Make and collect payments using Bacs, Faster Payments, Direct Debit and Open Banking. Manage cash flow, invoices, remittances and protect your business from fraud.
Jacqueline Powell: Hello and welcome to the Payments Podcast. I'm Jacqueline Powell, and today I'm delighted to host Marcus Hughes, Head of Strategic Business Development at Bottomline.
We're all aware that blockchain, its related assets and underlying distributed ledger technology are a hot topic right now. Marcus joins us again today to continue our journey on demystifying and navigating a clear pass through this complex material.
Today’s podcast is the second of a two-part series on what the financial regulators of major economies are doing to supervise blockchain and crypto assets. Welcome, Marcus, and thank you for joining us.
Marcus Hughes: Hi, Jacqui, and thank you for inviting me.
Jacqueline Powell: In the last episode, we looked at what regulators are doing about Bitcoin and other un-backed crypto assets. Today I'd like to turn to stablecoins. How are regulators approaching the challenge of supervising stablecoins, a relatively new form of crypto asset, which is gaining traction fast?
Marcus Hughes: Basically, stablecoins are cryptocurrency tokens which run on blockchain technology, but a key feature is that their operators say they are backed one-to-one by high-quality liquid assets, such as fiat US dollar deposits.
At present, stablecoins are primarily being used for buying and selling the more volatile cryptocurrencies, such as Bitcoin. By that I mean that stablecoin are seen as a safe haven for cryptocurrency traders when they're locking in investment gains while also remaining on chain and avoiding the delays involved – and the fees involved, of course, as well – in off-ramping back into fiat currencies.
In addition to this popular use case for stablecoin, some operators are now keen to drive adoption of stablecoins for instant and low-cost global payments. Overall, there are about $140bn worth of stablecoins outstanding. The best known names are probably Tether, Binance USD, and USD Coin, the latter of which is jointly run by Coinbase and Circle.
But stablecoins’ rapid growth and limited transparency has drawn scrutiny from the regulators. Their focus has intensified since it came to light quite recently that certain stablecoin are not always fully pegged one-to-one against high-quality liquid assets, but, in fact, they're pegged against other, more volatile and less liquid assets.
In the US, President Biden's administration has recognised the risks involved here. A working party, which is advising the US Government, has issued a series of recommendations that it says are urgent, given the rapid expansion of the stablecoin sector.
In December 2021, their report recommended that stablecoin issuers should become regulated, just like financial institutions – that is to say, insured depository institutions. In other words, they should obtain a full banking licence and be regulated, on a par with banks that are offering savings accounts for customers.
These are covered by insurance from the US FDIC. That's the Federal Deposit Insurance Corporation. Such a move would be a drastic increase in the supervision for issuers of stablecoins, which have so far managed to operate in the outer fringes of the financial system.
What's more, the SEC’s chairperson, Gary Gensler, has suggested that stablecoins, whose value is backed by securities, should have to work within existing securities laws. Originally, Tether and USD Coin claimed that every token was backed by cash, not securities. However, closer analysis has revealed that they're actually including significant holdings of commercial paper issued by large corporates.
This led regulators in the US and abroad to intensify their scrutiny of the stablecoin industry. In some cases, regulators are, indeed, considering developing their own central bank digital currencies, which could potentially threaten the position of private stablecoins.
Jacqueline Powell: Interesting. What are the regulators doing about stablecoins in other jurisdictions, then?
Marcus Hughes: Stablecoins are facing calls for tougher oversights, but actual regulations on both sides of the Atlantic are still lagging behind the rapid growth in these digital assets. In addition to the activity in the US, which we've just looked at, policymakers in the UK and mainland Europe are also exploring closer oversight of stablecoins.
International regulators are also taking their first steps towards supervising this fast-growing stablecoin market. Last year, two influential regulatory bodies – the Committee on Payments and Market Infrastructures, and the International Organisation of Securities Commissions, known as IOSCO – they published a report proposing that operators of stablecoins should be regulated as financial market infrastructures.
This means stablecoin operators would be regulated in the same way as payment systems and clearing houses. These rules would apply, of course, to stablecoins that regulators consider to be systemically important, which means those stablecoins which have the potential to disrupt payments. In this way, regulators are proposing the principle of same risk, same regulation.
The Bank of England's approach is consistent with these principles. The bank defines a stablecoin as, ‘Digital tokens issued by the private sector, which aim to maintain a stable value at all times, primarily in relation to existing national currencies.’
