Regulating financial innovation – going behind the scenes

Speaker: Christopher Woolard, Executive Director of Strategy and Competition
Location: Cambridge Centre for Alternative Finance annual conference, Judge Business School
Delivered on: 2 July 2019

Highlights:

• The UK has led the rest of the world with developments like the regulatory Sandbox, we are very proud of what has been achieved through it.
• Early engagement is incredibly valuable for monitoring, supervisory and policy purposes. Working with innovative firms helps us achieve a better bird’s-eye view, enhancing our understanding when the overall landscape is blurry and ­changing quickly.
• 'Stablecoin' is a term that has been widely adopted by industry, but we do not take it to be a distinct category of cryptoassets. Something labelled as a 'stablecoin' could sit within or outside of our regulatory perimeter.

Note: this is the speech as drafted and may differ from the delivered version.

Last month, Facebook announced its plans for Libra, the stablecoin it is planning to launch in conjunction with a number of payment and tech firms.

As has been widely reported, along with other regulators and central banks, we have been discussing their plans with Facebook.

If this comes to fruition, Libra could be very significant indeed.

It will pose questions for us as a regulator. It will pose questions for our colleagues at the Bank of England. It will pose questions for us working with our international partners. Moreover, its size and scale will pose questions for society and government more generally about what is acceptable and desirable in this space.

Historically, this may have been a sector that has lived by the mantra of ‘move fast and break things’, but the issues raised here require deep thought and detail.

In the UK, we’ve tried to manage some of those tensions through initiatives such as our regulatory Sandbox[1]. We believe that has worked well, but we are facing now issues that could have a fundamental effect on the financial services system.

As a result, we need to ensure that innovation works in the interests of consumers. To do that, we need to thoroughly understand the business models firms are suggesting and how they benefit consumers.

We need to consider whether consumers understand and actively consent to the trade-offs inherent in those business models.

And we need to consider the wider impact on market integrity and stability.

So, I thought it would be helpful to peel back the curtain a little on how we look to critically analyse different cryptoassets and why, ultimately, we don’t think labels such as ’stablecoin’ are very helpful.

Now, I have to stress, what I’m about to say applies to all cryptoassets. I’m not talking specifically about Facebook or any one firm, but the rest of my comments should be taken as illustrative of the kinds of challenges we are facing up to as regulators.

What are ‘stablecoins’?

Market participants use ’stablecoin‘ as a broad term, which encompasses a variety of different types of cryptoassets. In essence, stablecoins hope to be less volatile than other cryptoassets and, so the argument goes, be more appropriate for a variety of use cases.

Back in October 2018, the FCA published a joint report alongside the Bank of England and HM Treasury as part of a domestic Cryptoassets Taskforce[2]. In brief, we categorised cryptoassets into 3 broad types:

1. Exchange tokens. Often referred to as ’cryptocurrencies‘, cryptoassets, such as Bitcoin, Litecoin and equivalents, utilise a distributed ledger technology (DLT) platform and are not issued or backed by a central bank or other central authority. They do not provide the types of rights or access provided by security or utility tokens, but are used as a means of exchange or for investment purposes.
2. Security tokens are tokens, which amount to a ‘specified investment’. These may provide rights such as ownership, repayment of a specific sum of money, or entitlement to a share in future profits. They may also be transferable securities or another type of financial instrument under the EU’s Markets in Financial Instruments Directive II (MiFID II).
3. Utility tokens are tokens, which can be redeemed for access to a specific product or service that is typically provided using a DLT platform. I mention this framework as it is important context. Just as the term ’cryptoasset‘ can mean different types of token, so can the term ’stablecoin‘.

Let’s take an example. ’Stablecoin‘ could refer to a cryptoasset backed by fiat currency. In certain cases, a fiat-collateralised cryptoasset could constitute e-money if it meets the definition provided in the Electronic Money (e-money) Regulations[3].

If a cryptoasset is e-money then the issuer needs to be authorised as an e-money issuer and needs to comply with all relevant requirements under the E-Money and Payment Services Regulations.

It could be illegal to do otherwise.  We have already authorised e-money firms that use DLT, including graduates of the regulatory Sandbox.

But the term ’stablecoin‘ could equally apply to algorithmically controlled tokens. Or those backed by ’real world‘ assets such as securities or, indeed, other cryptoassets.

Such ’stablecoins‘ would need to be evaluated on their characteristics, but could amount to regulated products, including, for example, collective investment schemes. 

However, to keep things short and simple, a ’stablecoin‘ could fall within or between any of the regulatory categories I’ve described previously. This makes us question how useful this one term – ’stablecoin‘ – is when it comes to labelling all these different tokens.

’Non-stable non-coins‘?

This issue isn’t specific to stablecoins. We tend to avoid the term ’cryptocurrency‘, as they generally don’t meet[4] the core economic criteria of money – as a unit of account, store of value and efficient means of exchange. We prefer to say ’cryptoasset‘, as it is more neutral and captures the broader range of tokens that are not just designed to act as a means of exchange.

So, whilst ’stablecoin‘ is a term that has been widely adopted by industry, we do not take it to be a distinct category of cryptoassets.

Something labelled as a ’stablecoin‘ could sit within or outside of our regulatory perimeter. Depending on its structure it could be many things – for instance, a derivative, a unit in a collective investment scheme, another kind of security or e-money.

