The UK Government has committed to placing the UK’s financial services sector at the forefront of crypto asset technology and innovation. Giving effect to that vision, the Financial Services and Markets Act 2023 (“FSMA 2023”) came into force on 29 August 2023. It provides a pathway towards comprehensive regulation of stablecoins in the UK.

How does the Act actually work? Is it workable? Are there concerns about regulatory overreach of the kind alleged against US regulators? Some thoughts.

The UK Government has decided against designing an entirely new and bespoke regulatory framework from the ground up. Instead, the new Act introduces the foundational concept of “Digital Settlement Assets” (DSAs). This concept is then retrofitted onto the UK’s existing regulatory regime for: a) E-Money and b) Payment Services.

Bringing stablecoins into the existing regulatory perimeter for payments and e-money meets the government’s stated objective of ‘same risk, same regulatory outcome’: aimed at avoiding regulatory arbitrage between traditional e-money/payments and stablecoins.

“E-money” is currently supervised by the Financial Conduct Authority under the Electronic Money Regulations 2011. These regulations already contain the standards and rules that must be met by issuers of electronic money in the UK. They stipulate capital and safeguarding requirements. The plan is to align the regime for Digital Settlement Assets with the existing regime for e-money (FSMA, s. 23 (3) (a) and Schedule 1).

“Payments services” are supervised by the Payment Services Regulator. It’s powers and duties are set out in the Financial Services (Banking Reform) Act 2013. It has a statutory responsibility for promoting competition in the market for payment systems, promoting innovation and protecting services users. This Act will be amended so as to apply to Digital Settlement Assets (s. 22 and Schedule 6).

Finally, where stablecoins payments are considered to be “systemically important” - because disruptions or deficiencies could threaten the stability of the UK’s financial system - the Bank of England will have an important supervisory role under the Banking Act 2009 (FSMA, s. 22 and Schedule 6). This will also be amended to apply to Digital Settlement Assets.

Yes and no. Key parts of FSMA 2023 are already in force with effect from 29 August 2023: including: a) the new statutory definition of Digital Settlement Assets and b) the introduction of the Treasury’s general power make new law regulating stablecoins (FSMA, s. 23).

However, the full regime will not enter into force until the Treasury makes further commencement regulations (under s. 86). Further guidance is expected from the Treasury as to precisely how and when this will occur in due course.

The Government’s original proposal – at the stablecoin consultation phase - was to define a stablecoin as a: “cryptographically secured digital representation of monetary value which is stabilised by reference to one or more fiat currencies and/or is issued and used as a means of making payment transactions” (See Consultation Response, paras 2.56 to 2.58).

However, the definition of “digital settlement assets” (DSAs) that has made it into the new Act is somewhat different. Reference to “stability by reference to fiat currencies” is now conspicuously absent.

A DSA is defined as: “….digital representation of value or rights, whether or not cryptographically secured, that— (a) can be used for the settlement of payment obligations, (b) can be transferred, stored or traded electronically, and (c) uses technology supporting the recording or storage of data (which may include distributed ledger technology)”

The reference to assets which can be used for the “settlement of payment obligations” is – in my view - ambiguous. Retail payments using crypto are not yet mainstream, but that may well change (eg. using Bitcoin’s lightening network). Moreover, Ether is already routinely used to pay for web3 goods and services online (eg. NFTs, gas). However, it is unlikely that the Treasury intended Bitcoin and Ether to fall within the ambit of stablecoin regulation.

On the other hand, it might be argued that Bitcoin and Ether are not “digital representations of value” because they are not semiotic: ie. they don’t ‘point to’ or represent any extrinsic value or rights such as fiat currency. Their value derives from the crypto system in which they are instantiated.

Interesting as that discussion may be (to lawyers), it would be unfortunate if the application of stablecoin regulations turned upon such nuanced analysis. The Treasury has an explicit power to modify the definition of “Digital Settlement Asset” (FSMA, s. 23 (6)). That power may well need to be exercised sooner rather than later to remove these potential ambiguities.

There is a very wide definition of the types of activity that will be subject to regulation. For example, the concept “DSA service provider” under the Banking Act 2009 will include:

• Creators or issuers of Digital Settlement Assets;

• Exchange providers;

• Anyone providing “any service which facilitates or supports the transfer of DSAs”.

• It also explicitly includes those who “provides services to safeguard, or to safeguard and administer, digital settlement assets including their private cryptographic keys (or means of access)”

  [See Banking Act 2009, s. 182 (5A) as amended by FSMA 2023]

The jurisdiction of stablecoin regulators over wallet providers is an explicit policy decision of the UK Government. The Government’s intention (as it made clear in during the consultation process) is to ensure that custody in addition “arranging the custody” of a token through a wallet is – where necessary - subject to appropriate regulation.

The ability of the UK Government to regulate wallet providers in the same way as “custodians” of stablecoins is (to say the least) contentious. Software wallet applications have no control over the contents of a user’s wallet and do not handle customer funds. Assets – including stablecoins - are not stored “in” a wallet, but rather, are recorded on the blockchain’s ledger. It therefore makes little sense to impose prudential, custody and safeguarding requirements on wallet providers in the same way as centralized exchanges or stablecoin issuers.