They use the term ‘systemic stablecoin’ to refer to those coin which are issued by private companies and have the clear potential to scale up, and grow rapidly, and to become widely used as a trusted form of sterling-denominated retail payments.
HM Treasury are proposing to bring systemic stablecoins into the bank's regulatory remit. This is consistent with its responsibilities for conventional systemic payment systems, under the Banking Act of 2009.
Early in April this year, HM Treasury made a series of important announcements about crypto assets. In particular, they said that stablecoins are to be regulated. This is to prepare the way for using stablecoin in the UK as a recognised form of payments. This will be implemented as soon as possible in Parliament, by reusing and extending the existing regime for electronic money and payment services.
Over a longer timeframe, the government will also consider bringing into the regulatory regime a broader set of crypto assets – for example, Bitcoin. Curiously, the Royal Mint is actually planning to launch a non-fungible token, or NFT, this summer. This NFT is intended to be an emblem of the forward-looking approach to crypto which the UK is now taking.
In order to regulate stablecoin, HM Treasury will extend existing payment legislation through the Payment Service Regulations of 2017, Electronic Money Regulations of 2011, and the Banking Act of 2009, and finally the Financial Services Banking Reform Act of 2013.
The UK government argues that many stablecoins which are backed one-to-one by fiat currencies actually have very similar characteristics to existing e-money. Bringing these stablecoin into the regulatory perimeter for payments, therefore, meets the government's stated objective of same risk, same regulatory outcome.
The government also considers that this approach prevents the opportunity for regulatory arbitrage between traditional e-money and stablecoins. This approach also provides greater clarity for firms and consumers.
The Bank of England already regulates and supervises systemic payment systems and service providers for those systems. The Bank of England would be the lead supervisor for systemic stablecoins, although the FCA and the Payment Systems Regulator will also have their own supervisory responsibilities.
I think it's no coincidence that this raft of new initiatives comes shortly after criticism from the crypto industry that the UK’s stringent regulatory approach, especially the FCA, was actually stifling innovation.
Jacqueline Powell: Marcus, given this insight, what specific requirements is the Bank of England likely to impose on systemic stablecoin issued in the UK?
Marcus Hughes: The Bank of England believes that several key components of the banking regime would need to be reflected in the regulatory model for systemic stablecoins. These components are capital requirements, liquidity requirements, and support from the central bank, a robust legal claim, and finally a backstop or deposit guarantee scheme to compensate depositors in the event of the stablecoin’s failure.
The Bank of England expects systemic stablecoins to be stable at all times and so offer support mechanisms and protections to ensure they can be redeemed at any time into fiat currencies on a one-to-one basis.
They, therefore, set out four possible regulatory models for systemic stablecoins: first, the bank model. This means a stablecoin issuer is subject to the current banking regime. Second, we have the high-quality liquid asset model. This is a model which restricts stablecoins holding only liquid assets, such as gilts or Treasury bills and central bank reserves.
Third, we have the central bank liability model. Under this proposal, liabilities are backed by central bank reserves. This approach, therefore, removes credit risk, market risk, and liquidity risk.
Finally, we have the deposit-backed model, in which liabilities are backed by commercial bank deposits. This is known as the ‘commercial bank liability model’ and would be similar to e-money institutions. Hence, the stablecoin would be exposed to commercial bank credit risk.
Recognising these risks and the uncertainty around issuing a stablecoin, or even a central bank digital currency, and the level of transaction it will gain, the Bank of England is proposing the use of limits to manage any transition from commercial bank deposits to new forms of money. That's a CBDC or a systemic stablecoin.
There would be various kinds of limits during the transition period, to ensure financial stability. These limits would probably operate in four ways: first, aggregate holdings. That's the limit on the total amount which individuals or businesses can hold. Then transactions – in other words, limits on individual or daily transaction limits. Third: access eligibility. This means possible restrictions on the types of users.
Finally: remuneration. This means there may be scaled remuneration rates. For example, low, or even negative, interest rates would be paid on digital money balances above a certain threshold, to discourage too much money being put into those stablecoin. So, you can see that concrete plans are really beginning to take shape in the UK for a stablecoin environment.
Jacqueline Powell: Yes, it certainly sounds that way, and very exciting. What is happening in practical terms of providing a suitable market infrastructure for stablecoins?
