The BOE, FCA, and PRA release interconnected papers assessing crypto-related financial stability risks and the state of crypto regulations in the UK

On March 24, 2022, the Bank of England (BOE), the Prudential Regulatory Authority (PRA), and the Financial Conduct Authority (FCA) released interrelated documents outlining crypto-related financial stability risks and analyzing the current state of crypto regulation in the UK. 

The BOE published a report titled ‘Financial Stability in Focus: Cryptoassets and decentralized finance (DeFi).’ The BOE’s Financial Policy Committee (FPC), in the report, examined the role of cryptoassets and DeFi in the financial system, specifically highlighting their financial stability implications. Additionally, it also laid down its approach to monitoring risks originating from them. On the same day, the FCA’s also published a notice reminding FCA-regulated firms of their obligations related to crypto-asset exposure.

Due to their limited size and interconnectedness within the wider financial system, the BOE’s FPC observed that, presently, crypto assets and DeFi pose a limited risk to the UK’s financial stability. Nonetheless, the FPC cautioned that “If the pace of growth seen in recent years continues, and as these assets become more interconnected with the wider financial system, cryptoassets, and DeFi will present financial stability risks.” 

The Bank of England sketches out the financial stability implications of crypto assets

The FPC in the BOE’s report recognized that cryptoassets and their underlying technology have the potential to improve the efficiency and resilience of the financial system over time, including through lower transaction costs and higher payment system interoperability. In order to ensure that the benefits from cryptoassets are realized sustainably, the FPC reminds policymakers that mitigating financial stability risks have to be made a priority. 

The FPC has identified the following key risks channels that stem from cryptoassets and associated markets:

Risks to systematic financial institutions: According to the FPC, thus far, no major UK bank has reported direct exposure to cryptoassets; however, it also noted that some banks are seeking to offer custodial services in the near future. The banks providing custodial services will have to store and safeguard the private wallet key of their users. Private keys create cryptographic signatures that execute instructions to transfer assets on behalf of the client to other holders. To protect private keys from being lost, duplicated, stolen, or damaged, custodians have to put robust security measures in place. Providing custodial services may create new operational risks for the banks. In case of a hack or security breach banks may suffer significant reputational damages, which could, in turn, reduce the overall level of confidence in those banks.

The FPC observed that some stablecoins can emerge as an alternative to commercial bank deposits, or grow in importance as a means of transacting as DeFi grows. If stablecoins backed by central bank reserves increase in popularity, then there could be a substantial shift away from household wealth being held as deposits at commercial banks to central bank reserves. A shift from commercial bank deposits to stablecoins would be a cause of concern if stablecoin business models aren’t subject to equivalent regulatory requirements for the same level of risks. This would create a regulatory arbitrage. For example, commercial banks are subjected to rules governing the assets they can use to back the commercial bank money they provide to the economy; however, no such rules exist for stablecoins as of yet.

Risks associated with core financial markets: As per the report, since cryptoassets currently represent only a small fraction of institutional investor portfolios, they are unlikely to present a risk to the UK and global financial stability in and of themselves. In case the investors increase their exposure level to crypto assets and make them a core part of their portfolios, then “spillovers to core financial markets” can materialize. For instance, in case of a large fall in cryptoasset valuations, investors may sell other financial assets, as a part of portfolio reallocation.

Risks from use for payments: Public confidence in money and payments could be undermined if those stablecoins that are used for payments fail to meet their obligations. One such scenario would be if they suffer an operational failure such as a privacy breach. The BOE stated that, in comparison to other cryptoassets, stablecoins should be subjected to additional requirements. Additionally, these requirements should be further strengthened if a stablecoin is deemed to be significant due to its size or interconnectedness. 

Impact on real economy balance sheets: Currently, cryptoasset holdings remain very limited as a share of UK net financial wealth. Therefore, the financial stability risks that could currently arise directly from household losses are also limited. Even so, the BOE forewarned that if the retail holdings of cryptoassets were to grow significantly – especially if funded by debt – a sharp correction in valuations could have a negative impact on consumer spending or their ability to service other debt.

