CAI0052

Written evidence submitted by HSBC

Introduction

HSBC appreciates the opportunity to respond to the Treasury Select Committee inquiry into the crypto-assets industry. Our global footprint and universal business model mean we are always looking for ways to improve the efficiency of transactions for our customers and to widen financial inclusion. We believe that our deep involvement with payments, Foreign Exchange and trade financing positions us well to help central banks and governments to continue to explore this topic.

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

HSBC believes that new forms of digital money can, in some cases, play a positive role, but are more likely to complement, rather than replace, traditional currencies. We are engaging in global discussions on the potential of CBDCs, stablecoins and cryptocurrencies, and the required regulatory arrangements for each.

CBDCs

Like all payment means, the principal driver for CBDC adoption would be a clear benefit or use case that distinguishes it from other options available. For a CBDC to be used as commonly as current payment methods, it would have to be well-understood by consumers and businesses alike and would need to meet at least the same standards of consumer trust as current electronic money.

Any retail CBDC will also have to compete with existing retail payment systems. To succeed, it will need to achieve high levels of participation and adoption by multiple stakeholders, including banks, non-bank intermediaries, merchants and end-users. This will require seamless integration with existing payments infrastructure, a strong end-user and merchant experience, and competitive yet fair incentives across both sides of the market to drive adoption.

In our view, the following specific considerations are likely to be important to drive adoption:

• Privacy and disclosure – such as ensuring both a high degree of privacy (rather than cash-like anonymity), while satisfying anti-money laundering, anti-terrorist financing and other regulations.
• Safety and resilience – delivering very high levels of reliability in times of normal infrastructure function, and operational resilience in case of, for example, infrastructure failure or cyber-attack. Alignment of authentication and payment or transaction limits against common digital payments.
• Universal access –keeping pace with evolving consumer interfaces and supporting smartphone app platforms, as well as strong integration with existing payment systems or networks.
• Relevance and adaptability – evolving with new services, for example machine-to-machine payments or the Internet of Things use cases.
• Effectiveness – enabling transfers with immediate settlement.
• Offline capabilities – the ability to make CBDC transactions anytime, anywhere.

We also think that it is important to add that, even as CBDCs are potentially introduced, cash should remain available for so long as there is public demand. Cash is a direct, tangible form of central bank money that has anchored transactions in the existing economic system. Losing access to cash could have important consequences for the economy and public interaction with the financial system. Those consequences could be especially important with regard to financial inclusion and the elderly, who on average use cash more often.

Stablecoins and cryptocurrencies

Stablecoins and cryptocurrencies are nascent, privately issued currencies, which have achieved some usage, but not widespread usage for payments in the UK. HSBC welcomes innovation in payments, but also thinks it is critical that regulatory environments are developed to manage the risks that any such innovation creates.

In the case of stablecoins and cryptocurrencies, we think that such regulation should be to at least the same standard as existing and widely used private commercial bank money. This is because stablecoins and cryptocurrencies, as private currencies, create at least the same risks as commercial bank money and, depending on their design, may create many others. We therefore think that the widely respected principle of ‘same activity, same risk, same rules’ should apply, which would result in the regulatory approach for commercial bank money being the bare minimum for stablecoins and cryptocurrencies.

In addition, because additional risks are often created by stablecoins and cryptocurrencies, we think that at least the following further measures are appropriate, over and above the same standards as commercial bank money regulation:

• Stablecoins and cryptocurrencies should be anchored in fiat domestic currency, in the case of the UK, in pounds, and to be fully redeemable against that fiat at par. This is because societies and economies need a common unit of account to operate effectively.
• The backing assets used for stablecoins and certain cryptocurrencies should be carefully analysed and regulated, and their size and quality need to be fit for purpose in a range of stress test scenarios.
• Any algorithms used in stablecoin and cryptocurrency designs need to be regulated, and it should not be the case the algorithms are seen as an alternative to adequate backing assets. Moreover, regulation should distinguish between algorithmic and asset backed stablecoins.

We think that such comprehensive regulation is a prerequisite for safe and widespread adoption of stablecoins and cryptocurrencies, particularly with respect to payments. If this is the case, the appeal of stablecoins and cryptocurrencies will be based on the innovation they create, rather than regulatory arbitrage compared to existing forms of money, such as commercial bank money.