Marcus Hughes: I think one of the best examples of practical preparations for stablecoin is again right here in the UK. In April 2021, the Bank of England announced a new omnibus account infrastructure. They published a set of rules designed for settling, in central bank funds, real-time transactions which run on new payment systems.
The Bank of England's intention here is that this new omnibus account will encourage innovative financial market infrastructures, specifically such as stablecoin-based payment systems.
The Bank of England is creating not only an operational infrastructure platform but also a regulatory framework to support DLT-based payment systems that operate in real time, and 24/7, and 365 days a year. Both the payment system operator and any participants in the new payment system will need to be fully regulated by the Bank of England.
The bank’s paper, called ‘An Access Policy for the new Omnibus Account’ is, therefore, a really important milestone, which marks a major step in the right direction for stablecoins going mainstream and being adopted by regulated financial institutions.
For me, this move is a powerful statement of intent that the UK is staking a claim to playing a key role in this emerging industry for blockchain-based innovation, but in a controlled and regulated manner.
The omnibus account is proving of great interest to a number of new stablecoin initiatives that need to settle in Central Bank fiat funds. A good example of this is Fnality, which is a private-sector stablecoin issuer supported by major banks, including Barclays and Lloyds. Fnality have already announced their intention to apply for an omnibus account at the Bank of England. Formerly, this was known as the Utility Settlement Coin, or USC.
Fnality is actually designed to enable customers to settle capital markets’ wholesale transactions, by using tokenised money on a blockchain. This is made possible by creating a common or shared account at the central bank. So, the Bank of England's omnibus account is actually tailor-made for these requirements.
Fnality uses a permissioned blockchain based on Ethereum and developed by Clearmatics. It’s planning to run blockchain payment systems in multiple currencies, with a regulated subsidiary in the jurisdiction of each currency in which it operates. It would not be surprising if other central banks adopt the omnibus account model to manage this process, but each in a different currency.
Jacqueline Powell: Marcus, staying with the Bank of England's omnibus account, then, can you share with us your thoughts on how that will work and what advantages it’ll offer in terms of risk management?
Marcus Hughes: Perfect. For me, holding fiat cash – that's central bank money – on a commingled omnibus account provides what's really the missing link to unlock much of blockchain’s potential for institutions. That's because it enables instant settlement while removing counterparty risk.
A typical scenario where this would be useful is if banks want to achieve real-time payments and securities settlement when trading in bonds or equities, but actually the Bank of England has also emphasised that the omnibus account is not limited to wholesale transactions, such as bank buying gilts and selling those gilts. Instead, the omnibus account can also be used to settle transactions on behalf of customers, such as a small business paying a supplier. So, an omnibus account could support a wide range of use cases, both for high-value and low-value transactions.
A payment system operator, such as Fnality, which uses an omnibus account, is not going to be limited to the real-time gross settlement system’s operating hours. That's provided any needed funding is added to the account during normal RTGS working hours. Hence, these new payment systems can operate 24/7 and 365 days a year, with instant settlement.
When a bank wants to use a payment system operator’s tokens to make a payment, it transfers money from its account at the central bank, into the payment system operator’s omnibus account at that same central bank.
The payment system operator then tokenises this funding. The bank then uses the tokens to make a payment, after which the recipient bank can choose to convert the received tokens back into central bank money and have it transferred to its own account at the central bank. Alternatively, the recipient bank could use the tokens for further payments on the same omnibus account.
The omnibus account contains the funds of different entities participating in that payment system, but all the funds are commingled or mixed on this single account. This allows the payment system operator to fully fund wholesale settlement on their platform with central bank money. The payment system operator, therefore, holds the omnibus account on behalf of their participants.
An omnibus account will allow participants to adjust funds allocated to the new payment system in real time and, therefore, offer improved flexibility to manage their intraday liquidity. To support topping up and drawing down, the payment system operator in the UK will need to join CHAPS as a direct participant.
In developing this omnibus account, the Bank of England is really greatly enhancing his reputation for innovation internationally, by providing a blueprint which other central banks could adopt in order to allow a series of stablecoins to operate in other currencies and countries, all in a secure and regulated model.
Jacqueline Powell: It's great to hear that the Bank of England is leading the way. Marcus, it's often said that the proper handling of data privacy is very important in the evolution of cryptocurrencies and stablecoins, as well as central bank digital currencies. Can you explain to our listeners why this is so important?
