The UK’s approach to the regulation of stablecoins

The Financial Conduct Authority (FCA) and the Bank of England (Bank) have recently published their proposed approach to regulating stablecoins. The proposals cover any payment systems in the future that use stablecoins on a ‘systemic’ scale.

Definition of stablecoins

There are a number of definitions of ‘a stablecoin’.

The Financial Stability Board (FSB) defines a stablecoin as ‘a category of cryptoassets that aim to maintain a stable value relative to a specified asset or basket of assets providing perceived stability when compared to the highly volatility of unbacked cryptoassets’.

Wikipedia defines it as follows: ‘A stablecoin is a type of cryptocurrency where the value of the digital asset is supposed to be pegged to a reference asset, which is either fiat money, exchange-traded commodities (such as precious metals or industrial metals), or another cryptocurrency.’

Stablecoins are used:

• To facilitate transactions between cryptoassets;
• As a method for consumers to enter and exit the cryptoassets market, converting cryptoassets to a fiat currency ‘off ramp’ or fiat currency to cryptoassets ‘on ramp’;
• As a method of payment;
• As a ‘store of value’ or investment;
• As collateral in decentralised finance (DeFi) to provide liquidity pools and help with price stability in market making applications; and
• For obtaining a yield on lending platforms

In general terms, there are two kinds of stablecoin, ‘fiat-backed’ stablecoins or so-called ‘algorithmic’ stablecoins. Whereas fiat-backed stablecoins are tied to real assets, algorithmic stablecoins work slightly differently, by controlling the supply of the token (and new sister coin) to maintain a level price.

The author has always held concerns that algorithmic stablecoins are a little more than illegal Ponzi schemes, often created by individuals who wish to replicate central banks, who routinely intervene in the market to protect the value of the national currencies. Regardless of this rather extreme view, many of these so-called stablecoins have proved to be far from stable, as they have been susceptible to large sell offs created by smart contracts designed to maintain the price. See for example, the price crash by Luna in May 2022 when $50 billion was wiped out in just three days.

The advantages of stablecoins are:

• Fiat-backed stablecoins used for payments can execute payments in real-time, 24/7;
• They can be designed for cross-border transactions;
• They encourage the development of interoperability to increase use by consumers with diverse origins quicker and easier; and
• They offer lower transaction fees.

But the potential risks are substantial:

• Vulnerable and technologically ‘unsavvy’ consumers should be excluded;
• Technology risks – much of the current technology is untested and may be unstable (in particular, the failure of custody services in relation to Celsius Network LLC and FTX Group);
• There is little or no supervision of those who promote or manage stablecoins, i.e, no ‘fit and proper person’ test; and
• There are concerns that extensive use could threaten global monetary stability.

The current market for stablecoins

Although the Ethereum blockchain saw over $7.5 trillion transactions in 2022, the majority of stablecoin transactions were conducted by US dollar stablecoins issued by Circle (USDC) and Tether (USDT), which had a market dominance of 87 per cent relative to the total stablecoin market cap of $123.4 billion.

The UK activity is small, some allow trading of stablecoins to GBP, but there are currently no GBP-denominated stablecoins issued in the UK.

Problems with the crypto market in general

The number of transactions reported by exchanges is often distorted by a number of practices. One of the issues with the cryptoasset market is that information, particularly about the composition of backing assets, is often unavailable, incomplete or opaque. This can permit consumers to be misled, which could result in a ‘run’ on the stablecoin.

Current regulation

Currently firms’ activities in relation to stablecoins are largely unregulated in the UK, so consumers are warned that they must be prepared to lose all their money.

The FCA’s current regulatory remit covers the anti-money laundering (AML) and counter-terrorist financing (CTF) supervision of cryptoassets businesses registered in the UK under the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017. The FCA also regulates the financial promotions concerning cryptoassets (through PS23/6: Financial promotions rules for cryptoassets).

Market failures

The background to the recent proposals is the recent high-profile failures of cryptoassets that claim to be stable, but in fact, this stability proved to be illusory. The main examples being Terra Luna and IRON.

One issue that has been identified in the consultation is the problem around redemption. At present, most issuers of fiat-backed stablecoins restrict redemption to wholesale users, such as exchanges, leaving retail consumers only able to trade their coins in the secondary market.

A case study in the consultation relates to the USD stablecoin which ‘de-pegged’ from the dollar to a low of $0.87, some small trades as low as $0.12 were executed. The issuer could offer redemption at par to their direct clients, but not to retail customers who made substantial losses.

Fraud in cryptoassets

There has been a growth in fraud related to cryptoassets, the most recent being related to the collapse of FTX and the prosecution of Sam Bankman-Fried. Evidence of various types of fraud has been used including:

• Front running: where algorithms are used to place orders immediately before and after trades.
• Pump and dump: where a small group of investors select and purchase shares in a company with a low market capitalisation.
• Wash trading: where traders collude to feed misleading information to the market.
• General mismanagement: new collapses of ‘Three Arrows Capital’ where the Singapore-based fund tried currency arbitrage on FX trading and went down despite a $2 billion investment from Grayscale Bitcoin Trust and a large position in Luna (see below). And Celsius Network, which turned a company with assets of $25 billion into bankruptcy owing $4 billion. It was offering 18.63 per cent annual interest.