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

The overall design of a CBDC model is very important when considering the main benefits and risks. There are potentially many different CBDC models, but the two main approaches are:

• The direct model, in which the central bank would hold the consumer's account and provide all payment services related to the CBDC. This would do away with many of the financial system's intermediaries. It would require central banks to take on the enormous volume of lending, account management and compliance activity associated with traditional retail banking, and likely require significant additional resourcing. This would lessen commercial bank deposit bases and raise the cost of credit that they provide, hurting economic growth. It would also alter the balance of the public/private partnership between the Bank of England and commercial banks, which could reduce product innovation. For these reasons, we see little support for this model in major economies.

• The indirect model, (sometimes alternatively called the ‘hybrid’ or ‘two-tier’ model), in which the CBDC is a direct claim against the central bank, but commercial actors such as banks would provide payment services related to it and perform all account management activity. This is more like current market structure. It is this indirect model, with its basis in partnership between central banks and financial intermediaries, that seems to us, and to many other commentators and authorities, to be on balance the most promising option under consideration. It is the model that has been adopted in CBDC trial designs in major economies, including in China and in Sweden.

If designed well, a CBDC could potentially offer a range of benefits, but these would need to be specifically considered and established to proceed:

• Payments – the possibility of faster and lower cost payments for consumers and businesses.
• Trust – as a Bank of England backed, trusted alternative to cryptocurrencies and stablecoins, a CBDC could reduce financial risks for consumers, as the introduction of a CBDC could act as a counterweight to the increased adoption of such riskier assets.
• Settlement – a CBDC could become a new instrument for settlement between wholesale financial and corporate institutions, reducing settlement risk, increasing overall market liquidity, and improving settlement transparency and operational efficiency.
• Innovation – CBDCs have the potential to fuel further innovation. For example, near instant payments, if achieved, could support the tokenisation of securities, by providing more rapid and certain ‘delivery vs. payment’ in these cases.
• Monetary Policy – a Bank of England CBDC might also help with the UK’s fiscal and monetary policy objectives, for example by providing a means of making direct, ‘programmable’ transfers to consumers and smart contracts to stimulate demand.
• Traceability vs Privacy – CBDCs can, if considered carefully, improve traceability of transactions for AML/CFT purposes while ensuring high levels of privacy.
• Energy – CBDCs, if well designed, would not incur the energy costs of some other digital currencies.

However, it is vital that these benefits are weighed against the risks that a CBDC might create, such as:

• Supply of credit – implicit in the concept of a CBDC is the ability to move money easily from bank deposits into an instrument issued by the central bank. This is currently possible by withdrawing cash, but not easy to achieve safely at scale. A CBDC could provide this safety at scale. Depending upon the participants and the relationship to the end customer, this could lead to a shift away from commercial bank deposits and in turn could lead to a decrease in the supply of credit, thus increasing the cost of credit to the real economy and harming economic growth. Analysis from a UK Finance (UKF) Working Group, of which HSBC was a participating member, has suggested that the amount of credit provided to the UK economy by banks could be reduced by 5-10% if 20% of deposits migrate from the commercial bank system into retail CBDC.
• Cost of credit – The Bank of England’s discussion paper on new forms of digital money suggested that in the region of 20% of existing commercial bank deposits could migrate into CBDC. Analysis from the above UKF Working Group also suggested the increase in the cost of credit could be higher than 80bps, which was above the upper end of Bank of England analysis.
• Product implications – the capacity of the banking sector to offer very long-term fixed interest rate assets, such as mortgages, is a function of the ability to behaviouralise interest rate insensitive deposits. Depending on the design of CBDC and the adoption levels, deposit bases could become more interest rate sensitive. Although it might be possible to offset some of this with derivatives, we believe it is unlikely that the market will sustain its current capacity, potentially narrowing mortgage product offering and reducing optionality to customers.
• Social inclusion – It is important to consider that members of society should always have access to physical cash. It is hoped any CBDC will increase social inclusion, but it also must not increase social exclusion.
• Interest-bearing – an additional factor is whether a CBDC should be interest bearing. The October 2020 paper ‘Central Bank Digital Currencies: foundational principles and core features’, by the Bank of England and several other leading central banks, states that an interest-bearing CBDC would create financial stability trade-offs and that more research is required in this area. That paper also raises the possibility of CBDC withdrawal caps to mitigate risks from a CBDC. This needs to be considered very carefully. On balance, we think an interest-bearing CBDC should be avoided.
• Financial stability – in situations of general economic stress, any ‘flight to safety’ from commercial to central banks assets that a CBDC could encourage might present liquidity issues for financial institutions and pose risks to the operation of markets and to financial stability. Different behaviour may be witnessed for deposits above and below the Financial Services Compensation Scheme threshold, depending on depositor sophistication. The possibility of ‘digital bank runs’ must be avoided.
• Market activity – the international Committee on Payments and Market Infrastructure (CPMI), of which the UK is a leading member, has noted that greater demand for CBDCs could affect repo and government bill markets and reduce interbank activity. CBDC design choices could therefore have broader implications for the role of central banks in the financial markets, and for monetary policy transmission mechanisms.
• Dependency on Wholesale Markets – the replacement of commercial deposits with wholesale funding could lead to several undesirable consequences. If the cost of wholesale funding compared to commercial deposits is higher, there would be cost of credit implications. It could lead to less diversification of funding or increased concentration risk for bank liabilities, increased refinancing risk due to reduced market windows and increased exposure to market volatility. Market capacity is also a factor and increased dependency on less stable investor bases may exacerbate exposure to market conditions and thus refinancing risk.
• Data protection and privacy – levels of anonymity, system-wide resilience and safeguards for data protection must also be considered fully, by governments as well as central banks. High standards will be imperative to protect against illicit actors and instil broad consumer and market confidence.
• Environmental – please see our response to question 13 below.
• Operationalising at the Central Bank – the challenges of incorporating the latest technology, ensuring proper data privacy and maximising domestic and international interoperability is substantive for a central bank to handle.

