Key takeaways from the FCA DP23/4
The Financial Conduct Authority (FCA) released a discussion paper in November (DP23/4) setting out how it proposes to regulate the issuance and custody of fiat-backed stablecoins under the Financial Services and Markets Act 2000 (FSMA). The paper also provides details on the use of stablecoins as a means of payment under the Payment Services Regulations 2017 (PSRs), which will be further discussed in a second article that we will be publishing on the discussion paper shortly.
Stablecoins, as defined in the discussion paper, are “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 high volatility of unbacked cryptoassets”. For the purposes of the first phase of cryptoasset regulation, the FCA is now focusing on the fiat-backet stablecoins (also considered as a regulated or approved stablecoin) which include those that “seek to maintain a stabilised value of the cryptoasset by reference to, and which may include the holding of, one or more specified fiat currencies”. This article provides an overview of what is expected from firms that are considering or are currently offering stablecoins as part of their business model, and how the proposals might affect them.
1. Overview of the requirements for the issuer of a stablecoin
a. Stablecoins’ backing assets
The FCA aims to ensure that that regulated stablecoins preserve a stable value by requiring issuers to constitute and maintain a reserve of backing assets, equivalent in value to the circulating supply of the regulated stablecoin at all times. Stablecoins should be sufficiently liquid to allow smooth and timely redemption on demand which would help to maintain confidence in it.
Regulated stablecoin’s backing assets should be low risk, secure and sufficiently liquid which could include government treasury debt instruments that mature in one year or less or short-term cash deposits.
Under the proposed regime, regulated stablecoin issuers can continue to benefit from the interest and returns from the backing assets. However, issuers will not be permitted to pay income or interest to consumers.
c. Safeguarding of stablecoins’ backing assets
It is proposed that the Client Assets (CASS) regime will be adapted to the new regime and will require the following:
- Segregation of the backing assets for regulated stablecoins which should be held on a statutory trust. Where a firm issues stablecoins in different currencies, the FCA is considering a potential requirement to ensure each coin’s backing assets are segregated from each other;
- Daily reconciliation should be carried out to check inaccuracies and revolve any discrepancies (shortfalls or excesses) to ensure issuers are safeguarding the right value of regulated stablecoin backing assets for consumers;
- Accurate records must be kept demonstrating that the firm holds the correct amount of regulated stablecoin backing assets it should be holding for customers, including records on the changing daily valuations of the backing assets;
- Issuers must appoint a CASS oversight officer who will be accountable for overseeing the regulated stablecoin backing assets;
- Regulated stablecoin firms will be required to provide the FCA with an annual audit, carried out by an independent external auditor, on how they comply with the CASS rules;
- Potential monthly report requirements on issuers’ stablecoin backing asset holdings; and
- Subject to the views requested in the Discussion Paper, up for consideration is the potential requirement for regulated stablecoin issuers to hold the stablecoin’s backing assets with an independent custodian.
d. Timeline for redemption
In order to ensure that all holders of regulated stablecoins can convert their stablecoin into fiat at par value at all times, the FCA proposes that issuers will need to ensure redemption at par value by the next UK business day after receiving the redemption request from regulated stablecoins holders. In addition, the FCA is proposing:
- The full redemption policy must be clearly always disclosed and accessible to consumers on the regulated stablecoin issuer’s website at all times; and
- Redemptions should not be overly restrictive so as to dissuade customers to redeem its stablecoin and not meet consumer duty outcomes.
The FCA is proposing to regulate the safekeeping of cryptoassets on behalf of firms/consumers by using existing custody provisions in CASS to ensure custodians take appropriate measures to protect clients’ custody assets when they are responsible for them. This will also allow for assets to be returned to clients as quickly and as whole as possible in the event of an insolvency. Accordingly, the FCA proposes to apply the following elements of the existing regime:
- Adequate arrangements to protect clients’ rights to their cryptoassets;
- Adequate organisational arrangements to minimise risk of loss or diminution of clients’ custody assets;
- Accurate books and records of clients’ custody assets holdings; and
- Adequate controls and governance to protect clients’ custody asset holdings.
a. The use of an omnibus wallet
The custody of cryptoassets allows access and safe storage of stablecoins and it has been common practice within the industry to outsource this to a third-party.
To protect customers’ interests, the FCA is considering allowing firms to use an omnibus wallet to safeguard customers’ cryptoassets if the customers’ ownership of the cryptoassets is preserved.
b. Governance arrangements, outsourcing requirements, annual audit and monthly reporting
Firms are expected to keep accurate and up to date records of the ownership of the stablecoins and to have appropriate governance arrangements in place defining the responsibilities of each individual in the process, as defined under the Senior Management and Certification Regime (SMCR).
If custody is outsourced, firms should ensure that due diligence is carried out before appointing the third-party and that the service agreement clearly defines the scope of the custody service.
