CAI0030

Written evidence submitted by the Digital Currencies Governance Group

The Digital Currencies Governance Group (DCGG), a trade body representing digital assets issuers and service providers, including stablecoin issuer Tether, digital assets exchange Bitfinex and cold wallet provider Ledger, supports developing a sound and proportionate regulatory framework for crypto assets and related service providers. We provide practical insights and state-of-the-art expert knowledge to inform legislators and regulators on opportunities and policies concerning digital assets. We believe now is a critical moment for the UK to showcase and put into action its potential to become a true global hub for global digital asset businesses, technology and investment, and consolidate its position as a leader in a vibrant and ever-innovating market. This paper presents evidence on the key aspects of the industry and the opportunities these would bring to the UK Economy.

To what extent are crypto-assets when used as digital currencies (such as Stablecoin) likely to replace traditional currencies?

DCGG believes that stablecoins will not be replacing traditional currencies, as their functionalities and use-cases largely differ and do not overlap in terms of consumer demand and functionalities. Stablecoins cater to a specific consumer demand that diverges from the one fulfilled by traditional currencies (i.e., payments). In particular, stablecoins exist as a solution to improving the price stability of digital assets, as well as improving mobility between different DLT infrastructure. Stablecoins respond to a demand for an asset that can not only be transferred on a blockchain and has minimized exposure to volatility, but also has the advantage of speed and ease of movement across several blockchains. This use-case is not so much a replacement for money, but rather a facilitator for arbitrage and investment opportunities. Users appreciate stablecoins’ ingrained features geared to drive liquidity, interoperability and technological safety. This means that the product is not widely used by retail customers and, in particular, not used for payments to merchants (for goods and services): put simply, stablecoins are not designed to provide what the retail sector needs in terms of user-friendliness, insurance, services around banking and payment services. Rather, stablecoins are geared towards intended purposes and contain features that are expected in a different context.

In conclusion, DCGG members have no reason to believe that stablecoins would replace traditional currencies, or even central bank digital currencies (CBDCs); rather, we are of the opinion that those will be interoperable with each other.

What opportunities and risks would the introduction of a Bank of England Digital Currency bring?

As part of a global CBDC movement, many jurisdictions are becoming interested in the issuance of a central bank digital currency, the UK included. The Bank of England is still at the exploratory stage, meaning it is now a crucial time to weigh the opportunities and risks of CBDCs and how a Digital Pound would affect the cryptoasset ecosystem.

In terms of opportunities related to prospective CBDCs (which are often compared to existing stablecoins circulating in the digital asset market), some stakeholders argue that this would improve economic resilience by adding another distribution channel for currencies and make transactions more efficient, whilst simultaneously reducing transaction costs. These are indisputable benefits for a flourishing UK digital financial market, however, DCGG is of the opinion that these opportunities can easily be achieved with already existing private stablecoin solutions, which are designed to exist on numerous blockchains to ensure interoperability. Moreover, existing privately-issued stablecoins already bring immense added value with their low transaction fees and shorter transfer time periods for cross-border payments, thereby expanding the scope of financial inclusion to a global level.

From the perspective of the cryptoasset industry, we believe that if a CBDC is entirely centralised, it would create vulnerabilities to external factors, thus increasing systemic risk. This would be an area where privately-issued stablecoins could bring significant advantage due to their ingrained functionalities and would create less systemic risk given the multiple private stablecoins with different structures that make it easier to mitigate such risks. Moreover, despite certain benefits CBDCs can bring to the cross-border payment infrastructure, it would be highly risky if there is significant use of a UK CBDC by residents of a foreign country: this could lead to currency substitution, thus limiting BoE’s control of monetary policy. This is especially alarming when a CBDC is based on strong, resilient, and stable currencies that seem desirable to residents of other countries, including those experiencing macroeconomic volatility. Equally, if the UK experiences significant volatility, CBDC can amplify macroeconomic risks. Finally, a CBDC could have a detrimental impact on incentivising private stablecoins from entering the UK market. This would diminish the UK’s ability to capitalise on the benefits of the new financial sector that is related to stablecoins and crypto assets as a whole.

