UK acts on stablecoin risk Managing the failure of systemic Digital Settlement Asset firms

On 31 May 2022, HM Treasury issued a consultation paper "Managing the failure of systemic digital settlement asset (including stablecoin) firms". The consultation sets out the Government’s proposed approach to managing the failure of systemic digital settlement asset (including stablecoin) firms, by applying a modified Financial Market Infrastructure Special Administration Regime to these firms. This comes at a time of heightened attention and increased regulatory scrutiny of cryptoassets, and stablecoins in particular (see our recent Digital Assets Digest) following recent market turmoil. It also follows the April 2022 response issued by the Government confirming its approach to the regulation of stablecoins.

Separately, the EU's response to stablecoins and crytpoassets in general (see our briefing here) is proceeding through the EU legislative process, with further negotiating rounds expected to take place in June 2022.

Background

Stablecoins are a form of cryptoasset which aim to maintain a stable value relative to other assets. Stablecoins can be pegged or linked to particular assets or algorithmically controlled. An algorithmically controlled stablecoin is one that is based on an algorithm designed to maintain price stability by adjusting the supply of tokens to match demand, thus affecting the quantity of tokens held.

In April 2022, the Government issued a response to its January 2021 consultation on cryptoasssets, confirming its intention to introduce legislation necessary to bring activities involving the use of stablecoins as a means of payment into the UK regulatory perimeter, chiefly via amendments to existing electronic money and payments legislation and regulation (see our briefing here). These provide the FCA with powers to regulate and supervise firms undertaking electronic money and payment services. In the response, the Government also stressed the importance of containing risks related to the failure of a systemic stablecoin firm which either acts as a systemic payment system and/or is a service provider of systemic importance.

Since the April 2022 response, a number of events have occurred in the cryptossets sector that have renewed concerns. In May 2022, high profile stablecoins - both algorithmic and those supposedly backed by reserves - broke their peg away from the dollar, causing massive drops in prices and fears of a "run-like scenario" (TerraUSD, an algorithmic stablecoin lost its 1:1 peg with the US dollar, while Tether, an asset-backed stablecoin also briefly lost its peg). In the consultation, the Government alludes to the turmoil noting: "Since the initial commitment to regulate certain types of stablecoins, events in cryptoasset markets have further highlighted the need for appropriate regulation to help mitigate consumer, market integrity and financial stability risks."

Proposals

The Government states that two special administration regimes currently exist in UK legislation that could potentially be applied to the administration of what it terms a digital settlement asset” (DSA) firm that is not a bank: the Financial Market Infrastructure Special Administration Regime (FMI SAR); or the Payment and E-Money Special Administration Regime (PESAR). The Government uses the term DSA to refer to the type of stablecoin it has consulted on previously, together with wider forms of digital assets used for payments/settlement. It uses the term “systemic DSA firm” to refer to systemic DSA payment systems and/or an operator of such a system or a DSA service provider of systemic importance. In the case of a stablecoin, this might include the issuer of a stablecoin, a wallet, or a third-party service provider.

The consultation notes that the FMI SAR was introduced to address the risks posed by the possible failure of payment systems recognised as systemic (e.g. Bacs) where the Government considered that disruption to/discontinuity would not best serve the public interest given potential impacts on financial stability. The PESAR was established to address the risks posed by the possible failure of payment and electronic money institutions. In the current consultation, the Government considers that it is yet unclear whether PESAR or FMI SAR regime would apply to the failure of a systemic DSA firm. The Government is therefore seeking views on a modified FMI SAR for managing the failure of a systemic DSA firm and on amendments that would be necessary to ensure its effectiveness. The principal proposed amendments to the FMI SAR - which would only apply to the administration of a systematic DSA firm, and not to other firms are:

• the addition of an new objective under the FMI SAR, being the return or transfer of funds and custody assets (the current primary objective being continuity of service, meaning that the administrator must focus primarily on the continued operation of the firm);
• the inclusion of a Bank of England right to direct administrators as to which of the two objectives should take priority in each case; and
• a requirement for the Bank of England to consult the FCA before seeking a special administration order for a systemic DSA firm that is subject to regulatory requirements imposed by both the Bank and the FCA, or directing an administrator with regard to the regime’s objectives.

The closing date for comments is 2 August 2022.

What about the EU?

In September 2020, the European Commission published MICA, which introduces a regulatory regime for unregulated cryptoassets and cryptoasset providers. As we stated in our briefing, stablecoins are caught under MICA. MICA differentiates between different types of stablecoins and places additional obligations in relation to stablecoins that are deemed significant (based on certain criteria set out in the Regulation). This includes obligations concerning interoperability, liquidity management and orderly wind-down of activities. MICA is currently proceeding through the EU legislative process.