A recent academic study found that fake trades occurred in 29 crypto exchanges amounting to trillions of dollars annually and estimated that 70 per cent of reported trades on unregulated exchanges were false. These fabricated volumes (trillions of dollars annually) improve the exchange ranking, temporarily distort prices, and relate to the exchange characteristics (e.g., age and userbase), market conditions, and regulation.

Current auditing of cryptoassets

Unfortunately, this is one of the areas where the accountancy profession has been slow to develop traction. For example, an article on the Institute of Chartered Accountants in England and Wales website states:

‘Cryptocurrencies are still a bit of an unknown entity when it comes to audit and assurance. What considerations do auditors need to take on board? Although it has existed for more than a decade, cryptocurrency is still somewhat of a novelty. Any official guidance is almost nonexistent. As a result, it can be extremely difficult to audit. How do you classify it?’

Another feature on the website points out that there has been an over-reliance on the use of blockchain, which may explain the lack of guidance. Concerns have been expressed around pricing data and ownership issues, including access to wallets and cases where there are disputes around the ownership of private keys.

Of real concern is the lack of a requirement to present independent audited accounts by stablecoins.

The FCA discussion paper

The FCA are planning a phased approach to regulation.

The first step in the FCA plan is to regulate the issuance and custody of fiat-backed stablecoins under the Financial Services and Markets Act 2000 (FSMA) and the use of these stablecoins as a means of payment under the Payment Services Regulations 2017. This follows the Treasury’s recent policy statement setting out the government’s intention to bring the two activities into the FSMA under the Regulated Activities Order (RAO).

Consideration is being given to requiring cryptoasset custodians to have adequate arrangements in place to minimise the risk of loss or the diminution of clients’ assets due to misuse, fraud, poor administration, inadequate record-keeping or other dishonesty. The FCA is also ‘exploring’ requirements for accurate record keeping (which might be ‘on-chain’) to help identification of the ownership rights of those assets in the event of default. New prudential requirements will be introduced to ensure that regulated stablecoin issuers and custodians have adequate financial resources.

The Treasury is also looking at whether overseas stablecoins could be assessed by an FCA authorised or registered firm before being used on UK payment chains.

The next stage will be using stablecoins for cryptoasset trading or dealing as a principal or agent. They are also considering allowing firms to become ‘payment arrangers’ in due course.

As is expected, the proposal is to identify the risks, use an outcomes-based approach, be technology agnostic and achieve a balance between innovation, while protecting consumers and market integrity.

The Bank of England discussion paper

The proposed regime recognises that systemic payment systems using stablecoins pose similar risks as other payment systems, so as a ‘new form of privately issued money’, issuers of stablecoins should meet standards that are at least equivalent to those that apply to commercial banks.

Issuers will be required to fully back stablecoins with deposits at the Bank of England. No interest will be paid on these deposits, to ensure that the stablecoins retain their value.

Without conducting a detailed analysis of the proposals, in general terms these proposals would seem to be a well-considered method of developing a new form of ‘digital money’ to transfer value in new payment systems.

Assessment of the proposed new regulatory framework

The acceptance by the UK government of the need to regulate stablecoins and cryptoassets in general is clearly to be commended. Currently, there is a perception in the market that New York is a safer place to deal in stablecoins because of the more proactive approach to regulation that has been taken hitherto by the US Securities and Exchange Commission than in the UK.

There is a general intention to make London a pivotal centre for the promotion and dealing in global cryptoassets, but such an intention requires a delicate balance to be struck between the need to impose stringent and enforceable regulations with a willingness to foster innovation.

There can be no doubt that the development of the FCA sandbox, which has been replicated in other jurisdictions, has played a major part in establishing London as a recognised centre for cryptoassets and the continuation of this approach will play an important role in supporting this aim.

Although it is accepted that ‘Rome can not be built in a day’ and a phased approach to the regulation of such a complex market with so many ‘moving parts’ is a difficult task, if stablecoins are to become generally accepted and trusted by the market, common sense dictates that a much more interventionist approach should be taken towards regulation and enforcement than that which is currently proposed.

The fundamental building block of trust in financial regulation is a requirement to provide regular, honest and fair accounts, which are independently audited to an international standard that is generally accepted. It is, therefore, the view of the author that the promoters of stablecoins and other cryptoassets must have legal obligations to prepare audited accounts which, as a minimum, set out the true value and extent of the assets that are being held, both in custodial ‘vaults’ and as security for ‘fiat-backed’ securities. It is, therefore, essential that these government proposals are introduced in lock step with an accelerated standard on the auditing of cryptocurrencies to be prepared by the UK accountancy professions.

It is also clear that, although a ‘light touch’ approach to regulation may help cement London as an international centre for the trading of cryptoassets, without a well-funded specialist enforcement agency who are provided with a substantial legal framework, which permits speedy and efficient intervention and prosecution, the government’s attempt to regulate the market may struggle to build the trust necessary to support such lofty ambitions.

Jeremy Barnett is a practising barrister at St Pauls Chambers and honorary professor of algorithmic regulation at UCL
stpaulschambers.com

Jeremy has recently co-authored academic papers on cybercrime and artificial intelligence for the Judiciary in JudicialTech. The paper on crypto and fraud can be found here and the paper on JudicialTech supporting justice can be found here.