by FMIs? What could be the benefits for trading, clearing and settlement?

21 What are the potential drawbacks of DLT for wholesale markets and

FMIs?

22 Is UK regulation or legislation fit for purpose in terms of the

adoption of DLT in wholesale markets and FMIs in the UK? How can FMI regulation/legislation by optimised for DLT?

23 What are the wider industry incentives or obstacles to the adoption

of DLT in wholesale markets and FMIs in the UK?

24 If market coordination is required to deliver the benefits of DLT, what

form could it take? 25 Would common standards, for example on interoperability, transparency/confidentiality, security or governance, help drive the uptake of DLT/new technology in financial markets? Where would common standards be most beneficial?

26 What should the UK government and regulators be doing to help

facilitate the adoption of DLT/new technology across financial markets/FMIs?

Other unregulated tokens and new

developments in the market

4.17 As discussed in chapter 1, the government notes that the primary use-case

for many unregulated tokens, typically referred to as exchange tokens (including Bitcoin and Ether) is for speculative investment purposes.4 Unregulated tokens are often traded on exchanges which operate like trading platforms allowing users to exchange one token for another or convert back into fiat. 4.18 The retail investment use of these tokens raises potential financial consumer, investment protection and market conduct issues, as the Cryptoassets Taskforce acknowledged in its 2018 final report. However, public understanding of the risks involved in investing in this space is improving (see FCA 2020 Research Note on cryptoassets). For instance, 89% of consumers correctly understood that they did not have regulatory protections. Furthermore, the market remains comparatively small in relation to the broader financial services market – the FCA has estimated the current base of cryptoasset users in the UK to include less than 4% of the population.

4.19 The government recently consulted on a measure designed to address risks

around consumer understanding of cryptoassets, proposing to bring certain cryptoassets into the scope of financial promotions regulations. This would hold cryptoasset promotions to the same standards as other financial promotions, ensuring that they are fair, clear and not misleading. If taken forward, this measure is intended to address key risks with respect to consumer awareness, reflecting findings that adverts are important components of the consumer journey with the ability to influence consumer sentiment.

4.20 Decentralised Finance (DeFi) is a relatively new and fast-growing sector

within the cryptocurrency landscape. DeFi platforms take the form of decentralised apps which are not controlled by a central authority, commonly known as/referred to as ‘dapps’. These dapps use a series of smart contracts to automate transactions, facilitating peer-to-peer lending, borrowing or trading with financial instruments on a permissionless network including, for example, platforms that enable users to earn interest on their tokens by connecting token holders to other borrowers.

4.21 At present, certain DeFi activities and tokens used to facilitate them, could

like other cryptoasset-related activities more broadly, fall within the regulatory perimeter (see FCA cryptoasset guidance). The government does not currently propose to bring specific DeFi activities into the scope of regulation, but recognises the increasingly important role played by DeFi. It will therefore keep this space under review and monitor developments closely. The government is keen to hear views on the possible benefits and risks posed by DeFi and whether these developments should be brought into the regulatory perimeter in the future. The government is also keen to understand views in relation to the practicalities of any future regulation given their decentralised nature, and lack of financial intermediaries.

4According to FCA research 47% UK consumers reported that they bought cryptoassets as a gamble that could make or lose money. The second most popular reason given was that cryptoassets formed part of a wider investment portfolio (25%).

Box 4.C: Questions for respondents

27 Do you see value in the government capturing tokens typically used

by retail consumers as a form of speculative investment under the regulatory perimeter in the future?

28 Do you have any views on how the government should bring these

tokens into the regulatory perimeter in the future?

29 What are the risks and opportunities you see in relation to DeFi?

30 Do you have any evidence of risks to consumers when using tokens

as a form of speculative investment or through DeFi that may be of interest to the government and UK authorities?

Chapter 5

Responding to this consultation and

call for evidence

Responding to this consultation and call for evidence

5.1 This consultation will close on 21 March 2021. We are inviting stakeholders

to provide responses to the questions set out above, share views on our proposed future approach, or to provide views on any issue relevant to the UK’s approach to cryptoassets and DLT. Who should respond? Responses are welcome from all stakeholders, including: Cryptoassets firms, technology firms and financial institutions

Other businesses impacted by cryptoasset regulation

Trade associations and representative bodies

Academics and legal firms

Consumer groups

How to submit responses

Please submit your responses to

cryptoasset.consultation@hmtreasury.gov.uk, or post to:

Cryptoassets and stablecoin consultation

Payments and Fintech

HM Treasury

1 Horse Guards Road

SW1A 2HQ

More information on how HM Treasury will use your personal data for the purposes of this consultation is available on the webpage.

Next steps

5.2 This first consultation sets out a proposed policy approach to bringing stable

tokens into the UK regulatory perimeter, focusing on responsibilities of financial services regulators. The government will carefully consider the responses received and use these to inform a response, setting out more detail on how the proposed approach may be implemented in law. Further

technical consultations will be issue by UK authorities on specific firm rules. An illustrative timeline of recent and ongoing workstreams is set out in the annex.

5.3 As part of this consultation, the government will also undertake a

programme of stakeholder engagement. This will maximise opportunities for stakeholders to share their views with the government.

HM Treasury contacts

This document can be downloaded from www.gov.uk

If you require this information in an alternative format or have general enquiries about HM Treasury and its work, contact:

Correspondence Team

HM Treasury

1 Horse Guards Road

London

SW1A 2HQ

Tel: 020 7270 5000

Email: public.enquiries@hmtreasury.gov.uk

Glossary of terms 1

Cryptoassets A broad term used to describe digital tokens often issued on a DLT system. These can vary fundamentally in their economic features and characteristics, from permission-less cryptoassets like bitcoin, to asset backed stablecoins.

Several definitions exist, which focus on characteristics including use of cryptography or DLT, the ability to transfer the token, or store or trade it electronically. Chapter one of the consultation sets out the different types of cryptoassets, and their key characteristics.

Cryptoasset

Wallets

A cryptoasset wallet typically allows the storage and management of cryptoassets and cryptographic keys (mainly private keys which correspond to public keys), in order to enable the user to store and transfer cryptoassets. However, wallet designs and the precise role of the wallet service provider do vary.

There are three types of cryptoasset wallets, according to their custody model: The secure storage of cryptographic keys, required to unlock and transfer funds. There are three types of custody: • custodial: where a service provider is in full control of keys and funds, generally in the interest of customer convenience when transacting (sometimes known as a ‘hot’ wallet). • non-custodial: where a customer is in full control of keys and unilaterally moves cryptoassets (sometimes known as a ‘cold’ wallet). • hybrid: where approval of both the service provider and the customer is required to unlock or move funds.

exchanges Venues facilitating the purchase or selling of cryptoassets, either in exchange for fiat currencies or other cryptoassets. .

• centralised: Exchange operator controls matching, clearing, and settlement. • peer-to-Peer: For clearing and settlement, the exchange operator connects buyers with sellers. • decentralised: No central operator required, instead all processes are directly executed on and by the DLT system.

Distributed

Ledger

Technology

Distributed Ledger Technology (DLT) is a type of technology that enables the sharing and updating of records in a distributed and decentralised way.

1 the above glossary provides definitions for the purpose of this consultation only

There are many different types of DLT platforms, and they usually combine elements of four common features: • data distribution: Many participants can keep a copy of the same ledger, and are may be able to read and access the data • decentralisation of control: Many participants can update the ledger, subject to agreed processes and controls • use of cryptography: Cryptography may be used to identify and authenticate approved participants, confirm data records, and facilitate consensus with regard to ledger alterations. The use of this technology is not unique to DLT • programmability: Computer-coded automation (such as smart contracts) can automatically execute transactions when certain, pre-agreed conditions are met, such as triggering periodical interest payments • programmability/automation: Computer-coded automation (such as smart contracts) can automatically implement the terms of an agreement, such as automatically triggering interest payments on a bond.

There is no standard definition or form of DLT. The specific combination of these features depends on what a particular DLT platform is being used for and the design choices made by developers. Blockchain A particular type of distributed ledger, which refers to a specific way of structuring data on a DLT platform by cryptographically linking groups of records (“blocks”) in an ever-growing “chain”.

See also definition for Distributed Ledger Technology (DLT). Stablecoin Referred to in this consultation as “stable tokens”. These are an evolution of cryptoassets, which are designed to minimise volatility in value. Stablecoins aim to maintain stability in their price, typically in relation to a stable asset such as fiat currency. There are two types of stablecoin:

asset backed: backed by collateral in the form of an asset, or a basket of assets, such as gold or a fiat currency algorithmic: a coin programmed to regulate issuance and redemption to match supply and demand.

See the consultation document for elaboration on different types of stablecoin.

Timeline of recent and ongoing workstreams

UK regulatory approach to cryptoassets and stablecoins: consultation and call for evidence (January 2021)

UK regulatory approach to

cryptoassets, stablecoins, and distributed ledger technology in financial markets: in title heading:

Response to the consultation and call for

evidence

April 2022

cryptoassets, stablecoins and distributed ledger technology in financial markets:

evidence

© Crown copyright 2022 This publication is licensed under the terms of the Open Government Licence v3.0 except where otherwise stated. To view this licence, visit nationalarchives.gov.uk/doc/open- government-licence/version/3. Where we have identified any third party copyright information you will need to obtain permission from the copyright holders concerned. This publication is available at: www.gov.uk/official-documents. Any enquiries regarding this publication should be sent to us at public.enquiries@hmtreasury.gov.uk ISBN: 978-1-911686-81-1 PU: 3206

Contents

Chapter 1 Introduction

Executive Summary

Chapter 2 The government's approach to

stablecoins

Chapter 3 Call for Evidence on

investment and wholesale uses

Chapter 4 Unregulated tokens and new

market developments

In January 2021, HM Treasury launched a Consultation and Call for Evidence on the regulatory approach to cryptoassets and stablecoins and the use of distributed ledger technology (DLT) in financial markets.

It set out the position that certain cryptoassets and DLT could drive transformational changes in financial markets and offer consumers new ways to transact and invest, but could also pose risks to consumers, market integrity and the stability of the financial system.

The government’s consultation sought views on how the UK can ensure its regulatory framework is equipped to harness such benefits, supporting the adoption of cutting-edge technologies, while mitigating the potential risks. Through its consultation, the government proposed a staged and proportionate approach to cryptoasset regulation, which is sensitive to risks posed and responsive to new developments in the market.

This response document confirms the government’s intention to take the necessary legislative steps to bring activities that issue or facilitate the use of stablecoins used as a means of payment into the UK regulatory perimeter, primarily by amending existing electronic money and payments legislation. The rationale for doing this is that certain stablecoins have the capacity to potentially become a widespread means of payment including by retail customers, driving consumer choice and efficiencies. It is, further, the government’s intention to consult later this year on regulating a wider set of cryptoasset activities, in view of their continued growth and uptake worldwide.