What impact could the use of crypto-assets have on social inclusion?

DCGG is of the opinion that cryptoassets significantly diversify the UK financial sector, allowing for a large-scale influx of market participants, which, through innovative investment channels, results in breaking down cross-border barriers, securing improved financial flows and ultimately, social and financial inclusion. For instance, stablecoins that are pegged to foreign currencies such as the U.S. dollar provide an alternative method for citizens to have access and exposure to one of the primary world currencies without having to actually hold the currency itself. Another potential advantage is disbursement – by making costs cheaper, quicker and safer, micro investment and remittances in developing countries would be significantly facilitated. This, along with what we highlighted in Question 2, proves that stablecoins are an indispensable part of increasing social and financial inclusion in an ever-innovating digital financial market.

Are the Government and regulators suitably equipped to grasp the opportunities presented by crypto-assets, whilst at the same time mitigating against the risks?

DCGG’s members believe that now that the UK is outside of the EU, there is a great opportunity to grasp the opportunities brought forward by cryptoassets and DLT finance. As a very consumer-oriented market, the UK is well-placed to reap the advantages of becoming will inevitably become a model jurisdiction in the deployment of cryptoasset products and services, innovative DLT projects, whilst improving and preserving a sound risk minimisation and consumer protection framework.

We are of the opinion that encouraging innovation and competition whilst mitigating risks to consumers and maintaining the stability of the financial system has the potential to make the UK the most eminent, safest, and most sought-after digital assets regulatory environment worldwide. This would not only attract more and more businesses, but would also bring a significant competitive advantage to the UK, making it a trailblazer in regulatory best-practices for cryptoassets. To achieve this, it is absolutely essential to ensure that the UK safeguards its entrepreneurial drive, and that future regulation related to diverse strands of the industry provides clarity, encourages the development of new technological solutions and investment and strikes the appropriate balance between sound risk management and fostering innovation for cryptoasset products and service providers.

There are a few aspects that do, however, need to be considered by decision-makers in order to prevent excessively troublesome crypto legislation in the UK’s current approach.

We believe the proposed requirement on issuers of payment cryptoassets to have 100% reserves convertibility into GBP is overly restrictive and uncompetitive, compared to the requirements by other jurisdictions in close proximity, such as the EU, where payment stablecoins backed by a foreign currency are required to have 30% of reserves backed by the pegged fiat currency whereas the remaining 70% can be reinvested in highly liquid financial instruments. This has been judged by the EU as a proportionate means of balancing risk and opportunity, giving them a significant competitive edge over the UK. Therefore, DCGG would welcome a more balanced approach by UK legislators towards stablecoins reserves in order to remain a competitive and prudent crypto market.

With regard to Decentralised Finance (DeFi), DCGG emphasizes the fact that DeFi entities should not be regulated like centralised structures that have full control and can be held liable, as the whole modus operandi of DeFi companies is completely different; for example, risk-management is algorithm-based. Also, in comparison to traditional centralised structures, DeFi companies do not store clients’ assets in centralised reserves. In this line of thought, DCGG’s members would encourage legislators to carefully adjust UK’s upcoming regulation on DeFi so as not to stifle innovation and drive potential investors away.

Finally, DCGG is concerned with the UK’s approach to wallet providers that requires FCA authorisation without consideration of the different types of wallets. For example, “cold wallets” (which represent solely a hardware USB device, where customers can store their digital assets securely and are the only ones who have access to the funds) do not have a custodial obligation. Hence, DCGG views that disparate rules should be established for “cold wallets” and assets custody wallets, once again reflecting the differing levels of risk attached to each.

What opportunities and risks could the use of crypto-assets—including Non-Fungible Tokens—pose for individuals, the economy, and the workings of both the public and private sectors?

In general, DCGG believes that for users, the use of cryptoassets would bring large-scale benefits in terms of social, financial and digital inclusion, improved quality of transaction speed and scope, and a host of opportunities for investment and arbitrage. In relation to the UK economy, we believe that having an open approach towards the industry, and taking advantage of the unique technological solutions offered by DLT to safeguard consumer protection and minimize risks, stands to make UK the most attractive crypto hub worldwide, as all the right prerequisites are currently at play. Finally, with regard to the workings of the public and private sectors, DCGG is of the opinion that cryptoasset products have the potential to establish a strong symbiotic relationship between the two sectors through private sector best-practices and expert approaches that could significantly and sustainably improve all necessary levels of the public sector in relation to traditional and digital finance.