This raises the spectre of the kind political and legal battles currently raging in the US about regulatory overreach. Consider the SEC’s allegation that Coinbase has acted as an unregistered “broker” under the Securities Exchange Act 1934 through its web3 wallet application. Or the IRS’s recent proposal to introduce tax reporting regulations to those who “effect” sales by providing access to smart contracts. Will the so called “war on crypto” spread to UK shores once the Act comes fully into force? I think not.

Fortunately, the UK regulations contain a number of inbuilt “safety valves” to allow for sensible and proportionate regulation of the space (including the regulation of wallet providers).

First, wallets (and other “service providers”) will not fall within the UK’s regulatory perimeter automatically: this is a matter of judgment and discretion. For example, the Bank of England’s jurisdiction does not arise unless the Treasury first makes a “recognition order” (s. 185A). The Treasury is obliged to apply its mind to the precise “nature” of the services provided before making such an order. It must also consult other regulators and consider any representations by the affected service provider. The Payment Services regime contains similar provisions.

Second, all service providers will not be treated alike. Even if an order of this type were made, a wallet provider will not necessarily be regulated in the same way as a stablecoin issuer: one size does not fit all. This is because, under the new regime, regulators will enjoy very wide discretion as to precisely how different kinds of service providers are regulated. For example, once a “recognition order” is made by the Treasury it is then up to the Bank of England to decide what (if any) directions or rules to impose. Those imposed upon a wallet provider may well be entirely different to those imposed upon a centralized exchange holding stablecoins on behalf of a user.

Third, the boundaries of the regulatory perimeter are not set in stone. For example, under the Banking Act 2009 the Treasury has a power to amend the definition of “DSA Service Provider” as it sees fit (s. 182 (5A)). More generally, under section 23 of FSMA 2023, the Treasury has a general power modify any primary legislation concerning stablecoins. Using these statutory provisions, the UK will be able to adopt an agile and flexible approach to the regulation of stablecoins.

If a light touch can be hoped for in respect of wallet providers, a heavier hand is likely to be applied to centralized issuers of stablecoins. Indeed the application of the UK’s E-Money regime to stablecoins may require a fundamental overhaul of the way that some stablecoins are designed, governed and operated in the UK.  The Government noted during its consultation process that stablecoins and their underlying technical and contractual arrangements can vary significantly. Stablecoin issuers do not necessarily offer all holders a legal claim on the issuer. The right of a holder to redeem the value of the token may sit with a third party or may not exist at all.

By contrast, offering a claim against the issuer is central to the definition of traditional E-Money within UK law. E-money is defined as “electronically 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”. Issuers of e-money are subject to initial and ongoing capital requirements. Safeguarding rules are designed to protect customer funds if an institution becomes insolvent. Funds are required either to be held in a separate account from the institution’s working capital, invested in high quality liquid assets, or covered by an appropriate insurance policy or comparable guarantee. E-money holders have the right to redeem their e-money at any time and at par value.

Within the new regime proposed for stablecoins, the government considered 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. …customers should generally be able to make a claim to either the stablecoin issuer or, where appropriate, the consumer facing entity” (Consultation Response, para. 2.61).

It is envisaged that the kind of safeguards that exist today under the UK’s E-Money regulations, will apply to customer funds received in exchange for issuing a stablecoins. 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). The claim will either be available against the stablecoin issuer itself or, where appropriate, a consumer facing entry such as the centralised exchange from which a consumer purchases the stablecoin.

The precise nature and scope of the E-Money regulations – as it applies to stablecoins in the UK - remains to be seen. The existing e-money regulations will be revoked (see FSMA 2023, Schedule 1) and replaced with an updated regime which that will also apply to Digital Settlement Assets.

One question is whether new statutory regime is capable of applying to stablecoins that are issued overseas but used in the UK: eg USDC/USDT. On my reading of the legislation, it would appear so. At least in principle. But only if deficiencies or disruption in these stablecoin systems were ever considered to pose a threat to the stability of the UK economy.

This is because under the Banking Act 2009 a “Payment System” refers to any arrangement designed to facilitate or control or facilitate the transfer of money “whether or not it operates wholly or partly in relation to persons or places outside of the United Kingdom” (s. 182 (5)).

Whether the same approach would apply to “non-systemic” stablecoins issued outside of the UK is much less clear. For example, the FCA’s recent Perimeter Guidance suggests that it would not generally expect a Payment Service Provider incorporated and located outside the UK to be within the scope of the Payment Services Regulations if all it does is to provide internet-based and other services to UK customers from that location (see Perimeter Guidance Manual, August 2023, para. 15.6).

The issue of jurisdictional reach of the UK’s stablecoin legislation will – in my view - need to be clarified in due course with further guidance and regulations from the Treasury, Bank of England and FCA.

The changes made by the FSMA 2023 provide the foundation for comprehensive regulation of stablecoins in the UK. The broad contours of the UK’s vision are now apparent.

Whilst some critics will argue that they are imperfect, they are at least perfectly flexible. They provide for a regulatory framework that is capable of being agile and responsive and which provides plenty of room for regulatory discretion. The Government’s open commitment to web3 innovation in financial services suggests that discretion will be exercised sensibly. Time will tell.