The government welcomes the work happening at international level on the regulation of cryptoassets, including stablecoins, and the UK continues to take a leading role in international fora. The government will ensure sufficient flexibility is built into the UK’s regulatory framework to allow regulators to adapt rules and requirements as international work concludes, benefiting too from the agility that will be afforded to UK financial services legislation by the Future Regulatory Framework.

The basis of the government’s proposal to bring stablecoins where used as a means of payment within the UK regulatory perimeter is broadly as follows:

a. The framework in the UK for e-money through the Electronic Money Regulations 2011 and Payment Service Regulations 2017 provides a robust foundation for payment firms in the UK. Although it does not today provide an explicit regime for regulating stablecoins, the government considers that an amended e-money framework can deliver a consistent framework to regulate stablecoin issuance and the provision of wallets and custody services. Establishing a regulatory environment for stablecoins used as payment simultaneously creates a basis to enable market entry to support innovation, while ensuring that appropriate regulatory standards apply for the benefit of customers, market integrity and stability.

b. In addition, the government plans to extend the applicability of Part 5 of the Banking Act 2009 to include stablecoin activities, to apply in cases where the risks posed have the potential to be systemic and so the threshold for Bank of England supervision is met. For entities authorised by the Financial Conduct Authority (FCA) and recognised under the Banking Act, the Bank of England will be the lead prudential authority. c. To ensure effective competition continues to be a central aspect of the UK’s approach to financial services and future technological innovation, the government is of the view that it is also necessary to extend the scope of the Financial Services (Banking Reform) Act 2013 in order to ensure relevant stablecoin-based payment systems are subject to appropriate competition regulation by the Payment Systems Regulator (PSR). Taken together, these changes will create the conditions for issuers and service providers of stablecoins used as a means of payment to operate and grow in the UK, in line with the government’s firm commitment to place the UK’s financial services sector at the forefront of cryptoasset technology and innovation. For consumers, bringing stablecoins into the regulatory framework means they will be able to use stablecoin services with confidence. The government will introduce this legislation when Parliamentary time allows, to deliver a world-leading regulatory regime for stablecoins.

The government also conducted a Call for Evidence on the investment and wholesale uses of DLT in financial markets. The government recognises the substantial benefits and transformative impact that could be delivered by DLT when adopted in Financial Market Infrastructures (FMIs), though the process of adopting these technologies needs to be managed carefully to ensure that any new risks arising are appropriately addressed. The government intends to support industry in ensuring that regulations can accommodate tokenisation and DLT in FMIs, and is developing an FMI Sandbox (to be up and running in 2023) to support firms wanting to innovate, including by using these technologies to provide FMI services. The government intends to work collaboratively with regulators and industry to identify and manage any issues relating to the adoption of DLT.

The government also posed broad questions on the role of other forms of cryptoassets used primarily as retail investments and the growth of decentralised finance. The government’s planned consultation on cryptoasset regulation will set out proposals for these innovations, reflecting feedback received.

Chapter 1

Introduction

1.1 In January 2021, HM Treasury launched a Consultation and Call for Evidence

on the regulatory approach to cryptoassets and stablecoins. The government’s consultation sought views on how the UK can ensure its regulatory framework is equipped to harness the benefits of new technologies, supporting innovation and competition, while mitigating risks to consumers, market integrity and financial stability. Proposals were informed by views from the UK’s Cryptoassets Taskforce ,1 which was established in 2018 with a mandate to consider the risks and benefits posed by cryptoassets and distributed ledger technology (DLT) in the UK, and to advise on the appropriate regulatory response.

1.2 In total, the government received 89 responses from a broad range of

organisations, industry trade bodies, universities and individuals.

1.3 Since the consultation was launched, the cryptoasset market has continued to

develop at pace, with the total market capitalisation for cryptoassets estimated to have reached between $2.6 -3 trillion in 2021 and falling over recent months to $2 trillion.2 While decentralised finance remains relatively small, it is nonetheless growing fast, from less than $10bn at the start of 2020 to nearly $100bn in September 2021.3 Consumer research from the Financial Conduct Authority (FCA) suggests the uptake of cryptoassets among UK consumers has also continued to increase, with 2.3 million adults now estimated to hold cryptoassets (up from 1.9 million last year) .4 Global policymakers have also noted its growing interconnectedness with the wider financial system.5

1.4 The government considers that clear and proportionate regulation is essential

to fostering competition and innovation in a fast -evolving sector. Against this backdrop, the government and regulatory authorities have already taken (or are in the process of t aking) a number of steps to address the most pressing gaps in the regulatory framework— a. Implementing a new anti -money laundering and counter terrorist financing (AML/CTF) regime for cryptoassets 6; and proposing amendments to implement the Financial Action Task Force (FATF) “travel rule” for transfers of cryptoassets.7 HM Treasury is considering submissions to its recent consultation and will publish a future response;

1 Membership includes senior representatives from the Bank of England, Financial Conduct Authority and HM Treasury. It is also attended by the Payments Systems Regulator. 2 According to online sources CoinGecko and Coinmarketcap.com, but are unverified.

3 See https://www.bankofengland.co.uk/speech/2021/october/jon-cunliffe-swifts-sibos-2021

4 See https://www.fca.org.uk/publications/research/research-note-cryptoasset-consumer-research-2021 5 See for example: https://www.imf.org/-/media/Files/Publications/GFSR/2021/October/English/ch2.ashx

6 See https://www.fca.org.uk/firms/financial-crime/cryptoassets-aml-ctf-regime

7 See https://www.gov.uk/government/consultations/amendments-to-the-money-laundering-terrorist-financing-and-transfer-of-funds-information-on-the-payer-regulations-2017-statutory-instrument-2022

b. Confirming the intention to extend the scope of the UK’s financial promotions regime to cryptoassets;8 c. Addressing consumer risk through regulator consumer warnings and increasing overall consumer education about crypto investments.

1.5 In terms of future regulatory development, the government proposed in its

consultation a staged and proportionate approach to regulation, which was sensitive to risks posed, and responsive to new developments in the market. In particular, the consultation highlighted that newer-developing forms of cryptoassets – stablecoins – had the potential to develop into a widespread means of payment , and potentially deliver improvements in payments transactions, especially for cross -border transactions. At the same time, depending on scale and the nature of their use, they could pose similar financial stability and consumer r isks as traditional regulated payments. In this regard, stablecoin has a potential ‘mainstream’ use that is distinct from other forms of cryptoasset (which are more akin to a form of investment than a means of payment).9

1.6 The government therefore intends to bring activities facilitating the use of

certain stablecoins, when used as a means of payment, into the UK regulatory perimeter. This will be done primarily by amending existing payments legislation, enabling the UK’s regulators to set firm -facing requirements in a framework set by government and Parliament. In line with the government’s staged approach to regulation, it is likely that future regulation will be needed for the wider market in cryptoassets, to respond to growing developments in the sector and to facilitate responsible innovation. The government will therefore consult later this year on bringing wider forms of cryptoasset activity within the UK regulatory perimeter.

1.7 The government also conducted a Call for Evidence on the investment and

wholesale uses of tokenisation and DLT in financial markets . The government recognises the substantial benefits that could be delivered by DLT when adopted in FMIs, particularly in enabling greater efficiency, transparency and resilience. However, the adoption of DLT in FMIs could lead to a fundamental change in existing structures and practices, such as for trading venues undertaking settlement activities, though the scale and nature of these changes could present substantial challenges and would need to be managed carefully.

1.8 The government intends to support industry in ensuring that current

legislation and regulation is adapted to accommodate tokenisation and DLT in FMIs, whilst ensuring that broad regulatory outcomes are stil l met, and on the basis that legislation should be technology neutral. To aid this, the government will implement a Financial Market Infrastructure Sandbox, which will be up and running in 2023. The FMI Sandbox will support firms wanting to use technologie s such as DLT to provide FMI services; this may include, for example, entities being provided with modifications to existing legislation, rules and standards where they act as a barrier to adoption. The Sandbox will enable the government and regulators to understand what changes need to be made to legislation (both to enable the adoption of new technology and

8 See: https://www.gov.uk/government/consultations/cryptoasset-promotions

9 For example, the Government’s consultation (p.13 -14) observed that 27% of stablecoin owners have used them to purchase goods and services, compared with nearly half (47%) of UK cryptoasset consumers who said they bought cryptocurrencies ‘as a gamble that could make or lose money’. 89% of these respondents understood that cryptoassets were not subject to regulatory protections.

to manage any new risks) and ensure they can implement any changes and additional requirements.

1.9 The government intends to work collaboratively with re gulators and with

industry to identify and manage any further issues relating to the adoption of DLT, particularly when considering the impact of DLT on existing market structures and practices. The government also recognises the importance of common stand ards in facilitating DLT and will consider with industry how to take work forward here both domestically and internationally.

1.10 The government also posed broad questions on the role of other forms of

cryptoassets used primarily as retail investments and the growth of decentralised finance. The government’s planned consultation on cryptoasset regulation will set out proposals for these innovations, reflecting feedback received.

1.11 The remainder of this document is split broadly into two. The first half outlines

the government’s overall policy approach to cryptoassets and the government’s proposed regulatory regime in relation to stablecoin, where used as a means of payment, specifically. The second half of the document sets out the government’s response to feedback on proposals to support the use of DLT in financial markets.

The government’s approach to stablecoins

Bringing stablecoins, where used as a means of payment, into the regulatory perimeter

2.1 Through the government’s consultation on stablecoins, a number of broad

themes emerged: a. A broad consensus on the need for international coordination of regulation, and close collaboration with other jurisdictions.

b. General agreement that a UK regulatory framework for stablecoins needs to be flexible enough to respond to rapid innovation, though some respondents requested a more detailed taxonomy, in light of the differing uses of stablecoins.

c. General agreement that systemically important entities (e.g. systemic stablecoin issuers and wallets) should be subject to Bank of England regulation, with respondents seeking further guidance on the thresholds for reaching systemic status.

d. Broad agreement that stablecoins referenced to a single currency should be subject to similar requirements as e-money, though a number of respondents highlighted that some current or proposed business models would not currently meet these regulatory standards.

e. A wide variety of views on the approach to ‘unbacked’ cryptoassets other than stablecoins, e.g. Bitcoin, some called for further regulation (for example, market abuse and prospectus-type rules); others argued that unbacked cryptoassets should not be subject to further financial services regulation given their unique qualities.