When talking about NFTs in particular, as many other cryptoassets, these tokens fulfill a specific and novel demand in an increasingly digitized world – art moving from the physical to the digital. Much like the demand for physical art, NFTs and NFT marketplaces allow the UK userbase to derive value from the NFT industry’s huge growth potential. Moreover, as NFTs are currently in such an early stage, the UK would gain significant advantage by consulting with industry experts to obtain sound understanding of the features, functionalities and customer demands met by NFTs. Because the NFT market is neither large enough, nor mature enough to warrant regulation at this stage, we believe the UK is taking the right approach, as opposed to the European Commission’s determination to regulate NFT marketplaces, per the Markets in Crypto-Assets Regulation. DCGG members believe that, if at the moment jurisdictions regulate the sale of digital art like the sale of cryptoassets, such an approach would be short-sighted, premature and would stifle innovation in the industry. DCGG encourages the UK government to better understand NFTs and NFT-related businesses through research, expert consultations and public inquiries to ensure it can leverage all opportunities for users and the economy that come from this space.

How can distributed ledger technology be applied in the financial services sector?

Through increased adoption and a pro-innovation approach, the UK would be able to gain competitive advantage introducing various innovative DLT-based technologies to the financial services sector.

We believe that DLT can be considered much safer than traditional payment systems and therefore does not require the same regulatory approach. In comparison to traditional payment systems, DLT offers a number of benefits such as less counterparty risk, lower settlement fees, simplified operational processes, safe access to lending platforms and a higher level of transparency. The technology should be the driver in this respect, and regulation should not front run it.

The blockchain is the most transparent way to accomplish and record transactions, which could help significantly improve the UK financial services sector as a whole. On the blockchain, transaction recording and verification is immediate and permanent due to DLT. When a transaction is recorded in the blockchain, transaction data such as price, asset, and ownership is verified, replicated and stored instantly. In this sense, we would urge to avoid the creation of new legislation by acknowledging the potential of existing e-money such as stable tokens, that can give an added value due to speed, immutability and record of their transactions.

What work has the Government (and its associated bodies) done to understand, prepare for and, where relevant, encourage changes that may be brought about by increased adoption of crypto-assets?

DCGG appreciates the Government’s explorative approach to cryptoasset regulation, and our members are happy to have observed an innovation-friendly (especially in comparison to other competitive jurisdictions) approach through the HMT’s approach to cryptoassets, the HMRC’s reasoning behind a bespoke regime on DeFi staking and lending, and the FCA’s sandbox, among others. Indeed, the entrepreneurial drive of the UK’s financial services ecosystem, coupled with an established market infrastructure and a well-functioning regulatory regime, gives the UK significant advantages. However, developments in the cryptoasset industry happen very quickly, so the UK has to maintain the flexible and open approach it has demonstrated so far itself in order to take full advantage of the crypto market.

A way for this process to continue is through the proposed Financial Market Infrastructure Sandbox, brought forward by effective collaboration between HM Treasury, the Bank of England and the FCA. The FMI Sandbox would provide a level-playing field for small and big players alike to pilot various solutions to address diverse legislative objectives and bring benefits to consumers and other market participants. One key element of fostering innovation is regulatory flexibility. The FCA’s sandbox approach is a highly useful tool for enabling innovation and ensuring that regulation is proportionate, and we are pleased that a growing proportion of companies using this sandbox come from the digital assets and blockchain world. We support the continued roll out of sandboxes to explore the benefits of innovative technologies in a variety of use-cases, including digital assets used for payments.

How might the Government’s processes – for instance the tax system - adapt should crypto-assets be adopted more widely?

