Systemic or non-systemic...that is the question

A comparison of the UK’s proposed stablecoin regimes

December 2023

In early November, the FCA and Bank of England (BoE) published sister discussion papers on proposals for the regulation of, respectively, non-systemic and systemic fiat-backed stablecoin (FBS) payment systems. These proposals reveal important differences between the two regimes, which have significant implications for developing business models in the space.

Overview

As described in our previous article, HM Treasury (HMT) plans to bring FBS within the regulatory perimeter by amending the Payment Services Regulation 2017 and creating two new activities — issuance and custody — under the Regulated Activities Order 2001 (RAO). That article considered, in detail, the FCA's discussion paper (PDF 1.4 MB) (DP) on rules related to both activities.

The BoE has now published a further discussion paper (DP) on the regulatory framework for FBS systems deemed systemic (or likely to become systemic). The BoE and Payment Systems Regulator (PSR) already regulate operators of traditional systemic payment systems (and service providers that provide `essential services') once recognised or designated by HMT. Legislative changes (under FSMA 2023) expanded this remit to include operators that transfer `digital settlement assets' — which includes FBS.

In the context of FBS, the BoE's remit can capture operators of systemic payment systems using FBS, systemic service providers (e.g. issuers, wallet providers, exchanges) or related service providers. The latter two categories could be recognised as systemic in their own right or systemic because they provide essential services to a systemic system or systemic service provider.

The BoE's DP is specifically scoped to address systems that are:

Payments-focused — i.e. FBS systems that are widely used for payments in the UK.
Retail-focused — i.e. FBS systems used by households and non-financial businesses. The BoE will set out its views on wholesale settlement “in due course” — it has alluded to potentially updating the RTGS system so that it can connect with a wider range of ledgers.
GBP-denominated — however, the BoE will monitor non-GBP denominated FBS that are being widely used and consider whether the regime requires amending.

Designation as systemic

The DP notes that HMT is responsible for designating `systemic' status where “any deficiencies in design of system, or disruption to operation, would likely threaten stability of, or confidence in, the UK financial system, or could have serious consequences for business or other interests in the UK”.

The BoE must be consulted as part of HMT's decision and will consider:

The number and value of the transactions passing through the system.
The nature of the transactions — e.g. criticality, currency denomination and risk profile.
Whether the transactions could be handled by other systems — i.e. substitutability and continuity.
The relationship with other systems — e.g. connectedness with systemically important FMIs, institutions and governments.
Whether the system is used by the BoE in its role as a monetary authority.

With a particular eye on Bigtech firms, the BoE may also recommend designation as systemic where a system is not currently operating at systemic scale but is likely to do so in the future (“systemic at launch”).

Once recognised as systemic, a relevant entity (or entities) would be subject to the BoE's powers to (i) obtain information, (ii) issue principles and binding codes of practice, (iii) make directions and (iv) issue enforcements.

The BoE will work with HMT and other regulators to allow for a smooth transition into the systemic regime and minimise regulatory overlaps. This co-operation will be set out in an MoU which is reviewed annually.

Interestingly, the BoE has said that it would not deem existing stablecoins (which are mainly pegged to USD) or any new sterling equivalent similarly focused on “transactions in the crypto world” systemic.

Summary of proposals

Leveraging the Principles for Financial Market Infrastructures (PFMIs) (PDF 296 KB) as a starting point, the BoE has proposed the following:

Issuers

BoE	FCA
FBS should be fully backed with central bank deposits.	Non-systemic FBS should be fully backed by short-term government debt instruments and cash deposits.
No interest should be paid on the central bank deposits and no interest to coin-holders. Backing assets should not be remunerated as systemic issuers are expected to play a very limited role in the transmission of monetary policy. Moreover, the treatment of these coins should align with other non-renumerated ‘money’ equivalents such as cash, e-money and the potential digital pound, rather than means of investment.	Non-systemic issuers should be permitted to retain interest revenue from backing assets, but not pass this on to customers.
There should be a robust safeguarding regime for backing assets: Backing assets should be kept in a statutory trust legal structure. This arrangement should be further supported by a bespoke set of rules governing segregation, reconciliation with issued stablecoins (at least daily), organisational controls and reporting / audit requirements.	Aligned to the FCA’s proposed non-systemic regime.
There should be additional capital requirements to mitigate operational risks and distribution costs. The BoE has proposed using the existing PFMI standards as a baseline — which dictates that a system must hold capital at least equal to the highest of: (a) six months of operating expenses, (b) potential business losses, or (c) wind-down — with some modifications to mitigate the risk of a shortfall in backing assets. Issuers would need to have their calculations approved by the BoE. As with backing assets, these reserve assets would need to be held in a trust. However, unlike backing assets, these reserve assets could comprise a narrow set of high-quality and highly-liquid commercial assets (rather than central bank deposits).	Overall capital requirements for non-systemic issuers to be prescribed by a new prudential sourcebook — CRYPTOPRU.
Systemic issuers should have a UK presence (i.e. be set up as subsidiaries). Other parts of the systemic payment chain could also be subject to subsidiarisation requirements if the BoE uses its ‘powers of direction’. However, HMT is not pursuing an automatic location requirement for recognised entities (other than issuers).	The FCA’s proposed non-systemic issuer scope is already limited to FBS issued in or from the UK.
All coin-holders should be able to redeem their stablecoins at par (minus any fees) and on demand (i.e., at minimum by end of day). The BoE has gone further than the FCA by noting that issuers would be required to demonstrate how they intend to manage redemptions both in normal times and in stress, and both during and outside of the operating hours of payment systems they use to process redemption requests.	Aligned to the FCA’s proposed non-systemic regime.
Individual holding limits may be needed. The BoE has proposed these limits be set at a level consistent with, and no higher than, those set for the digital pound, if introduced. (The BoE’s DP on the digital pound has proposed this be between £10,000 and £20,000 — see more in our article here). The limits would apply to all stablecoins used in systemic payment systems, and would be raised, or removed completely, if the BoE believed risks had been mitigated. Other types of limits, such as on transaction volume or size could also be imposed during the ‘mobilisation period’.	No holding limits in the FCA’s proposed non-systemic regime.
The BoE is considering legally separating non-stablecoin services from vertically-integrated business models. In particular, the BoE may require a systemic issuer to form a legal entity that is sufficiently financially, operationally, and organisationally separate from other entities in the wider group, so that it is bankruptcy remote.	The FCA’s non-systemic regime is also considering vertical disintegration more broadly.
Application of the modified FMI Special Administration Regime (FMI SAR) would be used for firm failure. The BoE may seek to place a systemic issuer (or other recognised service provider) into special administration under the FMI SAR, as modified by HMT. HMT’s proposed modifications include adding a new objective (the timely return of funds) alongside the existing objective (the continuity of services).	The FCA has proposed that failure of non-systemic issuers be dealt with under standard corporate insolvency procedures (for the time being).