2.2 Through the consultation, the government also sought areas of specific and

targeted feedback, including on how to classify cryptoassets, including stablecoin, in UK regulation. The consultation noted the FCA’s 2019 publication, ‘PS19/22 Guidance on cryptoassets’10, which described three broad categories of token: e-money tokens, security tokens and unregulated tokens – exploring if these terms should continue to be adopted, and if a new category of ‘stable tokens’ should be additionally created. This new category of token would refer to tokens which stabilise their value by referencing assets such as fiat currency (i.e. those commonly known as stablecoins) and could more reliably be used as a means of exchange or store of value.

2.3 The majority of respondents supported the proposal to continue using a

classification that is broadly consistent with existing guidance issued by UK authorities. Respondents also supported supplementing existing guidance wit h new categories where it is appropriate. Respondents agreed with the government's proposal to

10 https://www.fca.org.uk/publication/policy/ps19-22.pdf

develop a UK taxonomy, while urging the government to ensure international cohesion and support consistent definitions and a common understanding.

2.4 Respondents also observed that given the rapidly evolving market and hybrid

nature of many tokens, it was important that any classification be sufficiently flexible. Feedback highlighted the importance of having the ability to further adapt classifications to reflect definitions adopted at the international level. Despite this desire for flexibility, there were also a number of calls for more granular categorisation, with the flexibility to update guidance as new models or uses emerge. Some respondents noted that some existing uses were not covered in the categories discussed in the consultation – or should be explicitly carved from scope. Examples given included deposits recorded on DLT, settlement tokens, and hybrid tokens.

2.5 For stablecoin specifically, some respondents questioned the use of ‘stable

token’ instead of the more widely accepted term ‘stablecoin’. They also noted the different characteristics and risks p resented by tokens which maintain a stable value (e.g. between tokenised forms of central bank money and privately issued tokens which reference their value from other assets). Respondents highlighted that different stablecoins may require a different regu latory treatment and that the UK regime should account for that. Similarly, some respondents called for a clearer delineation between stablecoins which are linked to a fiat currency and stablecoins which reference other assets.

2.6 Respondents also highlighte d the importance of a clearly defined scope for

consumers and market participants seeking to navigate the UK’s regulatory framework. Respondents also queried the regulatory treatment of a number of different stablecoins.

2.7 Following consideration of the res ponses, the government maintains its

position that, in a fast-growing and nascent area of financial services, the regulatory framework for cryptoassets and classifications ought to be designed with flexibility , since static classification or definitions co uld quickly become outdated. In designing that flexibility, however, the government recognises that clarity must be achieved to ensure that market participants are able to identify where activities fall within the perimeter and the requirements and obligations that this entails.

2.8 The government considers that some forms of digital money or tokens – for

example, those intended for wholesale settlement – may already fall within the relevant UK legal frameworks. However, this also depends on the structure of t he token and nature of the activities concerned.

In its 2021 consultation, the government asked for views on:

1. Continuing to use a classification that is broadly consistent with existing

guidance issued by UK authorities, supplemented with new categories where needed.

2. The proposed new regulated category of ‘stable tokens’.

2.9 Future legislation will provide a clear framework in the UK, providing clarity as

to the scope of activities to which the regime applies. The government expects this to be supplemented by further detailed i nformation on activities and tokens in scope from the relevant financial regulators.

2.10 With respect to stablecoin used as a means of payment specifically, the

government proposes that the regulation should capture all stablecoins that reference fiat currencies, including a single currency stablecoin or stablecoin based on a basket of currencies. This takes on board arguments made about the diversity of models and uses of stablecoins, and the government’s priority to regulate those that have the capacity to p otentially develop into a widespread means of payment. In light of stakeholder feedback and the desire for more commonly understood methodology, the government has also decided to adopt the terminology of ‘stablecoin’.11 2.11 The government will also continue to work closely with international partners, to harmonise guidance and concepts where possible. The government has sought to reflect the Financial Stability Board’s (FSB) recommendations on the regulation, supervision and oversight of global stabl ecoin arrangements12, and the CPMI-IOSCO consultative report 13 on the application of the Principles for Financial Market Infrastructures to stablecoin arrangements, and will leave room to update the regulatory framework as international standards are developed.

2.12 Greater flexibility to maintain the UK’s regulatory regime will also be supported

by the introduction of the Future Regulatory Framework, which will make it easier to adjust retained EU law and give the ability to regulators to set regulatory rules instead of relying on prescriptive, inflexible legislation. This will extend to the FCA’s regulatory framework for payments services and e -money (including once stablecoin activities are brought into that regime), creating a regulatory framework that can better adapt as the market develops.

Objectives, principles and design

2.13 The government’s consultation sought views on a number of objectives and

principles to guide the design of the UK’s regulatory regime for stablecoins and understand the respective priorities in order to promote competition, innovation and support UK competitiveness; protect financial stability and market integrity; and deliver robust consumer protection.

2.14 In addition, the consultation sought feedback on the proposal that the

government should broadly define the scope of the regulatory perimeter, objectives and principles in statute, with detailed rules provided by the UK’s independent regulators.

2.15 A question was also asked on what, if any, location requirements should apply

to entities subject to the new regulatory framework.

11 For the avoidance of doubt, this expression is not intended to bear a relation to references to “coin” or “coinage” present in other legislation. 12 https://www.fsb.org/2020/10/regulation-supervision-and-oversight-of-global-stablecoin-arrangements/

13 https://www.bis.org/cpmi/publ/d198.htm

In its 2021 consultation, the government asked:

1 For views on it’s proposed objectives and principles for cryptoassets

regulation, including whether certain ones should be prioritised and whether there may be tension between them.

2 Whether respondents agreed with the approach outlined, in which

the r egulatory perimeter, objectives and principles are set by government and HM Treasury, with detailed rules to follow set by the UK’s independent regulators.

3 For views on the extent to which the UK’s approach should align to

those in other jurisdictions. 4 For views on location and legal entity requirements.

2.16 Feedback from respondents included a wide range of views on how objectives

and principles should be prioritised. A large number of respondents were supportive of the intention to ensure the UK’s approach is agile and aligns to international standards. However, some respondents noted a possible tension between the aim to retain rulemaking ‘agility’ and a preference for regulatory certainty. Respondents also highlighted the importance of mechanisms for continued industry and expert engagement in a fast-evolving area which has largely operated without regulation to date. Some respondents pointed to the exper ience of UK cryptoasset businesses in adapting to new anti -money laundering/counter-terrorist financing requirements to support this.

2.17 Many industry respondents called for innovation and competition to be

prioritised, highlighting the potential opportuniti es for the UK to attract innovative firms following the UK’s departure from the EU. However, some stakeholders felt that this should not be at the expense of robust consumer protection, citing high levels of fraudulent activity in cryptoasset markets, market integrity concerns and evidence of consumers experiencing significant losses.

2.18 Respondents overwhelmingly agreed that the regulatory perimeter, objectives

and principles should be set by government and Parliament, with firm-facing rules set by the UK’s i ndependent regulators. However, many respondents emphasised that rules implemented by the regulators should be developed in close consultation with industry. Several respondents highlighted challenges faced by a relatively nascent industry in adapting to a nti-money laundering and counter -terrorist financing regulation, and highlighted the need for effective implementation and sufficient capacity and expertise across the UK’s regulators. Respondents also noted the importance of intelligence, data monitoring and information sharing across the UK regulators.

2.19 The vast majority of respondents stated that global alignment is particularly

important in a sector which operates on a borderless basis, and highlighted the risk that firms seek to circumvent requirements in individual jurisdictions without internationally agreed standards. However, beyond this generally held principle, differing views emerged as to the stance the UK should adopt. Many stated they would like to see the UK take a global leadership position with the aim of steering the

global regulatory guidance. Others suggested the UK should prioritise developing harmonised rules through international organisations and standard -setting bodies, ahead of implementing a UK -specific regime. Others proposed that if a global framework cannot be achieved, an alternative option could be minimum operating and conduct standards for currently unregulated cryptoasset activities.

2.20 On the issue of location requirements, there was some support from

respondents for requiring firms to be authorised in the UK in order to actively market stablecoin to UK consumers . Some noted that it is not appropriate to introduce a location requirement for overseas issuers or service providers of tokens, but rather that the marketing and prom otion of tokens into the UK which is directed to certain categories of investors should be regulated where appropriate. Others suggested that if a firm was issuing a GBP stablecoin they should do so under the authority of the UK wherever they are based. The reason stated for this is that a lack of location and legal entity requirements for providers of stablecoin services would unduly increase the overall threat stablecoin could pose to financial stability, both in the UK and internationally. Those that supported location and legal entity requirements believed these should be based on the activity being conducted and the materiality of that activity.

2.21 There was also, however, broad consensus that location requirements would

be challenging to enforce due to the global nature of stablecoins, and that they could stifle innovation.

2.22 Several respondents argued that the UK should ensure its overall regulatory

approach is not more onerous than that in other jurisdictions. Those respondents argued that the governme nt should ensure it adopts an approach that puts it in a strong competitive position to attract technology-driven investment and new business to the UK.

2.23 Following consideration of the responses, the government will broadly

maintain the principles and objec tives described in the consultation paper and use these to continue to monitor the framework and regulatory requirements required. The government’s view is that clear and proportionate regulation is essential to creating a framework in which the sector can continue to innovate.

2.24 A number of respondents noted concerns relating to the environmental

impact of certain cryptoassets and called on the government to factor these impacts into its future regime. The government reiterates its firm commitment to positioning the UK at the forefront of green finance and recognises the issue of rising energy consumption from certain cryptoassets; the government’s consultation later this year on regulating a wider set of cryptoasset activities will reflect green commitments and ensure that the approach is aligned to environmental objectives including the UK’s net zero target. In this context, the government notes that some stablecoins may be based on ‘proof of stake’ blockchain systems and may not face energy -consumption issues which typically relate to the ‘mining’ or proof -of-work process underpinning certain cryptoassets. The government welcomes the efforts of some cryptoassets to move to more energy efficient ‘proof of stake’ processes.

2.25 With respect to the design of future regulation, the government will maintain

the proposed approach in which the regulatory perimeter, objectives and principles are set by government and HM Treasury, with detailed rules set by the UK’s independent regulators. This approach is consistent with the government’s proposals

under the Future Regulatory Framework Review .14 The government judges that this agile approach will allow the UK to capitalise, to the fullest extent, on the freedoms gained by leaving the European Union. It will enable UK regul ators to adapt to new developments in the market, including internationally, and adapt rules to ensure they work for consumers and market participants.

