Cryptoassets continue to be in the spotlight with prices no longer heading ‘to the moon’, the recent high-profile failure of an algorithmic stablecoin and the difficulties experienced by various service providers. This all forms the backdrop to the UK Government’s publication of proposals with respect to managing the failure of systemic digital settlement asset firms.
The UK Government's paper forms part of, and fits within, the broader push by the UK Government to start bringing crypto into the scope of established regulatory regimes for electronic money and payment systems. The current proposals should therefore be read in the context of earlier papers (on which, see our previous posts, including on the UK’s next steps towards stablecoin regulation).
The paper’s topic is ‘systemic digital settlement asset firms’. This consultation only deals with ‘digital settlement assets’(DSAs), i.e., (i) certain stablecoins (e.g. which derive their value by referencing assets such as fiat currencies) but not algorithmic stablecoins or stablecoins that reference other assets such as commodities; and (ii) other wider forms of digital assets used for payments/settlements. Only ‘Systemic DSA firms’ are covered: i.e. DSA payment systems, operators or service providers of systemic importance (this would include certain issuers, a wallet or third-party services provider), which are not banks.
The UK Government recognises that there is a lack of clarity over which regime should apply to systemic DSA firms: the Financial Market Infrastructure Special Administration Regime (the FMI SAR) or the Payment and E-money special administration regime (PESAR).
The UK Government recognises that both regimes have useful properties for maintaining financial stability. The FMI SAR imposes an objective on administrators to pursue the continuity of a failed payment system’s services ahead of the interests of its creditors and provides the Bank of England with powers of direction and oversight to this end. By contrast, in the PESAR, one of the administrators’ main objectives is to ensure the prompt return of funds to customers and avoid delays.
The UK Government proposal is that, in advance of any consideration of a bespoke legal framework for DSA firms, an amended form of the FMI SAR be the appropriate framework to manage the failure of a firm. The proposal includes adding an additional objective covering the return or transfer of funds and custody assets which may only be considered when the FMI SAR is applied in relation to systemic DSA firms. This would allow administrators to take in to account the return of customer funds and private keys as well as continuity of service.
The Bank of England would be given a power to direct administrators as to which objective should take precedence (continuity of service or return of funds), but where the DSA firm is also regulated by the FCA, the Bank of England would also need to consult with the FCA before a special administration order is sought or it gives directions on the relevant objective. Such changes will not impact the way in which the regime applies to traditional payment systems.
- There is little detail on what would constitute a ‘systemic’ DSA firm, beyond a slightly indirect reference to designation as a systemic payment system under Part 5 of the Banking Act 2009: broadly, where disruption to a payment system’s operation may threaten the stability of the UK financial system or have significant consequences for businesses or other interests. This would fit with the current drafting of the FMI SAR which provides for the ability of HM Treasury to designate a company as one falling under the FMI SAR. There is also no express definition of DSA yet, nor how this will fit in with the various definitions of “stablecoin” and “cryptoasset” to be used in various changes to UK rules and legislation (in particular, whether the definition of DSA will be aligned with that of “stablecoin” for the purposes of the changes to the regulatory perimeter).
- The FMI SAR provides that the Bank of England may apply to the court for an FMI administration order to be granted. It would be sensible, under the amended FMI SAR regime, that the Bank of England specifies the objective the administrators are to prioritise at the time of the court order / application as the administrators will need to know the primary objective immediately on their appointment. Like most bank insolvencies, dialogue would likely be needed beforehand between the Bank of England and the proposed administrators so that they can prepare for the relevant objective as part of the essential contingency planning to take on the appointment.
- The paper is currently silent on how this new objective will interact with the statutory order of priority, in particular whether the return of funds to holders will take priority to the expenses of the insolvency. The FMI SAR does not currently address this, meaning additional amendments will be needed to provide for how this new objective will operate in practice. It seems likely that the PESAR asset pool statutory order of priority would be followed, namely: (i) costs of distributing the asset pool (including funds that were not safeguarded but ought to have been); (ii) claims of electronic money holders; and (iii) the expenses of the insolvency.
- It is unclear when exactly the FMI SAR would take precedence over the PESAR in relation to a systemic DSA firm where both could apply, but the paper states that this will ‘generally’ be the case. Where a DSA firm is not ‘systemic’ and it is an issuer of a stablecoin that constitutes e-money, the PESAR would continue to apply instead of the amended FMI SAR.
- The consultation does not cover banks who issue cryptoassets and leaves open the question of whether, if banks start issuing stablecoins or similar cryptoassets, changes to the existing resolution/insolvency regimes will be required.
- The nature of cryptoassets (i.e., decentralised and underpinned by a global blockchain ledger) means that any legislative regime, be it the amended FMI SAR or other legislation, may not be sufficient to actually achieve the financial stability sought in the event of the failure of a systemic DSA firm. Nevertheless, the UK is grasping the nettle at the root and is laying the foundations for what could be a challenging and a highly legally uncertain process if and when the failure of a systemic DSA firm occurs.