Marcus Hughes: Privacy is certainly a controversial topic in the crypto debate. Regulators want to ensure data protection and privacy. This is one compelling reason why the development of central bank digital currencies could offer a safe alternative to certain private-sector stablecoin initiatives, which might want to monetise end users’ data. Facebook and the Libra Association’s failed Diem stablecoin initiative comes to mind in that context.
In a way, CBDCs are central banks’ response to Big Tech’s incursion into digital payments, in order to prevent them from gaining a strong market share and exploiting consumer data. This potential risk of the abuse of consumer data by Big Tech is actually a major driver for central bank digital currencies.
For me, this is one of the reasons why CBDCs may ultimately prove more attractive than stablecoin in the long term. Apart from in a few highly authoritarian states, most of the world's central banks have no commercial interest in storing, managing, or monetising the data of users. This is very different to the opportunity which a Big Tech company might see in issuing a private stablecoin to its large customer base.
There are many ways in which such a company, maybe in social media, could manipulate and capitalise on this huge database on people’s spending habits, along with their likes and dislikes. Clearly, any private-sector company issuing stablecoin, or intermediating payments in new forms of digital money, would need to be fully compliant with the UK data protection laws.
Jacqueline Powell: What is happening in Europe regarding anonymity of transactions using digital money?
Marcus Hughes: On this delicate issue of user privacy and anonymity in transactions in stablecoin and CBDCs, the European Central Bank is exploring an offline functionality whereby holdings, balances, and transaction amounts would not be known to anybody but the user.
To contain the risk, these balances and private offline payments would have a modest upper limit. In general, a greater degree of privacy could be considered for lower-value online and offline payments.
These payments could be subject to simplified checks for anti-money laundering and countering the financing of terrorism, which higher. Meanwhile, higher-value transactions would remain subject to the standard controls, of course.
Regarding cryptocurrencies like Bitcoin, it's important to note that two European Parliament committees recently voted to outlaw anonymous cryptocurrency transactions, as part of an EU anti-money laundering package. They voted for the new rules, which will require all transfers of crypto, no matter how small, to include information on the sender and the beneficiary, with this data made available to national regulators.
These new KYC rules would also cover transactions from so-called ‘unhosted wallets’, which are wallet addresses that are in the custody of private users. The requirements are designed to bring crypto in line with AML requirements for normal payments of over €1,000. However, the decision to not have a €1,000 minimum limit was made because the speed and virtue – or virtual nature, rather – of crypto transactions mean they easily circumvent existing rules.
Crypto advocates have been fighting to stop these proposals, which they claim will stifle innovation and undermine the self-hosted wallets that many individuals use to protect their digital assets. But the proposal will now go to the full European Parliament and national ministers for approval.
Jacqueline Powell: It's insightful. Thank you. Marcus, what other areas of the crypto ecosystem are attracting regulatory scrutiny?
Marcus Hughes: A fast-emerging crypto market that has great potential to be highly disruptive is decentralised finance, which is also known as ‘DeFi’ for short. ‘DeFi’ is the generic term for a growing number of decentralised applications which operate on public blockchains but without the need for any intermediaries, such as brokerages, exchanges, or banks. Instead of using these types of intermediaries, DeFi deploys smart contracts on blockchains. The most popular for this purpose is Ethereum.
At present, the most common use case for DeFi is lending, which represents about half of the DeFi market. However, in principle, DeFi can be deployed to replicate a range of financial services, such as savings, insurance, derivatives, and securities trading. The DeFi market is quite small at present, but it's grown very fast, from less than $10bn at the start of 2020, to more than $100 billion today.
Supporters claim that DeFi has the potential to disrupt traditional markets, by building a system that bypasses the custodian, as well as record-keeping and trading roles, all of which were typically performed by regulated banks, brokers, or exchanges.
This development could potentially offer a radically different way for investors to trade on the markets. Instead of using a traditional market maker to help buyers and sellers, investors will be able to deposit their own assets into a smart contract and let automated computer code handle buying and selling with other interested parties.
Smart contracts are able to hold funds and take in data, as well as performing settlement and clearing, but the highly decentralised and global structure of the DeFi sector, along with the difficulty in tracing end users, creates a unique set of challenges for regulators.
The sector is opaque and complex, and it performs financial activities that carry risk and would definitely need to be regulated in the traditional financial sector. In an extreme form, the DeFi platform could be completely decentralised, with no identical legal entity, no ownership, nor even a point of human contact.