2.26 The government will also continue to work with international partners to

ensure common standards, recognising the borderless nature of cryptoassets activity. In this, the government welcomes the consultative report of CPMI -IOSCO15, which confirms that the common international standards for payments systems, the Principles for Financial Market Infrastructure, apply to any systemic stablecoin arrangements used for payments, and provides guidance on addressing their novel features. The government also supports the ongoing monitoring and coordinating role of the Financial Stability Board (FSB), and its progress report on the implementation of its recommendations for global stablecoin arrangements.

2.27 In terms of jurisdiction, wallet providers and other entities providing stablecoin

activities for payments in the UK must be authorised by the FCA and would, if deemed systemic, also be subject to Bank of England supervision.

2.28 With respect to location-based obligations specifically, the government notes

that certain location requirements already exist in UK payments legislation as a condition of authorisation, notably under the Payment Services Regulations 2017 and Electronic Money Regulations 2011 –separate from the additional question of what location requirements may be applied to systemic stablecoins under Bank of England supervision. Where stablecoins a re brought into the existing regulatory perimeter covered by the FCA’s Regulations, the requirements of the Regulations will apply, including provisions requiring entities to be based in the UK. This is relevant where firms may be dual regulated by the FCA and Bank of England in the future.

2.29 The government recognises that making further adjustments to location

requirements in a stablecoin -specific context may interact with the regulatory treatment of other payments -related activities. Further consideration of the topic would be beneficial in the context of broader future consultation, such as the government’s consultation on the systemic perimeter for payments planned later this year.

Expanding the regulatory perimeter: considerations and sequencing

2.30 Through the consultation, the government sought views on how best to

sequence proposed regulatory reforms, in order to focus on where opportunities and risks were most acute. Specifically, the government proposed: • Focusing the first phase of legislative changes on stablecoins used as a means of payment. This reflected the propensity of stablecoin to potentially become a widespread means of payment and store of value;

14 https://www.gov.uk/government/consultations/future-regulatory-framework-frf-review-proposals-for-reform 15 The Committee on Payments and Market Infrastructures and International Organization of Securities

Commissions

• Considering the case for bringing a broader set of cryptoasset s (such as Bitcoin) into a regu latory regime to a longer timetable. In the interim, applying regulation in relation to consumer communications via the financial promotions regime, alongside anti -money laundering and counter -terrorist financing regulation.

2.31 In testing these proposals, the consultation sought to understand if

respondents agreed with the government’s assessment of the benefits and risks, underpinning the proposed approach. The consultation highlighted the potential competitive benefits from using stablecoins as a means of pa yment to challenge incumbents; the potential to deliver greater speed, efficiency and resilience through distributed-ledger technology; and to potentially support financial inclusion and economic growth, including across borders. In addition, the governmen t identified potential risks from stablecoins used as a means of payment (in the absence of regulation) to financial stability and market integrity, as well as to consumers and competition. The government considered that appropriately designed regulation could promote innovation and industry growth, enabling responsible industry actors to innovate while ensuring the protection of consumers and the market.

In its 2021 consultation, the government asked:

1. Whether respondents agreed with the government’s assessment of risks

and opportunities. 2. For views on the proposed initial scope of UK cryptoasset regulation.

3. Whether respondents agreed that this approach best balances the

government’s stated objectives and principles.

2.32 There was broad agreement from respondents regarding the government‘s

assessment of opportunities and risks . A large number of respondents focused on potential risks to consumers and highlighted the importance of awareness and education. Several consumer groups called for a broader conversation directed at consumers about the different forms of cryptoassets and the risks they present. A number of respondents highlighted the role of cryptoassets in potentially facilitating financial crime and fraud, as well as ongoing conce rns about market manipulation within the industry. Other areas of risk noted by respondents included operational risk; pricing pressure linked to demand; corporate balance sheet risk; and regulatory oversight and enforcement risks for a new asset class.

2.33 Respondents also noted a number of specific possible benefits, including

improved financial inclusion and accessibility; reduced transaction costs; faster payment settlement times; and greater transparency of costs.

2.34 In turn, there was broad agreement among respondents that the ‘backed’

nature of stablecoins makes them similar to traditional financial instruments and that there is a strong argument for bringing them within the regulatory perimeter. There was further support for HM Treasury’s technology agnostic approach, where the focus is on regulating the activity rather than the underlying technology. Respondents also

agreed that it was right to focus legislative changes on stablecoins initially , while noting the need to ensure that there are suitable carv e-outs for tokens which may already fall within existing regulations to avoid firms having to follow two sets of regulations for the same activities.

2.35 In aggregate, a significant majority of respondents agreed that the proposed

approach balanced the government’s stated objectives and principles, although there were mixed views on the effect of bringing stablecoin used as a means of payment into the regulatory perimeter. Some respondents suggested that bringing stablecoins into the scope of the regulatory perimeter would reduce the risks to financial stability and market integrity arising from the increasing use of these tokens as a means of payment and would also go a significant way to enhancing consumer protection. Respondents stated that limiting the scope to these tokens at this stage should also help to promote competition and innovation.

2.36 Conversely, some respondents warned that introducing regulation could have

an impact on the usage of stablecoins as a means of payment and may drive consumers to use unregulated tokens instead, which may give rise to financial stability and consumer protection concerns. Market abuse regulation was also cited as a potential gap that could lead to consumer risks and inhibit growth in the wider ‘unbacked’ cryptoasset market.

2.37 In light of the feedback received, the government will continue to focus the

first phase of legislative changes on bringing stablecoins used as a means of payment into the UK’s regulatory perimeter. The use of stablecoins in retail payments is emerging, and the government considers that with appropriate protections, stablecoins could play an important role in facilitating improvements and competition in payments.

2.38 The market for stablecoins is also growing. The FSB’s progress report on the

implementation of the FSB recommendations states that the total market capitalisation of stablecoins reportedly stood at around $123 billion in September 2021, as part of the broader growth of the cryptoasset market. The largest existing stablecoin is Tether, with a reported market capitalisation of approximately $68bn. In the past year, other stablecoins, such as USD Coin and Binance USD, have also reached considerable market capitalisations.

2.39 However, the government notes that stablecoins are currently predominantly

used to facilitate trading and investment activities in unbacked cryptoassets, like Bitcoin, and also play a critical function in emerging decentralised finance applications. The government is of the view that this will need to be further considered under a further extension of the regulatory regime to include other activities beyond stablecoins used as a means of payment.

2.40 Despite prioritising regulation for stablecoins used as a means of payment as

an initial step, the government considers that additional r egulation of a broader set of cryptoasset activities, particularly as a means of investment, should form a second legislative phase. This is needed to respond to the increasing uptake of wider cryptoassets; the risks to consumers and markets of their remai ning outside the regulatory perimeter for an extended period; and in order to create a regulatory environment in which these services can responsibly innovate. A further consultation will follow later this year.

Stablecoin legislation: scope and requirements

2.41 Following consultation and the broad support for the approach proposed, the

government intends to extend the existing payments regulatory regime to cover issuers of stablecoins and entities providing related services.

2.42 The government intends to do this by amending existing legislation governing

electronic money and payments (and other relevant legislation) at the earliest available opportunity. The government believes that many stablecoins that reference fiat currencies share characteristics with existing e-money. Bringing these stablecoins into the regulatory perimeter for payments therefore critically meets the government’s stated objective of ‘same risk, same regulatory outcome’. The government also considers that this approach avoids opportunities for regulatory arbitrage between traditional e -money and stablecoins and provides greater clarity for firms and consumers.

2.43 The principal legal instruments that will require amendment are the Electronic

Money Regulations 2011, the Payment Services Regulations 2017 and Parts 5 of the Banking Act 2009, and the Financial Services (Banking Reform) Act 2013. In turn, this means that a regulatory mandate in relation to stablecoin will be developed for each of the Financial Conduct Authority, Bank of England, and Payment Systems Regulator, as is the case today for traditional payment services and e -money where there is a need to consider co-responsibility for regulation between the three authorities.

Regulation by the Financial Conduct Authority

2.44 The Electronic Money Regulations 2011 and Payments Services Regulations

2017 provide powers principally to the FCA16 to regulate and supervise firms engaged in relevant payment activities. The regulations operate on the basis of an authorisation or registration regime, requiring an application to the FCA in order for a firm to be permitted to provide services in the UK. The legislation establishes the prudential requirements (such as capital requirements), in addition to the essential conduct and operational standards that firms must meet. The FCA has a combination of rulemaking and enforcement powers as the designated competent authority.

2.45 The government considers that the regulatory framework provides a robust

foundation for payment and e-money firms in the UK. While it may not be applicable on a strictly like-for-like basis to stablecoins, an adjusted framework could be used as a vehicle to regulate stablecoin issuance and wallet providers on an appropriate, consistent and level basis.

2.46 In its consultation, the government proposed that rules and requirements

under the UK stablecoin regime would take relevant aspects of the UK’s current approach to e-money and payment services regulation, drawing on existing rules as far as possible. The consultation proposed to:

16 The Payment Systems Regulator also has some limited regulatory areas of competence in relation to payment systems (and ATMs) under the Payment Services Regulations.

• Establish an FCA authorisation and supervision regime that would capture stablecoins which could be used as a means of payment. It also outlined the broad requirements, activities and functions that would be captured as part of the regime. It proposed that these requirements would be lighter for smaller firms, mirroring existing arrangements. • Exclude certain stablecoins (namely algorithmic stablecoins, or those that may be linked to assets other than fiat currency) from scope, on the grounds that they share similar characteristics to unbacked cryptoassets (i.e. they do not reference their value by fiat currency and may not offer sufficient price stability). • Allow for exclusions to the authorisation and supervision regime, in line with current payments and e-money regulation, where a firm may conduct an activity that falls within scope, but the nature of that activity is exempted or does not require authorisation.

2.47 The consultation also sought a number of views from correspondents to better

shape and receive feedback on the proposed regulatory regime.

In its 2021 consultation, the government asked:

4. Whether respondents agreed that the activities and functions outlined are

sufficient to capture the activities that should fall within the scope of regulation.

5. Whether respondents agreed that the government should primarily use

existing payments regulations as the basis of the requirements for a new stablecoin regime, applying enhanced requirements where appropriate on the basis of mitigating relevant risks and what other existing legislation and specific requirements should also be considered.

6. Whether respondents agreed with the high -level requirements outlined

and whether any additional requirements are needed.

7. For views on whether single -fiat tokens should be required to meet the

requirements of e-money under the EMRs, with possible adaptation a nd additional requirements where needed.

8. For views on whether exclusions to the authorisation regime are needed

in relation to the stablecoins regime, in light of the government’s objectives and, if so, which activities should be excluded.

9. For views on the appropriate classification and treatment of tokens that

seek to maintain a stable value through the use of algorithms.