DCGG strongly believes that the UK government must account for all the specificities of the cryptoasset industry and its many diverse business models, before attempting to regulate them under regimes that do not properly capture these products’ features and functionalities. As a notable example, in its recent consultation on the DeFi staking and lending of cryptoassets consultation launched by HMRC, several options for the taxation treatment of DeFi staking and lending were suggested by the Government, along with a strong statement that regulation must not stifle innovation in the DeFi space. DCGG welcomes such an approach: we have provided evidence on how the third option suggested by the HMRC - applying a ‘no gain no loss’ treatment to lending and staking transactions – is the most beneficial to the DeFi space, because players and users in the industry are significantly less equipped than traditional finance players to face the complications of a tax system that, precisely because of the nascent character of the industry, is plagued by uncertainty. We encourage the UK government to continue approaching different stands of the cryptoasset market in such a way in order to prevent double regulation or severely restrictive regulation that would inevitably lead to cryptoasset businesses being pushed away from the UK market.

How effective have the regulatory measures introduced by the Government - for instance around advertising and money laundering - been in increasing consumer protection around crypto-assets?

We welcome the principle of regulatory measures around advertising and money laundering as it can only increase the understanding of the benefits of crypto as part of a healthy financial system. We believe these regulatory measures should be proportionate and accurately reflect risks, should distinguish between sophisticated and unsophisticated market participants, and should treat crypto-assets no differently from other asset classes.

Is the Government striking the right balance between regulating crypto-assets to provide adequate protection for consumers and businesses and not stifling innovation?

DCGG’s members believe that the UK is currently in a unique position with the potential to be best-equipped (in comparison to competitive jurisdictions) to create a sound regulatory environment for the industry that allows both for innovation to continue growing in the space and for the UK customer to be fully protected. We suggest that the UK government approaches cryptoassets in a way that is not overburdensome and adequately accounts for their characteristics and particular business models, while specifying a set of prudential, conduct and consumer protection requirements that allow innovation and economic growth.

Could regulation benefit crypto-asset start-ups by improving consumer trust and resilience?

We are supportive of regulation that works with the grain of what is still a rapidly emerging industry without stifling growth or blocking off opportunities. With regard to start-ups, we are strongly supportive of sandboxes, which have been a great success story for the FCA, and welcome that an increasing number of companies using them are in the crypto space. As mentioned above, we support the continued roll out of sandboxes to explore the benefits of innovative technologies in a variety of use-cases, including digital assets used for payments.

The Government can capitalise on deploying incentive-based regulation in this area. The industry is constantly creating new innovative solutions to improve on the above-mentioned aspects, and Zero-Knowledge Proof (ZKP) is just one example of these solutions. ZKP is a cost-effective technology, which allows digital authentication without disclosing sensitive personal data. ZKP prevents the possibility of any information, either from the sender’s or receiver’s end, from being compromised, and it could serve as a part of the foundation of KYC regulation for digital assets.

How are Governments and regulators in other countries approaching crypto-assets, and what lessons can the UK learn from overseas?

The recently finalised text of the EU’s Markets in Crypto-Assets Regulation demonstrated to the industry that a significant majority of the EU’s regulators wish to adopt a more restrictive approach to cryptoasset regulation, which was also observed with intentions to regulate even emerging pockets of the industry such as DeFi and NFTs. Our members believe that this plan is rather impulsive and untimely, because as a result of some of MiCA’s restrictive provisions, many crypto businesses will be unable to apply for a license and would be forced to seek other jurisdictions in which to operate.

Our view is that the UK should have a more open approach, unlike competitive jurisdictions such as the EU, by seeking to align it to financially sound jurisdictions, however we do not think the UK should wait for other jurisdictions to act in order for it to seek alignment. Our view is that the UK has the opportunity to be one of the first movers in establishing a regime that is designed to grasp the potential of reliable digital e-money, such as stablecoins, to unleash the potential of UK regulated digital assets. If the UK develops an appropriate regime through emulating best-practices from jurisdictions that are more ahead in that field, and avoids uncertainty and excessive administrative burdens, we see no reason why other jurisdictions would not look to emulate and align with it. The UK has the unique opportunity to be a pioneer in a sound digital asset regime and thus set a precedent on the global regulatory stage.

September 2022

7