The race is on to regulate crypto. Last month the EU announced that its regulation on markets in cryptoassets had been agreed in principle. Now the UK has unveiled its own legislation for rolling out the government’s “staged and proportionate” approach to regulating cryptoassets. However, the impact for market participants will only become clear once more detailed rules are released in due course.

Defining digital settlement assets

The Financial Services and Markets Bill proposes reforms to the regulation of the UK financial sector. The reforms include handing power to the Treasury to create new digital asset regulatory regimes and bring certain cryptoassets within the scope of, and modify, existing regulatory frameworks.

These powers hang on the definition of “digital settlement asset”. A new concept in UK law, it is taken to mean a digital representation of value or rights, whether or not cryptographically secured, that:

• can be used for the settlement of payment obligations, 
• can be transferred, stored or traded electronically, and
• uses technology supporting the recording or storage of data (which may include distributed ledger technology).

The definition mirrors in part the “cryptoasset” definition proposed by the EU’s MiCA Regulation but, unlike the EU’s proposed term, emphasises that such assets must be able to be used for the settlement of payment obligations, thereby potentially excluding those cryptoassets used for investment purposes only.

The term “stablecoin” does not appear in the Bill but it is expected that the government will use this definition of digital settlement asset, which encompasses a range of technologies and structures, to put into action its plans to regulate stablecoins used as a means of payment.

The Bill further permits Treasury to amend the definition of digital settlement asset, thereby allowing Treasury to expand the perimeter of their regulatory powers to other types of cryptoassets. The rationale is that this enables Treasury to potentially extend the regulatory net to other cryptoassets used for investment purposes, which is expected to be the subject of a consultation paper later this year.

A digital settlement asset regulatory regime

Under the Bill, the Treasury is granted a sweeping range of powers to create a regulatory regime around digital settlement assets. These powers include:

• amending legislation to regulate payments that include digital settlement assets, 
• amending legislation to regulate payment systems that include arrangements using digital settlement assets, as well as their service providers, 
• making insolvency arrangements in relation to those payment systems.

Certain legislative changes proposed by Treasury will require the consent of Parliament, but in all cases will avoid the need for a new Act. A further power contained in the Bill allows Treasury, if necessary, to provide for any regulations implementing any of the above without delay, which should enable the Treasury to react quickly to DLT and cryptoasset innovations.

Expanding the perimeter of e-money and payments legislation

In addition to empowering Treasury to develop new regulations, the Bill also allows for digital settlement assets to be brought within scope of existing e-money and payments legislation.

Through amendments to the Financial Services (Banking Reform) Act 2013, a payment system using digital settlement assets may be designated as a regulated payment system by Treasury, which will bring such payment system under the remit of the Payments Systems Regulator. The PSR will then have powers to issue directions, influence system rules, conduct investigations and so on, with the primary aim of ensuring that the relevant DSA-based payment systems are subject to appropriate economic and competition regulation.

The unique characteristics of stablecoins and other cryptoassets means that they may fall outside the UK’s electronic money regime. To the UK government, this omission conflicts with the principle of “same risk, same regulation”. It is envisaged, therefore, that the broad powers afforded to Treasury in respect of digital settlement assets will also enable Treasury to establish an FCA authorisation and supervision regime of digital settlement assets drawing on existing electronic money and payments regulation.

Digital settlement assets are not definitively brought within scope of the UK’s e-money regime under this Bill, but Treasury would have the power to apply such e-money rules to digital settlement assets in future.

Managing systemic stablecoin risk

The Bill also responds to concerns about the systemic risk some stablecoin arrangements may pose.

Part 5 of the Banking Act 2009 is extended to include payment systems using digital settlement assets and digital settlement asset service providers (which includes firms that provide services to a payment system chain, such as safeguarding, stablecoin creation or issuance, and exchange providers). To the extent that the Treasury considers a DSA payment system or service provider as likely to threaten the stability of or confidence in the UK financial system, or have serious consequences for business or other interests throughout the UK, the Treasury may specify the DSA payment system or service provider as a recognised entity. The Bank of England will then oversee those entities and will be able to, for instance, issue principles and codes of practice, give directions and take enforcement action.

The Treasury is also empowered to bring digital settlement assets within scope of the Financial Markets Infrastructure Special Administration Regime (FMI SAR), with appropriate modifications. The FMI SAR is a bespoke administration regime currently applicable to payment systems that allows an administrator to pursue an objective of service continuity if a payment system fails, even if this is not in the best interests of creditors. The Treasury has indicated that it plans to amend the FMI SAR so it can be effectively applied to digital settlement assets.

Next steps

The second reading of the Bill is scheduled to take place in September and royal assent is expected in early 2023. However, as described above, the Bill does not itself set crypto regulation. The Treasury will follow up with more detail on the intended use of its new powers to create the regulatory framework, with the Bank of England and the FCA consulting on the specifics of the relevant rules. In the meantime, the Treasury plans to consult later in the year on how it might extend the regulatory perimeter to a broader pool of cryptoassets.

Read our note for more on the Financial Services and Markets Bill.