We also question whether tokens governed by algorithms or underpinned by other cryptoassets are necessarily ’stable‘.

Volatility and stability are important concepts, but they are relative in nature. Whilst a wobbly tripod is seldom a good thing in the world of wildlife photography, ’volatility‘ in financial services is completely context-dependent.

The FCA does not have criteria, nor a legal basis, for endorsing such claims for cryptoassets.

Asking the right questions

Instead, when faced with novelty, we try to gain a crisper view. We ask:

• What is this thing, why is there a new term and what problem is it trying to address?
• Who is it for – wholesale banks or retail consumers? Is it within our regulatory scope or outside?
• Is this really an innovation or just something old in a new, flashy wrapper?
• Is this potentially to the benefit of consumers and competitive markets or is it likely causing harm by increasing complexity and other risks?

In short, we seek to consider any cryptoasset, including those labelled ’stablecoin‘, on a case-by-case basis and we encourage both consumers and firms to do likewise.

This analysis is particularly important when identifying whether a specific cryptoasset sits within our regulatory perimeter or outside of it. Our recent perimeter guidance consultation on cryptoassets provides more detailed clarity for firms – we’ll be publishing a feedback statement on this shortly.

As we seek answers to those questions, we expect any would-be cryptoasset issuer to be asking a few of their own before launching a product:

• Is my product a beneficial innovation for consumers and markets? Or does it include hidden bugs and unmitigated risks?
• Am I prepared to be open and cooperative with domestic and international regulatory agencies? How do I approach issues like anti-money laundering?
• Will the target market I have in mind for this cryptoasset be able to make an informed and balanced judgement of the risks and benefits of investing in or using such an asset?
• Finally, and most importantly, have I completed the regulatory, legal and technical due diligence in advance of launching a new product or service?

In financial services it is vital that innovators get it right the first time round.

When it comes to other people’s money, or safeguarding against terrorist financing, corner cutting is simply not an option.

For those who think the model is to try it in beta for a few million people and see what happens, there may be activities here that are illegal without authorisation in many countries, not just the UK.

The UK has led the rest of the world with developments like the regulatory Sandbox, we are very proud of what has been achieved through it.

One thing that unites those who have been through the Sandbox is the professionalism and preparation shown by the firms involved, who all recognise there is a finite amount of learning through failing fast that can be tolerated when consumers are at risk of harm.

Navigating the landscape

We accept that this not an easy landscape to navigate.

But big surprises in financial markets do not generally end in positive outcomes for consumers, regulators or firms. 

We invite firms to consider applying to our Innovation firm support services[5], such as direct support[6], which provides regulatory feedback for eligible innovative propositions or the Regulatory Sandbox, which provides firms with the opportunity to set-up compliant and controlled tests.

We’ve worked with many innovative firms on cryptoassets to-date – over a third[7] of propositions accepted to test in the Sandbox so-far have involved an application of DLT.

For us, this is a win-win.

Not only do we help bolster competition by helping innovative firms overcome regulatory barriers, to the benefit of markets and consumers, but we also learn more about fast-moving, developing technologies potentially disrupting financial services over time.

Early engagement is incredibly valuable for monitoring, supervisory and policy purposes. Working with innovative firms helps us achieve a better bird’s-eye view, enhancing our understanding when the overall landscape is blurry and ­changing quickly.

Similarly, we also seek to understand the consumer journey.

In March, we published[8] consumer research that challenged some of our previous conceptions about the extent of UK consumers’ usage.

For instance, we found that only 3% of those surveyed had ever bought cryptoassets directly, and many of those who had had only purchased relatively small amounts.

But we also found evidence of potential harm for some consumers, who exhibit risky behaviours and don’t always complete any due diligence prior to purchasing.

And the insights we gain through our research work and active engagement with firms directly influence our policy judgements. We committed last year, as part of the UK Cryptoasset Taskforce to explore a potential ban on the sale of certain derivatives and transferable securities referencing cryptoassets to retail clients. I’m pleased to say that we will shortly publish a consultation.

And while we, along with the Bank of England and others, have delivered several large pieces of work at a domestic level since the Taskforce report was published last autumn, we firmly believe in the need for international coordination and collaboration on this issue.

Innovation won’t pause whilst regulators in different jurisdictions each scramble to get the best snapshot – that is why it is critical that regulators work in concert internationally on fast-moving, cross-border issues.

Seeing the bigger picture

While it is still relatively early days for cryptoasset issuers, both for those marketing themselves as ’stable‘ and those not, we need to look at the substance, beyond just the hype.

That’s not to be dismissive. There could be some fascinating uses that transform how we consume online.

So, when firms claim ’stability‘ we, therefore, encourage all, from regulators to consumers to firms, to think critically about what sits behind the token’s label. How does this token work and what is its aim?

For us, we need to bring new technology, jargon and marketing back to first principles before we can answer tricky policy questions on topics such as consumer protection, market integrity or competition.

Distilling these issues down to the fundamentals help us see the bigger picture.

The picture painted of crypto-use in the future could be impressive, compelling even captivating.

When considering these changes as regulators we need to be ready to lean in, to experiment, learn and adapt, but always be ready to protect consumers, competition and market integrity.

So it is crucial that we also think about the reality – the technical details, the technology; and the legal position.

In other words, we, ourselves need to go behind the scenes.