2.48 Most respondents agreed that the UK’s existing payments regulations offer a

good basis for stablecoins , particularly those used in retail payments, where the Electronic Money Regulations 2011 and Payments Services Regulations 2017 are

primarily applicable. Respondents noted that the regulations are well-understood and have been established over a number of years. However, some responses highlighted potential risks from seeking to retrofit existing requirements on the basis that it may be difficult to future-proof them and capture new innovations in the market, or that they may be inappropriate for tokens used in the wholesale market.

2.49 The majority of respondents agreed that the activities and functions outlined

in the consultation were sufficient to capture the activities that should fall within the scope of regulation. This included the activities of issuing, creating or destroying tokens; value stabilisation and reserve management; validation of transactions; access; transmission of funds; providing custody services for a third party; executing transactions in stablecoins; and exchanging tokens for fiat currency.

2.50 Most respondents also agreed in principle with the high -level requirements

the consultation expected would apply, including: authorisation requirements with associated conditions for authorisation; prudential requirements; requirements for the maintenance and management of a r eserve of assets; orderly failure and insolvency requirements; safeguarding the token; systems, controls, risk management and governance; notification and reporting; record keeping; conduct requirements; financial crime requirements; outsourcing requirements; operational resilience, service reliability and continuity requirements; and security requirements.

2.51 Several respondents asked for further detailed guidance on the functions and

activities in scope (for example, whether decentralised organisations that issue stablecoins via smart contracts would be within scope). Respondents also sought detail on the types of requirements that would apply, such as whether the regime would include strong customer authentication requirements. Some respondents noted concer n about potential overlaps between new requirements and those in relation to existing regimes, in particular the UK’s AML/CTF registration regime for cryptoasset businesses.

2.52 In relation to whether tokens referencing a single fiat currency should be

required to meet e -money requirements, responses were broadly supportive. Some felt that the Electronic Money Regulations 2011 would be a good starting -point but suggested that amendments may be needed due to definitional issues and potential additional risks po sed, meaning that certain current business propositions may currently fall out of scope. Others felt that there should be a separate regime to account for differences in the way stablecoins operate.

2.53 There was general agreement that unbacked tokens that se ek to maintain a

stable value through the use of algorithms should be regarded as different to asset - backed stablecoins. However, views on how to approach them varied – some felt that they fit in the category of unregulated exchange tokens (and as such sho uld not be subject to comprehensive regulation), while others thought doing so may offer an arbitrage opportunity and so they should be subject to a regulatory regime to address potential consumer harm or financial stability risks. It was also suggested th at such tokens may become more stable with scale. 2.54 On the topic of whether exclusions to the authorisation regime are needed, several respondents noted the existing exemptions in the Electronic Money Regulations 2011 and Payment Services Regulations 2017 wo uld be broadly applicable. Other activities that respondents suggested should be out of scope included non-custodial wallets (which give control of the wallet to individuals and not

a third party), and validation of transactions and access, where these fun ctions are delivered by technology firms that are not involved in buying/selling tokens.

Changes to the FCA’s e-money and payment services

regimes

2.55 After carefully considering responses to the consultation and via ongoing

consultation with the UK’s regulators, the government’s proposed regulatory approach will entail changes to the e-money and payment services regimes to provide the FCA with appropriate powers over stablecoin issuers and other entities, including wallet providers. The approach will ensure convertibility into fiat currency, at par and on demand. FCA guidance and rules will set out in detail the requirements that apply to specific activities.

2.56 The existing payments framework would need to be adjusted to cater for this

model and the government therefore intends to make appropriate amendments to certain aspects of the regulations, for example the definition of e-money.

2.57 Overall, the governme nt is minded to develop a definition for ‘payment

cryptoasset’ (or something similar) that brings into scope any cryptographically secured digital representation of monetary value which is, among other things stabilised by reference to one or more fiat cur rencies and/or is issued and used as a means of making payment transactions.

2.58 It is proposed that a definition along these lines would capture all stablecoins

that reference fiat currencies, including a single currency stablecoin or stablecoin based on a basket of currencies.17 2.59 This would, intentionally exclude a number of existing stablecoin models, including stablecoins which stabilise their value by referencing other assets such as commodities. Having further considered feedback, and following detailed engagement with the FCA, the government considers that in practice those tokens are unlikely to meet the minimum requirements that are expected from a token used in retail payments. Further, as noted in feedback, depending on the particular structure of the arrangements, many tokens which stabilise their value by referencing other assets, like commodities, may already fall within the regulatory perimeter (e.g. as specified investments). Though this is subject to a case-by-case assessment.

2.60 Stablecoins and their underlying technical and contractual arrangements can

vary significantly. Notably, in some arrangements, the stablecoin issuer may not offer holders a legal claim on the issuer. This means that the right of a customer to redeem the value of the token (or against a reserve of assets) may sit with a third party, or may not exist at all. In contrast, offering a claim against the issuer is firmly established within the definition of traditional e -money: “stored monetary value as represented by a claim on the issuer which is issued on receipt of funds for the purpose of making payment transactions…”.

17 The legislation would also capture instruments achieving the same effect, e.g. a stablecoin referencing another stablecoin linked to fiat money, or an instrument which derives its value predominantly from reference to fiat currency.

2.61 Within the new regulatory regime proposed for stablecoins, the government

consider that it would be unacceptable for there to be no legal claim at all for the customer, as this would fail to deliver the level of consumer protection necessary and would not provide equivalence between traditional e -money and stablecoin used as a means of payment. However, given the particular characteristics of stablecoins and that the customer relationship may be with a third -party intermediary (such as a wallet), the government considers that customers should generally be able to make a claim to either the stablecoin issuer or, where appropriate, the consumer facing entity. The legal requirement would continue to sit with the issuer but requiring the issuer to fulfil directly the legal claim requirement is a high bar, which may only be necessary in systemic cases. In cases of systemic risk, and where judged necessary, the Bank of England may seek to require a direct legal claim on the issuer to address financial stability risks. The statutory redemption rights set out in the Electronic Money Regulations 2011 would also apply.

2.62 The government also intends that safeguarding requireme nts, which exist

today under the Electronic Money Regulations 2011, will apply to customer funds received in exchange for issuing a stablecoin. Safeguarding rules are designed to protect customer funds if an institution becomes insolvent and includes, for example, the requirements that funds are either held in a separate account from the institution’s working capital, invested in high quality liquid assets, or are covered by an appropriate insurance policy or comparable guarantee. It means in practice that each £1 token issued will need to be safeguarded with £1GBP, and those funds cannot be used for any purpose (e.g. lending). Further detail on how this will be enacted in a stablecoin- specific context would be set out by the FCA.

2.63 More widely, the broad appa ratus and key features of the Electronic Money

Regulations 2011 would apply to stablecoin issuance, ensuring consistency with traditional e-money regulation.

2.64 With respect to exemptions from the regulatory regime, the government

proposes to impose broadly the same set of exemptions which exist within the Electronic Money Regulations 2011 to stablecoins. This includes, for example, the limited network exclusion.

2.65 Finally, the Electronic Money Regulations 2011 and Payment Services

Regulations 2017 also establi sh their own, tailored requirements in relation to consumer protection.

Introduction of a new regulated custodial activity

2.66 The role of the wallet provider is a key feature of cryptoassets, unlike

traditional e -money. Customer interaction with a stableco in (i.e. onboarding the customer and providing access to the token) often takes place through the third-party wallet provider (or an exchange), which hold the stablecoin or the means of access to the stablecoin (i.e. the ‘private key’) on behalf of consumers using their services. This allows for stablecoins to be exchanged without redemption of the underlying funds via the issuer. The issuer instead holds the assets or funds backing the stablecoin, whereas the wallet provider or exchange provides access to the token.

2.67 The government considers that regulation is therefore required to ensure the

custody or arranging the custody of the token is subject to appropriate regulation.

The intention would be to cover the act of someone other than the issuer holding the stablecoin used as a means of payment (or means of access to the stablecoin) on behalf of a third party. It would be intended to capture wallet providers or any firms (e.g. exchanges) offering similar services. It would therefore bring within the UK regulatory perimeter firms that provide services to custody or arrange the custody of stablecoins used as a means of payment on behalf of customers.

2.68 The government will set out in legislation how that new activity will be

brought within the regulatory perimeter, and the FCA’s powers. Bringing custody into the regulatory perimeter will bring this activity into the UK’s jurisdiction, requiring authorisation by the FCA. The government and regulators will provide further detail on exclusions to this regime in due course.

2.69 The FCA will establish the detailed set of regulatory rules applicable to

stablecoin custodians, covering for example: • Prudential and organisational requirements; • Reporting requirements; • Conduct of business requirements; • Operational resilience • Custody/safeguarding requirements; • Consumer protections.

2.70 Where a firm providing custody (or arranging custody) also meets the

requirements of the Banking Act and is therefore recognised as systemic, the firm would be dual regulated by the FCA and Bank of England.

Regulation by the Bank of England and the Payment

Systems Regulator

2.71 Today, the Bank of England regulates and supervises systemic payment

systems and service providers for those systems, following the making of a recognition Order by HM Treasury under Part 5 of the Banking Act 2009 that identifies a particular payment system as systemic. Criteria for recognition as a systemic payment system includes: potential disruption to the UK financial system; with factors including likely volume and value of transactions; the nature of transactions and links to oth er systems, as well as substitutability; and use by the Bank of England in its role as monetary authority. The Bank of England has powers to publish and enforce codes of practice for operators of payment systems and service providers, set system rules, and issue directions.

2.72 At consultation, HM Treasury sought views on proposals to give the Bank of

England responsibility for systemic stablecoin payment systems and service providers, noting the concerns of the Financial Policy Committee (FPC) about potential systemic risk. The government proposed continuing to apply a high bar for the recognition of a particular payment system as systemic, as is achieved by the recognition -based process under HM Treasury.

2.73 A similar question on expanding regulatory responsibility was asked in relation

to the Payment Systems Regulator which, like the Bank of England, is responsible today for overseeing payment systems, with an ancillary role for participants in those systems.

In its 2021 consultation, the government asked:

1. Whether respondents agreed that Part 5 of the Banking Act should apply

to systems that facilitate the transfer of new types of stablecoins.

2. For views on potentially extending Bank of England regulation of wider

service providers in the stablecoin chain, where systemic.

3. Whether respondents agreed that Part 5 of FSBRA 2013 should apply to

payment systems facilitating the transfer of new types of stablecoins.

2.74 There was general support for the extension of Part 5 of the Banking Act 2009

to systemic stablecoin payment systems where that system meets the amended definition of a ‘payment system’. Several respondents highlighted, however, that most stablecoin arrangements are unlikely to reach the threshold of becoming systemically important to the UK, particularly in the near-term. Some respondents recommended ongoing monitoring until a payment system becomes systemic.