This market is still in its infancy, but its rapid growth means that regulators need to assess the risks of a broad range of financial services being delivered from DeFi platforms, and how to ensure these risks are managed in the DeFi world to the same standards that are managed in traditional financial markets.
Crypto traders sometimes lend coins to DeFi schemes in return for interest payments, a process known as ‘staking’. The strategy can provide attractive returns, but investors also face serious risks, such as losing all of their capital. To date, regulators have struggled to find ways to gain oversight of this new industry, in which pre-programmed algorithms run organisations, instead of physical boards of directors and senior management.
For a number of analysts, the DeFi industry is an experimental and unregulated alternative financial system, something of a ‘Wild West’, which is rife with scams and hacks. Global regulators have taken the first step to bring DeFi under regulatory oversight. The Financial Action Task Force, or FATF, is an inter-governmental body based in Paris which sets standards for AML.
They've declared that the creators, owners, and operators of DeFi services should comply with rules designed to prevent money laundering and terrorism financing. So, FATF have urged that national regulators apply these standards to individuals who maintain control or sufficient influence over DeFi applications.
Jacqueline Powell: Thank you, Marcus. That's very interesting. We are limited in time, so, as we draw this podcast to a close, do you have any concluding remarks on the regulators’ approach to crypto assets?
Marcus Hughes: Overall, I have to admit that regulators have been quite slow to respond to the challenge of Bitcoin and other private digital assets. That's why there is an urgent need for clearer regulation before the crypto industry gets too large to supervise us.
The regulators, who have limited resources, are at least increasing their scrutiny of the digital asset market, trying to ensure investor protection and mitigating the risk of cryptocurrencies being used in money laundering and the financing of terrorism and fraud.
The market is growing fast, and it's hard to keep pace with its rapid innovation, so the regulators definitely have their work cut out. As we've seen, significantly more progress has been made in terms of developing a regulatory framework for stablecoins – for example, the important work by the Bank of England.
The Bank for International Settlements announced in a recent report that major regulators around the world are likely to agree a global framework for crypto this year. Undoubtedly, discussions about the high-level principles for cryptocurrency and DeFi have intensified in recent months. The pace at which rules are developing in individual jurisdictions has also strengthened the urgency for delivering a global framework.
The risk in 2022 is that large jurisdictions, like Europe, the UK, the US, and China, will keep moving forward but actually along different tracks, and that each jurisdiction will produce a regulatory system which is globally inconsistent, unfortunately.
There's a high risk that different approaches adopted in different jurisdictions could create an opportunity for regulatory arbitrage, where films – where firms, I should say – and individuals pick the most advantageous places for their specific business.
This situation would not be in the best interests of this exciting and very global industry. So, the regulators really need to communicate with each other and create a consensus way forward. Time is clearly of the essence.
In view of the increasing adoption of crypto assets, especially as a volatile investment asset in the case of unbacked cryptocurrencies like Bitcoin, but also as an instant instrument in the case of stablecoin, the need for proper regulation and clear rules is becoming increasingly urgent. Only this way, we will be able to reduce uncertainty and minimise the risk of financial instability.
Jacqueline Powell: Thank you so much, Marcus, for sharing your views, and thank you for joining us today.
Marcus Hughes: Thank you, Jacqui. I look forward to the next podcast.
Jacqueline Powell: For our listeners, if you've enjoyed this podcast, I'd like to recommend you listen to other podcasts on blockchain and central bank digital currencies, which Marcus recorded over the last few months, but that's all for today from the Payments Podcast. We'll be back soon, with more insights on the changing payments landscape. Thank you and goodbye.
Blockchain and its assets have made their way into the financial services industry and are a topic that everyone wants to know more about. In this part 1 of our 2-part series Marcus Hughes, Head of Strategic Business Development at Bottomline, lays out the foundation of essential cryptocurrencies such as consumer protection, data protection, and fraud protection.
Marcus Hughes, Head of Strategic Business Development at Bottomline, talks about all things we need to know about Central Bank Digital Currencies (CBDC's). In this part 1/2, learn about CBDC's, their risks, how they differ from other digital currencies, and much more.
Our solution experts are here to help.+44 118 925 8250
Chat with one of our solution experts. We'll recommend the right product to fit your needs.
Please note, you'll need to accept analytics cookies to use our chat function.
Tell us a bit about you and your business and we’ll get back to you with all the information you need.