Ultimately, to address the fast-paced growth of cryptoasset markets, encourage sustainable innovation and maintain broader trust and integrity in the financial system, the FPC called for enhanced regulatory and law enforcement frameworks, both domestically and at a global level. 

The BOE Governor Andrew Bailey called for high levels of international collaboration to stop DeFi from spiraling out of the authorities' control. In the meantime, he said that the FPC is concerned about the loopholes in the present regulatory regime —“there is currently scope for regulatory arbitrage, and there is a danger that risks grow rapidly before an internationally agreed framework is in place.” Consequently, the  FPC urged financial institutions to take an extremely cautious approach to the adoption of crypto assets until a regime is in place.

FCA’s notice to all regulated firms with exposure to cryptoassets

The FCA also recently published a statement regarding the existing obligation that all FCA-regulated firms have when interacting with or exposed to cryptoassets. Additionally, in a recent update, the FCA announced that it is extending its registration deadline for 12 firms including Revolut, Cooper, and blockchain. coms’ crypto wallet.

Firms should take into account the following risk areas when cryptoasset related activities:

Being clear with customers: The firms must identify and manage risks relating to cryptoassets. They should also ensure that the consumers are aware of the extent of the business that is regulated and that they can clearly distinguish between regulated and unregulated elements of the business.

Registration of cryptoasset businesses: Conducting cryptoasset businesses in the UK without registration or temporary permission under the Temporary Registration Regime is a criminal offense, therefore firms should make sure that they are registered with the FCA.

In addition, the FCA noted that a high number of crypto businesses aren’t meeting the required anti-money laundering standards. Just 33 companies have made it onto the register. More than 80% of firms assessed by the regulator have either withdrawn their applications or been rejected. To ensure compliance with the Money Laundering, Terrorist Financing, and Transfer of Funds (Information on the Payer) Regulations 2017, the firms must put in place robust due diligence and money laundering controls in place. On the other hand, there has been a backlash from the crypto industry over FCA’s handling of the registration process. Reportedly, the FCA has been unresponsive and slow to approve the applications. Going forward, the crypto business should put compliance first and the FCA should, on its part, proactively collaborate with crypto businesses, understand their business activities, and assist them in bringing their operations into compliance.

Assessing risks: Firms should assess the risks posed by a customer whose wealth or funds are derived from the sale of cryptoassets, or other cryptoasset related activities, using the same criteria that would be applied to other sources of wealth or funds.

Prudential considerations: The firms that are subject to the FCA’s new investment firm prudential regime have to assess and mitigate the potential for harm to clients, to the markets in which the firm operates, and to itself.

Custody considerations: All FCA-regulated firms must observe the FCA’s Principles for Business. Principle 10 of these principles requires firms to arrange adequate protection for their clients’ assets. As part of these protections, the FCA’s Client Assets Sourcebook (CASS) provides detailed rules for firms to follow when holding regulated assets in custody. Where cryptoassets are specified investments, firms providing custody services of such assets will likely be subjected to the CASS regime. 

Domestic and international engagement: To facilitate international cooperation and enforce international standards, the FCA stated that it will continue working with the International Organization of Securities Commissions (IOSCO), the Financial Stability Board (FSB), and the Financial Action Task Force (FATF). Domestically, it will work closely with the UK government and other parties through the Cryptoassets Taskforce.

The PRA’s letter to regulated firms on exposure to crypto assets

The BOE prudentially regulates and supervises financial services through the PRA. The PRA released a letter explaining how its prudential framework applies to registered firms. Moreover, the  PRA announced that it is going to conduct a survey of firms’ current and planned exposures over 2022. The PRA’s survey would apply to regulated credit institutions and designated investment firms that currently provide or are planning to provide crypto-related products or services, in the coming two years

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