Transfer function / payment system

BoE

FCA

Systemic payment systems should identify a legal entity or natural person as the ‘payment system operator’ (PSO) — that can be held accountable for end-to-end risk management and regulatory compliance:

The specific entity chosen will depend on the structure of the system — i.e. could be the entity operating a permissioned ledger or the issuer using a permissionless ledger.
The PSO must ensure the system’s infrastructure (including ledger) meets the BoE’s requirements. (The BoE acknowledges that the PSO may be unable to exercise sufficient control over public ledgers. However, it is open to solutions — either technological or legal — that mitigate the “core risks” of permissionless ledgers to a degree that the BoE deems satisfactory).
The PSO must also ensure that the system’s settlement asset meets the BoE’s requirements.

Not included in the FCA’s proposed non-systemic regime.

Wallets

BoE	FCA
Hosted wallets should protect coin-holders’ legal rights (and ability to redeem at par in fiat) at all times: Overall, the BoE intends to rely predominantly on the FCA’s non-systemic CASS-based regime for custodians. It does not, in general, expect to regulate stablecoin wallets directly. However, if a wallet provider is recognised as systemic by HMT, the BoE could apply its own requirements. The BoE is still exploring the risks associated with un-hosted wallets and their suitability to be used at systemic scale. Some hurdles identified by the BoE include the lack of AML/CFT checks, consequent difficulties for issuers to deliver on timely redemption and difficulties to deliver on the application of holding limits.	Aligned to the FCA’s proposed non-systemic regime.
Requirements exist for exchanges providing wallet services: The BoE will regulate exchanges providing custody services against its proposed requirements for custodians, if recognised by HMT. Additionally, if an exchange performs the activity of settling payment transactions at systemic scale, it could fall within the BoE’s remit for systemic payment systems and be regulated as such.	Not in scope of FCA proposed non-systemic regime.
Risks of off-chain transactions should also be addressed: The BoE proposes that if entities (like exchanges and wallet providers) develop their own off-chain ledgers at a systemic scale, the BoE may regulate them directly either as a payment system operator or as a systemic service provider.	Not in scope of FCA proposed non-systemic regime.

Other service providers (incl. technology, privacy and infrastructure providers)

BoE

FCA

Depending on the activity performed and the risks posed, these service providers may come into the BoE’s remit in various ways:

Where relevant, and in particular where they provide services to a wider set of financial services firms, these service providers may be captured by the regime for critical third-parties, subject to HMT designation.
The BoE may alternatively recommend that they be specified by HMT as a critical service provider to a firm already recognised by HMT in the systemic payment chain or recognised as a systemic service provider in its own right.

Not in scope of FCA proposed non-systemic regime.

What does this mean for firms?

The proposals have significant implications for developing stablecoin business models, for example:

Firms with a large user base may be recognised as systemic at launch. Other firms may begin to operate as non-systemic and later have to navigate the transition onto the BoE's systemic regime. Where such firms are already regulated by the FCA (e.g. as an issuer) they would also become regulated by the BoE and, where relevant, the PSR. Close engagement between the industry and regulators is needed to enable firms that are close to reaching systemic levels to prepare for, and thus mitigate the costs of, transition.
If an issuer transitioned onto the systemic regime, it would need to entirely convert its backing assets into central bank deposits. Moreover, it would lose the ability to retain interest on these assets. The BoE encourages firms to build revenue-generating use cases in payments (such as efficiency, cost and functionality) rather than rely on interest rates.
In order to quell BoE concerns about chains operating in a fully decentralised manner, systemic systems would need to identify a PSO to operate as an accountable `central entity'. Firms would need to determine solutions for how the PSO could ensure overall compliance as well as attest to the quality of the system's infrastructure and settlement assets.
Firms could be caught under new location requirements. Systemic issuers would automatically be subject to UK subsidiarisation while other entities might also be caught under the BoE's powers of direction.
Firms may need to determine how to implement holding limits for customers which could prove operationally difficult to enforce due to the multiplicity of entities within the blockchain (e.g. issuers, wallets, exchanges).

More clarity is expected once the BoE and FCA DP feedback deadlines pass in February 2024, and they move into the consultation phase. KPMG in the UK can support firms with the wide range of challenges stemming from these developments. If you have any questions or would like to discuss further, please get in touch.