2.75 In turn, the majority of respondents also agreed that Part 5 of the Financial

Services (Banking Reform) Act 2013 should apply to payment systems facilitating the transfer of new types of stablecoin. Though several respondents noted that enhanced regulation would need to be balanced against possible impacts on competition and UK competitiveness.

2.76 There was also general agreement that the Bank of England should extend its

regulation to service providers where they are deemed systemic or where they provide services in connection with systemic stablecoin payment systems. However, one respondent suggested that effective regulation wo uld require an internationally coordinated approach to supervision, involving other international regulatory bodies, given that arrangements are intended to operate on a cross-border basis.

2.77 Further to the consultation and ongoing dialogue with the independent

regulators, the government considers that it is necessary to extend the scope of the Banking Act 2009 to capture relevant stablecoin -based payments systems . The government anticipates broadening the definition of a payment system to include arrangements that facilitate or control the transfer of ‘digital settlement assets’ (or something to that effect), which would be designed to capture stablecoin -based arrangements. Such a digital settlement asset would be drawn broadly, in order to ensure req uired regulatory flexibility. In line with the Bank of England’s existing powers, where appropriate this would enable supervision of a recognised entity at launch.

2.78 The Bank of England’s Digital Money Discussion Paper18 considered the types

of stablecoin r egulatory models that may be suitable to mitigate risks posed by systemic stablecoins. This included a bank model, in which the stablecoin would be regulated within the existing banking regime, as well as models where the stablecoins

18 https://www.bankofengland.co.uk/paper/2021/new-forms-of-digital-money

would be backed by central bank liabilities, deposits at commercial banks, or in high quality liquid assets respectively. The powers under the Banking Act are intended to facilitate regulation in line with any of these models if deemed appropriate for stability purposes. The Bank has published responses to its discussion paper and will consult on a final approach to backing models in due course.

2.79 In turn, the government also intends to extend the scope of the Financial

Services (Banking Reform) Act , to capture relevant stablecoin -based systems within the purview of the Payment Systems Regulator. Clarification will be provided so that the legislation operates appropriately for ‘digital settlement assets’.

2.80 Furthermore, the government proposes widening the application of the

Banking Act to include a defined set of service providers to which regulation could apply, in particular wallets, but also other entities such as exchanges, or to custodians of stablecoin reserves . These extensions will apply where use is made of ‘digital settlement assets’ and will be framed so as to provide flexibility to account for future developments in stablecoin.

2.81 A similar approach would be adopted in the Financial Services (Banking

Reform) Act 2013 to clarify the reach of the Payment Systems Regulator over a defined set of entities to which the regulation will apply, in particular wallets, but also other entities such as exchanges or stablecoin reserves.

2.82 Finally, the government considers that arrangements will be needed to

manage risks related to systemic stablecoin failure . This was not included in the government’s consultation; however, the Bank of England’s subsequent discussion paper, published in June 202119, highlighted the importance of appropriate backstop arrangements for these firms to meet the F inancial Policy Committee’s expectations and ensure sufficient public confidence.

2.83 Further work will be required to understand if there is a need for a bespoke

legal framework for the failure of systemic stablecoin firms and, if so, its design. In the interim, it is important to ensure existing special administration regimes can be effectively applied to stablecoin firms. At present, however, there is arguably a lack of clarity over which special administration regime (SAR) would apply were a systemic stablecoin firm to fail. Furthermore, the fluid and developing nature of stablecoin business models and their use means there is an ongoing risk that models evolve beyond the bounds of the existing frameworks. Amendments are therefore needed to clarify which regime applies and ensure that there are no regulatory gaps in terms of consumer protection and financial stability.

2.84 HM Treasury therefore intends to make appropriate amendments to the

Financial Market Infrastructure SAR, and clarify that it, rather than the Payments and E-Money SAR, should (with alterations) apply to systemic stablecoin arrangements. A consultation on the initial amendments deemed necessary will be launched later this year.

Co-responsibility for regulation

2.85 A feature of the current design of UK payments and e-money legislation is a

degree of regulatory overlap between the authorities, where responsibilities are distributed across the regulators and they set requirements and oversee firms

pursuant to their differing statutory objectives. Both the Bank of England and Payment Systems Regulator have responsibilities in relation to payment systems but with very different mandates (financial stability and effective competition respectively). The Payment Systems Regulator also has certain responsibilities in relation to participants in payment systems (such as banks or other forms of payment service providers). However, the FCA is the authority primarily responsible for regulating payment services provision.20

2.86 Under the government’s proposal to extend the existing payments and e -

money regulatory frameworks to certain stablecoins, further regulatory overlaps will apply. In particular, regulatory overlaps will arise between the Bank of England and FCA. In this sce nario, the government expects that the Bank of England will be the lead prudential regulator for systemic stablecoin entities that are also FCA authorised.

2.87 Several respondents sought clarity on how the regime would treat operators

or providers that transition from FCA authorisation requirements to Bank of England systemic regulation and called for effective coordination across the UK’s regulatory authorities. Some concerns were raised about the potential for differing requirements, particularly if a stablecoin becomes systemic over time.

2.88 These sorts of regulatory overlaps are managed today through a number of

legislative provisions that require the regulatory authorities (and HM Treasury) to consult the relevant parties where appropriate so as to ensure re gulatory coherence. While these provisions are effective, the government considers that providing additional clarity as to the application of regulation where there is overlapping regulation would be beneficial.

2.89 To ensure sufficient transparency and a hol istic regulatory approach, the

government intends to put in place a regime that allows for the clear identification of the applicable regulatory requirements (e.g. in relation to prudential rules) where a payment system is recognised as systemic. In addition, the Bank of England, FCA and Payment Systems Regulator will be required to set out in a clearly accessible and publicly available means their approach to co-regulation.

20 The FCA’s mandate for regulating payment services is broad, covering conduct, market integrity, and non-bank prudential regulation, as well as areas of competition. The Payment Systems Regulator’s (PSR) mandate for regulating participants in payment systems is primarily to promote effective competition, innovation, and ensure that user needs are met. The PSR’s current general strategy can be found here: https://www.psr.org.uk/publications/general/the-psr-strategy/

Call for Evidence on investment and wholesale uses

3.1 In addition to exploring a regulatory framework for stablecoins, the

government’s consultation sought stakeholder views on a broader range of questions in relation to cryptoassets used for investment purposes, and the use of DLT in financial markets. In particular, it asked about the benefits and drawbacks of adopting DLT across financial market infrastructures; whether there are obstacles to its adoption; and what further actions government and regulators should consider in this space.

Security tokens

3.2 The use of tokens to facilitate securities transactions is an important

development for the financial sector. The representation of traditional securities, such as equities or debt, on a distributed ledger (the ‘tokenisation’ of assets) could have substantial implications for the way assets are traded or capital is raised. Security tokens that exist and are traded exclusively on the distributed ledger (and are therefore ‘digitally native’) are also playing an increasing role across markets.21

3.3 As part of the FCA’s Regulatory Sandbox programme, firms have also

compliantly issued equities, bonds and structured products on the Ethereum blockchain. These small -scale tests showed the potential of DLT -based systems to deliver securities issuances more efficiently; f aster and cheaper when compared to traditional issuances, while increasing the transparency of ownership. However, the government recognises that existing regimes were not originally intended to support the use of cryptoassets or DLT-based innovations. The call for evidence therefore asked for views on areas of existing regulation where clarification or amendments are needed to support the use of security tokens.

3.4 Respondents noted that existing legislation and definitions provide a good

starting point for enabling tokenisation, but stressed the need to provide regulatory certainty by providing guidance and/or amending existing rules early where clear regulatory obstacles to digitisation have been identified. Clarifications to ensure, where possible, that security tokens fall within existing regulations (in particular within the Regulated Activities Order and UK M arkets in Financial Infrastructure Directive) were endorsed by many responses. Responses also noted various areas of legislation that would potentially benefit from further clarification and/or amendment. Respondents in particular highlighted areas of existing financial market infrastructure legislation, such as the UK Central Securities Depositories and Settlement Finality Regulations – the responses to these areas are covered in more detail below.

3.5 HM Treasury will work closely with the Bank, FCA and industry to consider

what possible changes may b e necessary, and the means (i.e. guidance or the need for legislation). Given DLT is at an early stage of adoption, further issues with the existing legislative framework may be identified as DLT is used more widely, meaning

See for example https://www.societegenerale.com/en/news/press-release/luxse-admits-security- tokens-issued-societe-generale and https://axoni.com/press/blackrock-goes-live-on-axoni-equity-swaps-network/

it is important that a flexible approach is taken to ensure that legislation is able to evolve over time in response to market developments.

DLT-based financial market infrastructure

3.6 DLT is a type of technology that enables the sharing and updating of records

in a decentralised way. While there is no standard definition of DLT, DLT systems are characterised by various features, including use of cryptography, distribution of data across multiple participants, the programmability/automation of functions, and (in some cases) decentralisation of control.

3.7 The call for evidence discussed the potential benefits of DLT systems for

financial market infrastructure. FMIs such as central securities depositories (CSDs) and central counterparties (CCPs), together with trading venues and other intermediaries, underpin financial market activity in the UK and worldwide. These entities process financial market transactions for a network of otherwise unconnected businesses and individuals. They assist in minimising the costs involved in making payments, settling transactions in financial instruments, or managing overall risk in these transactions. The application of DLT to these processes could have significant consequences for the UK’s financial market. Because of this, the government sought feedback from industry to understand its potential impact on FMIs and financial markets, and to help clarify what policy interventions may be needed now and in the future. The following sections of this document summarise the responses received from the call for evidence on those questions related to DLT based FMI.