An annual CASS audit and monthly regulatory reporting are considered within the discussion paper.
3. Other key takeaways for custodians and issuers
a. Senior Management Arrangements, Systems and Controls (SYSC) sourcebook
Regulated stablecoin issuers and custodians are expected to have robust governance arrangements with competent individuals withclear reporting lines, effective risk management and control mechanisms. This is in addition to directors and senior managers taking direct and practical responsibility for the organisation of the business.
The application of SMCR would depend on the size and complexity of the firm, the potential harm arising from the business and whether the firm is solo or dual regulated. Solo regulated firms (regulated solely by the FCA) can be classified as limited scope, core or enhanced and dual regulated firms (regulated by both FCA and PRA) are required to comply with the FCA’s regime and Bank of England’s Code of Practice for the governance of recognised payment system operators.
b. Protecting customers’ interests
Regulated stablecoin issuers that target retail consumers will need to consider the Consumer Duty in the design and build of their stablecoins, as well their ongoing operation.
The discussion paper also considers the FCA’s rules for cryptoasset financial promotions with the expectation that issuers publish key information on their regulated stablecoins in a way that is fair, clear and not misleading on their website and main communication channels, for consumers to understand. In addition, categorising clients (retail vs. professional clients) and restrictions on inducements are elements that issuers and custodians should consider as part of their compliance with the financial promotion’s rules.
There is an expectation for a firm’s terms and conditions, underlying a regulated stablecoin, to be reasonable and proportionate. Regulated stablecoin issuers should also consider and comply with any other law that applies to the firm’s activities, including consumer protection legislation such as the Consumer Rights Act 2015.
The discussion paper proposes to apply the FCA Complaints handbook (DISP sourcebook) and to allow access to the Financial Ombudsman Service in case of dispute so as to improve trust and confidence in the regulated financial services market. However, there are no plans to extend the Financial Services Compensation Scheme to cover the issuing and custody of stablecoins activities.
c. Prudential requirements
The proposed own funds requirements are closely aligned to those currently in force for MIFID firms including, a permanent minimum requirement (PMR), a fixed overhead requirement (FOR), and an activity-based “K-factor” requirement (KFR). The definition and types of capital that are considered as regulatory capital will include the traditional Common Equity Tier 1 (CET1), Additional Tier 1 (AT1), Tier 2 (T2).
In addition, firms will also need to consider liquidity. The FCA proposes a basic liquid asset requirement, based on a proportion of a firm’s FOR, which must be met with tightly defined core liquid assets (such as short-term deposits with UK banks, units in short term money market funds and assets representing claims on or guaranteed by the UK Government or Bank of England).
Firms will also be subject to general requirements to manage and monitor concentration risks as part of an individual capital adequacy and risk assessment (ICARA) that firms must conduct on an ongoing basis.
The ICARA should cover:
- Identification, monitoring and mitigation of harms
- Business model planning and forecasting
- Recovery and wind-down planning
- Assessing the adequacy of financial resources
- Senior management involvement in overseeing the appropriateness of the governance and risk management
It is expected that the parent entity (including unregulated parent entities) will be required to hold sufficient capital to support its subsidiaries under the Group Capital Test (GCT). The aim of this proposal is to ensure stable group structures – by ensuring that excessive leverage is not employed in holding structures to fund the regulatory capital of regulated entities.
Public disclosure of the prudential information on a dedicated part of the firm’s website is proposed to support effective market discipline and facilitate constructive engagement by all stakeholders.
d. Operational resilience
Firms are expected to demonstrate the ability to prevent, adapt, respond to, recover and learn from operational disruptions to protect consumer and market integrity. In line with SYSC 15A, firms should have a comprehensive understanding and mapping of the people, processes, technology, facilities and information necessary to deliver its important services.
Returning customers’ funds in of stablecoins issuers and custodian firm failures
Firms are expected to wind-down in an orderly manner or enter insolvency in a way that minimises customers’ harm and the financial market and as such, CASS rules should apply in the event of the following:
- The failure of the issuer;
- The failure of the firm responsible for safeguarding the backing assets if not the issuer; and
- The failure of the bank/custodian holding the backing assets for either the issuer or the firm responsible for safeguarding the backing assets, if not the issuer.
e. Financial crime
Regulated issuers and custodians will be required to have systems and controls to counter money laundering, terrorist financing, proliferation financing risk as per SYSC 6 and existing legislative requirements. The Money Laundering Reporting Officer (MLRO) should have adequate oversight of the activities of the firm and provide annual financial crime reports and fraud information in case of incident to the FCA.
While the rules described above are not final, currently registered cryptoassets providers, fintech, overseas cryptoassets and stablecoins businesses are recommended to assess their business model against the proposals. In our next article, we’ll look at the proposed regulation of payment services that use fiat-backed stablecoins.