The potential benefits of adopting DLT in wholesale

markets and FMIs

3.8 Responses noted that, while it is in its infancy in terms of adoption across

financial markets, DLT could substantially improve h ow FMIs operate. However, the realisation of these benefits, as well as potential drawbacks, will likely depend on the type of DLT systems employed and on how implementation is managed. Some of the key potential benefits identified in the Call for Evidence included: • Delivering greater operational efficiency. Most responses highlighted that DLT could streamline and automate existing processes, delivering faster settlement times, more efficient reconciliation arrangements and quicker processing of corporate actions (such as coupon or dividend payments). Many responses emphasised that this could lead to changes in market practices, such as the shortening of settlement cycles, support same day settlement and the reduction of settlement failures (some respondents noted that existing technology could also achieve some of these benefits). Many responses suggested that the use of a single ledger could reduce the fragmentation of processes across different entities (though some responses highlighted the possibility of increased fragmentation, see below). All these outcomes, if realised, could deliver savings both for FMIs and end-users. • Reducing risk. Most respondents suggested that DLT could be used to enable transactions to be settled immediately and with complete certainty (given a record is immutable and cannot be changed). This could reduce

different types of risk (such as the risk of a counterparty failing to fulfil its side of a transaction), with the potential to reduce the amount of capital necessary to hold against such exposures. • Improved transparency and traceability of transactions. Respondents felt that DLT systems could better enable information to be synchronised and shared between participants. This could increase the visibility of financial market activity for both market participants and regulators, who could see market data in real-time. DLT financial market infrastructures could reduce the fragmentation of data across the market ecosystem (given that currently information tends to be held by different intermediaries running separate unsynchronised databases, while on a distributed ledger all information would be available and synchronised immediately on an ongoing basis). Again, some respondents stressed that reducing fragmentation will depend on whether DLT systems are able to interoperate both with each other and with legacy non-DLT systems. Respondents felt that DLT could potentially help enable more direct relationships between market participants (allowing issuers to have more direct relationships with their investors), enable end- investors to be more easily identified, and more easily facilitate know-your- customer and anti-money laundering checks. • Increased resilience in FMI services. DLT-based networks are potentially more able to withstand outages, with its distributed/decentralised nature ensuring that there is no single point of failure, meaning a DLT system could continue to operate despite outages with individual participants.

3.9 Many respondents suggested DLT could be adopted in different ways by FMIs. It could enable existing FMIs to provide a more effective service, or it could lead to the appearance of new FMIs using DLT to perform infrastructure services more efficiently. Some respondents suggested that the presence of new FMIs using DLT could create more competition in the provision of FMI services, giving users greater choice . Ultimately, DLT could facilitate disintermediation, by enabling services currently performed by multiple different types of FMI to be carried out on a single distributed ledger, thereby creating new, more integrated forms of FMI. Fewer entities sitting between buyer and seller could potentially mean that trading and post-trade services as a whole could be made more streamlined; conversely, this could introduce risks without the protections facilitated by intermediaries.

3.10 In the long term, depending on how DLT is implemented, these developments

could therefore amount to a fundamental reorganisation of financial markets, with new types of intermediary and potentially altered relationships between market actors (particularly investors and companies).

The potential drawbacks of adopting DLT in wholesale

markets and FMIs

3.11 The Call for Evidence also asked about potential drawbacks of adopting DLT

across wholesale markets and in FMIs. Some key drawbacks highlighted in the responses were:

• Disruption to existing market practices. Respondents noted that the adoption of DLT could disrupt financial markets, and not always positively. For instance, DLT systems could change trading and settlement lifecycles in a way that potentially increased liquidity requirements (given that users would need to have pre-funded cash and securities available for each settlement, with instantaneous settlement of transactions undermining netting, which offsets and reduces liquidity needs). Some respondents flagged that changing market cycles due to the implementation of DLT could mean the loss of intervals in the market that currently function as a safety measure (for example, if DLT networks were to operate on a 24/7 basis, this could remove the current breaks in trading used for performing maintenance). Continuous trading could also mean markets would not have time to disseminate and adjust to new information, potentially creating a financial stability risk due to disequilibrated pricing. • Greater fragmentation: Many respondents noted that the appearance of new forms of FMI could fragment liquidity pools, particularly if interoperability is not developed, given that post trade activities are currently consolidated and concentrated in few FMIs. Although a DLT system may provide new efficiencies, participants having to join multiple different DLT- based FMIs could face additional costs and burdens. There is a risk that different types or classes of security could be traded on separate venues that are not interoperable, meaning greater fragmentation for users. Inconsistent adoption of DLT across jurisdictions internationally could create fragmentation in global markets. • Difficulties in implementation. Respondents noted the difficulty in evolving out of legacy structures and processes, especially given the significant potential changes to existing business models. DLT-based systems may need to be interoperable with legacy systems, at least in the short- to medium- term, as well as each other, to facilitate any transition. The initial investment required to set up a DLT FMI may be significant, particularly when DLT has yet to be tested at scale (and current market structures work relatively well).

3.12 Respondents emphasised that the extent of any disadvantages may also

depend on the type of DLT -based system adopted and could in many cases be mitigated by maintaining aspects of existing systems. For instance, current FMIs are particularly reliant on the need f or a central operator responsible for managing the internal functioning of the system, and for ensuring that the system meets its regulatory requirements. A DLT FMI that lacks the functions of central operator may struggle to fulfil these functions, wherea s a DLT FMI that does enable some form of central administration may be in the position to do so more effectively.

3.13 Current FMIs also need to ensure that they have suitable and robust

participants, while a DLT FMI operating a ‘permissionless’ system (in oth er words an open network that can be accessed by anyone) may be unable to do this. These issues may mean that certain forms of DLT FMI may not have sufficient governance and systems and controls in order to operate in mainstream financial markets or become acceptable from a regulatory standpoint. Conversely, a ‘permissioned’ system may be better able to deal with these issues, given their ability to manage who can participate on their system.

3.14 Respondents noted that some of the changes often associated with DLT

systems are not necessarily enabled by DLT alone, though DLT could be an effective way to facilitate such changes. For example, DLT may help deliver 24/7 operation for financial markets, though it is not intrinsically necessary that DLT FMIs would operate on a 24/7 basis (they could potentially use different operating hours if that was the preference of its users), and existing technologies may also be capable of enabling 24/7 operation.

Shortcomings of the current legislative/regulatory

framework

3.15 The Call for Evidence asked whether UK regulation or legislation supports the

adoption of DLT in wholesale markets and FMIs, as well as how regulation and legislation might be optimised for DLT. Respondents cited obstacles to the adoption of DLT in wholesale markets and FMIs in UK law, which require review, and then clarification and/or amendment. It was widely noted by respondents that the current legal and regulatory framework largely pre -dates technologies like DLT. As a result, concepts and terms used in U K legislation and regulation reflect the roles and functions of traditional financial infrastructures and intermediaries and the operation of existing legacy IT systems, and may need to be updated to accommodate new technologies like DLT. Any changes shoul d seek to ensure that legislation remains technology neutral and able to adapt to DLT.

3.16 A central point highlighted by responses was the need for an assessment of

the current roles and responsibilities of FMIs. In particular, responses focused on the role of central securities depositories (CSDs), the institutions that hold securities and perform settlement, issuance and maintenance functions, as well as other FMIs. The adoption of DLT may require changes to the UK Central Securities Depositories Regulation (CSDR, Regulation (EU) No 909/2014), the retained EU legislation that sets requirements for the authorisation and supervision of UK CSDs and certain settlement aspects of securities transactions. Respondents particularly questioned the existing requirement in the CSDR that requires trading venues to use a CSD to record/settle securities traded on its platforms, noting that changes to this requirement may be needed to realise the full benefits of DLT (by enabling trading venues to use DLT to record and settle transactions traded on their market). It is also unclear whether the definitions in the CSDR would accommodate how DLT -based systems function, in particular the definition of ‘book-entry’ requirements or a ‘securities account’. Further legislative provisions may need to be revisited, such as those around cash settlement and outsourcing.

3.17 Responses raised fundamental legal questions around the ownership of

securities tokenised using DLT, and how they fit within existing legislation. In particular, the Unce rtificated Securities Regulations (USRs), which enable units of a security to be evidenced and transferred electronically, were highlighted, given the USRs need to be applied to DLT systems to enable them to evidence transfer of title for each transaction in DLT securities. Respondents stressed that the USRs were not made with DLT in mind and may need to be revised to ensure they are fit for accommodating DLT. Clarity may need to be provided around what constitutes settlement for DLT-based securities (and at what precise point a settlement is said to have occurred in a DLT -based system), to ensure that legal certainty is preserved for

the settlement of transactions. New requirements may also be needed to address new challenges and risks arising from DLT such as smart contracts and cyber security risks. There are also potential conflicts of law issues should a DLT network have nodes in multiple jurisdictions.

3.18 Some respondents identified other areas of legislation that may contain

barriers to use of DLT in mar kets. Definitions and provisions in UK MiFID were identified as in need of clarification/amendment, as well as those in the UK Settlement Finality Regulations and Financial Collateral Regulations. Respondents also highlighted potential changes to provisions in other relevant legislation such prospectus rules, the Companies Act, the UK EMIR, GDPR, MAR, AIFMD, UCITS, EBR, OEIC Regulations, the FCA CASS rules and the FCA COLL handbook.

3.19 Given the relatively limited amount of experience firms have with using DLT

for FMI services, it may still be difficult for firms to identify all provisions in legislation that could act as a barrier to the use of DLT FMIs in future. Further obstacles in legislation may become more apparent as use of DLT becomes more widespread, meaning a degree of legislative and regulatory flexibility may be required.

Views on the adoption of DLT in wholesale markets, market coordination and common standards

3.20 The Call for Evidence also sought views regarding industry incentives or

obstacles to adopting DLT in wholesale markets; on whether there is a need for market coordination; and on the adoption of common standards. Responses noted that the potential benefits (outlined above) provided a strong rationale to allow for the adoption of DLT, while noting the challenges to adopting DLT around an uncertain regulatory framework, the investment/resourcing costs and lengthy timeline for implementation. The small scale of current experiments may mean that there may not always be full consideration of how DLT FMIs could or should interact with other post trade products and services, and what the impact on markets as a whole will be. 3.21 Responses noted that market coordination could entail a variety of initiatives, with the use of sandboxes, expert working gr oups, and developing standards (particularly those facilitate interoperability and appropriate governance) all endorsed by respondents. Respondents highlighted national and supranational bodies that are engaged on the issues relating to DLT -adoption, such as the FSB, the BIS Innovation Hub and Global Financial Innovation Network (GFIN). Responses noted that coordination at international level, particularly through participation in both regulator and industry forums, would ensure better outcomes for cross border activity, such as by collectively developing best practices and setting international standards.

Role of government and regulators in facilitating DLT in

financial markets

3.22 The Call for Evidence asked about what the UK government and regulators

should be doing to help facilitate the adoption of DLT/new technology across financial markets and FMIs. Most responses suggested that optimising the UK's legal and regulatory framework as the key priority for government and regulators. Respondents encouraged the government to work with market participants when modifying the

UK’s regulatory framework to ensure that it responds to the needs of the financial services industry.

3.23 Respondents noted that there is a need to test solutions, in order to learn from

practical experience how DLT will be adopted in FMIs. This should entail enabling firms to request exemptions/modifications to requirements that are obstacles to using DLT in UK legislation. Regulatory sandboxes were regularly cited as an effective way of trialling and nurturing new technologies. The FCA Sandbox was emphasised as a positive tool for UK policymakers, given it enables a balanced understanding of the benefits and the risks to be gained, with insights then used to inform policy making and supervisory practice (with the caveat that the FCA Sandbox tests solutions within the existing rules, and does not allow changes to legislation). Several responses also cited similar approaches taken in other jurisdictions, in particular the EU pilot regime, as providing benefits here. Respondents were supportive of some form of sandbox or pilot regime as a stepping -stone towards the development of permanent market changes.

3.24 Respondents highlighted several further ways the government could

incentivise industry to explo re DLT based systems, including through tax incentives and grants.

Government response to the Call for Evidence on DLT in

FMIs

3.25 The government recognises that using DLT to provide the FMI services that

underpin financial markets could unlock substantial benefits, enabling present -day processes to become more efficient, transparent, less costly, and more resilient. There are also po tential risks that need to be managed, particularly in the disruption to existing market practices and the potential fragmentation in the provision of FMI services (both between DLT and legacy systems and between DLT systems themselves). DLT could radicall y change the way wholesale markets operate, with existing intermediaries and business models replaced by DLT-based entities, though it is likely that DLT and non-DLT systems will operate side-by-side for at least the medium term.

3.26 After considering the res ponses to the Call for Evidence, the government

recognises that existing financial services regulation and legislation were drafted without DLT in mind, meaning current legislative provisions may contain obstacles or ambiguities which hinder the adoption o f DLT, or mean it is difficult to realise the potential benefits fully. The government intends to support industry in ensuring that legislation and regulation can accommodate tokenisation and DLT in FMIs.

3.27 While legislative changes are likely to be required, it is not yet fully clear how

and where these changes should be made. Responses to the call for evidence therefore called for a sandbox -style regime whereby participants could request exemptions from or modifications to existing legislation, in order to facilitate testing of DLT in FMIs and enable the UK authorities to gain a better understanding around the legislative changes necessary to accommodate DLT.

3.28 Following consideration of the views shared in the call for evidence and

industry feedback, in April 2021, the Chancellor announced that HM Treasury would partner with the FCA and Bank of England to develop a Financial Market Infrastructure (FMI) Sandbox. This would support firms wanting to test new technologies or

structures, in particular (but not necessarily limited to) DLT, to provide the infrastructure services that underpin markets (such as trading and settlement). We anticipate that the sandbox will do this by creating a regulatory framework that is temporarily modified for participati ng entities, where existing rules, regulation and legislation currently act as a barrier to adoption. Participants would still have to meet the high regulatory standards expected of existing FMIs, and regulatory outcomes, in particular those relating to financial stability and cyber security, should continue to be safeguarded. This will give industry the opportunity to use DLT to provide FMI services (and be able to test in the market), but in a controlled manner and with appropriate regulatory oversight. It should enable HM Treasury and the regulators to understand if and how FMI legislation needs to be amended permanently to accommodate DLT.

3.29 The FMI Sandbox will be up and running in 2023. Multiple iterations of the

Sandbox, whereby testing can take place for different market functions and activities, may ultimately be taken forward. In terms of the technology being tested , the government intends to ensure that the scope of the Sandbox can go potentially wider than DLT, to allow innovation with other solutio ns which may not strictly be DLT - based, but where other similar benefits could be delivered. This will safeguard the principle of technological neutrality emphasised by many responses to the Call for Evidence.

3.30 HM Treasury intends to legislate for powers th at will enable it to set up the

FMI Sandbox (and potentially multiple iterations of the Sandbox) when Parliamentary time allows. We expect further consultation with industry in advance of HM Treasury introducing secondary legislation to set out the detailed legislative framework of the Sandbox. 3.31 In designing the Sandbox, HM Treasury, working with regulators and industry, will need to address the following issues: • The relevant legislation that may be modified or disapplied for Sandbox participants, in cases where it does not support new technologies such as DLT and where there is a clear case for doing so. Currently, we envision including provisions covered by retained EU law and legislation transposing EU law (CSDR, MiFIR, SFD, FCARs) and existing UK law (USRs, FSMA, FSMA Recognition Requirements, FSMA Regulated Activities Order, UK company law). • The types of entity that will have access to the Sandbox. For example, the sandbox could support certain types of trading venue, such as Multilateral Trading Facilities (MTFs), who want to provide CSD-type functions (such as issuance, settlement, and securities maintenance) in addition to trading. • The requirements that Sandbox participants will need to meet in order to maintain the high standards expected of existing FMIs. For example, were the Sandbox to include trading venues performing securities settlement functions, this trading venue will be subject to an appropriate set of regulatory requirements (such as the relevant rules from UK CSDR), adapted to enable the use of DLT for settlement, while maintaining high regulatory standards overall. We would also expect Sandbox participants to have clear business plans setting out how they intend to ‘scale up’ (and exit the Sandbox) in a safe manner, as well as the ability to wind down their operations without causing wider disruption to the market.

• The nature and scale of activities permissible within the Sandbox, to reflect that it is designed to safely test new innovative arrangements, structures and new requirements in the market. Given the experimental nature of the Sandbox, these are necessary in order to avoid entities in the Sandbox operating at a level that poses risks to financial stability. This may include setting restrictions on the types of securities that are in scope, limits on the volumes of transactions that Sandbox entities can trade/settle, and limits/thresholds on the value of securities that can be issued in the Sandbox. We will need to consider whether or not participating firms could offer their services to wholesale markets only or potentially to retail investors as well. • The roles and responsibilities of the regulators with regards to the running of the sandbox and providing oversight of participants. 3.32 Lessons learned from t he Sandbox could support permanent rule changes, and we will seek to ensure that HM Treasury and the regulators have the ability to make changes to legislation quickly in response to feedback from the Sandbox, again in consultation with industry. 3.33 The government will continue to assess, on the basis of industry feedback, where changes could be made permanently to legislation, provided such changes do not undermine existing regulatory outcomes. Certain new features of DLT which are not covered by existing le gislation may need new requirements, such as smart contracts, private wallets, and private keys, which the government will consider how to take forward. How to handle and address new issues and risks arising from how DLT functions (such as the functioning of smart contracts and cyber security) would need to be considered. The government is aware that DLT is one of many technologies touted to deliver significant improvements in financial markets and will seek to ensure that technological neutrality remains at the core of its approach to changing legislation. It will consider these issues within the wider context of the proposed Future Regulatory Framework, as well as via the FMI Sandbox.

3.34 The government will continue to work together with industry and regulat ors

to assess the impact of DLT adoption on markets as a whole. This may particularly focus on the scenario where DLT and non -DLT technologies operate alongside one another, where there is a need to mitigate possible negative impacts such as fragmentation. The government will therefore consider carefully the suggestions made around market coordination and particularly on setting common standards both within the UK and internationally, to encourage innovation while maintaining financial stability.

Other UK work to explore the use of DLT and digital technologies, including Central Bank Digital Currencies

3.35 A number of respondents to the call for evidence noted the potentially

important role central bank digital currencies (CBDC) could play in facilitating the adoption of DLT in financial markets. The UK is continuing to play a leading role in exploring the opportunities and risks of CBDCs, and similar innovations which could support more efficient settlement in wholesale space. At Fintech Week 2021, the Chancellor announced a new Taskforce led by HM Treasury and the Bank of England to lead the UK’s exploration of a retail CBDC, with separate forums to engage civil

society and technology experts throughout. The government and the Bank of England have not yet made a decision on whether to introduce a CBDC in the UK, and will engage widely with industry.

3.36 On 16 April 2021 the Bank of England launched a new omnibus account

model. These accounts allow operators of payments systems to hold funds in the omnibus account t o fund their participants’ balances with central bank money. Operators of new and existing payment systems can apply to the Bank to open an omnibus account. We anticipate that this will facilitate the emergence of innovative payment services, making use of the security of central bank money settlement. Systemically important payment systems accessing omnibus accounts would be supervised by the Bank under the existing regulatory framework.

3.37 In addition, London is now home to the new Bank of International Settlements

Innovation Hub. The London hub is focusing its work on CBDC and innovative market infrastructures amongst other topics, and the Bank is working closely with the Hub. One of the Hub’s projects this year focuses on how payments in RTGS infrastructures could be linked (synchronised) with digital asset ledgers and payment systems in other currencies. The Bank has also experimented through its Fintech Accelerator and conducted a proof of concept to enable the renewed RTGS to link to innovative DLT- based infrastructures.

Chapter 4

Unregulated tokens and new market developments

3.38 As part of the call for evidence the government sought evidence on risks, opportunities and regulatory issues relating to unregulated cryptoassets such as Bitcoin and Ether, where used primarily as an investment or a means of return.

3.39 Most respondents who answered the question saw merit in exploring further

the case for comprehensive regulation of services facilitating investment and trading of unregulated tokens . Some r espondents argued that applying strict requirements could force consumers to use exchanges and other service providers based overseas which may seek to offer services to UK consumers without protections or oversight. A number of respondents highlighted the importance of an open dialogue with the industry.

3.40 The Call for Evidence also sought evidence on newer cryptoasset

developments, namely decentralised finance, which is a fast -growing sector within the cryptoasset landscape, encompassing a variety of diffe rent activities – such as lending – on decentralised applications using protocols.

3.41 A common theme among responses was that decentralised finance is a

nascent and fast-evolving technology, which adds an additional layer of complexity and innovation to the cryptoasset ecosystem, but currently requires a high level of technical understanding. Several respondents highlighted the potential of decentralised finance to reinvent and disrupt existing financial service business models in more efficient and effective structures, offering improved savings yields for example and cheaper remittances. With it also comes the opportunity for regulatory arbitrage and the need to ensure that, regardless of technology, the principle of “same risk, same regulatory outcome” applies.

3.42 Respondents provided feedback a range of specific risks relating to

decentralised finance, including: theft through security breaches; disruption and financial losses from governance or protocol bugs or errors; risks that decentralised finance protoc ols could be used to facilitate financial crime; legal and regulatory challenges relating to an absence of originating legal controlling body which can be held liable in the case of fraud or failure. A number of respondents, who answered this question, rec ommended continuing to monitor decentralised finance and considering consumer awareness measures to communicate risks as well as further guidance on how activities may fall within the current FCA perimeter.

3.43 Following consideration of the responses, HM Treasury is continuing to assess

the appropriate regulatory response to broader cryptoassets (i.e. beyond stablecoins used as a means of payment). In line with stakeholder views, the government will continue to monitor this fast -growing area of financial servi ces, and will work collaboratively with the UK financial regulators and industry to consider appropriate future regulation. The government will also continue to work closely with international partners, to ensure common standards which enable innovation an d harmonise guidance and concepts. HM Treasury will consult later in 2022 on its proposed approach.

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