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

Increasing social and financial inclusion is a priority area for industry, regulators and government. There have been considerable efforts in the UK over many years to increase access to financial services and particularly to bank accounts.

It is important to ensure that claims that crypto-assets can accelerate social inclusion are clear and evidence based, with a particularly high standard of evidence and rigour being applied in order to protect the interests of the marginalised and vulnerable.

Citing examples in very small economies, some have claimed that a direct CBDC could help drive bank inclusion, but direct CBDCs have only been adopted or proposed in economies that have relatively under-developed banking systems. They have not yet been proposed seriously for any major advanced economy, and even major emerging markets that have developed CBDCs have adopted indirect models.

Greater clarity is needed on whether and how crypto-assets could help those that remain ‘unbanked’, or whether they are best-placed to do so in comparison to existing initiatives, such as Basic Bank Accounts. Further study would therefore be helpful to assess how they might increase access to bank accounts and to financial and public services more broadly.

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

It is very important that the UK’s regulatory institutions, including the Bank of England, HMT, the PRA and the FCA, are fully empowered and equipped to understand and deal with in a coordinated manner the opportunities and challenges of crypto-assets.

The governance of digital money, along with questions around issuance, reserves, coin transfer and stabilisation should fit domestically within the wider remit of existing supervisory bodies. The Banking Act 2009 already provides the supervisory powers needed to regulate systematic payment systems. Other questions related to prudential and conduct risks should be incorporated within the mandate of the appropriate supervisory bodies.

This approach ensures that those with the greatest knowledge of financial sector risks and capabilities to regulate them effectively across the entirety of the financial sector are given the capacity to do so. It is important that any overarching governance model reflect the distributed nature of expertise among the different supervisory bodies.

HMT have proposed to bring systemic stablecoins into the Bank’s regulatory remit, in line with its responsibilities for systemic payments systems under the Banking Act 2009, which is welcome.

The Bank of England’s Financial Policy Committee FPC has previously set out its expectations for stablecoins, and the Bank conducted the ‘New Forms of Digital Money Consultation’ in 2021. We fully support these efforts, and agree in particular with the aim of ensuring the same level of public confidence in stablecoins as commercial bank money.

As such, and as previously stated, we think that the regulatory approach for commercial bank money should be the bare minimum for stablecoins and cryptocurrencies, and that the UK’s regulatory institutions must be readied to implement this. This is because stablecoins and cryptocurrencies, as private currencies, create at least the same risks as commercial bank money and, depending on their design, may create many others.

In addition to the approach for commercial bank money, as already stated, we think it important that regulators have the powers and resources to ensure that:

• stablecoins and cryptocurrencies are anchored and convertible into fiat;
• they can analyse their backing assets to determine that their size and quality are fit for purpose in a range of stress test scenarios;
• any algorithms used in stablecoin designs are appropriate and safe; and
• in particular, algorithms are never seen as an alternative to adequate backing assets.

Additionally, as crypto-assets are global by nature, the government continue to seek global cooperation through existing international bodies such as CPMI-IOSCO, the Basel Committee on Banking Supervision and the Financial Stability Board (FSB) to ensure robust international oversight.

CBDCs will expose central banks to the technical challenges of incorporating the latest technology, ensuring proper data privacy and maximizing domestic and international interoperability. The cost of addressing these challenges needs to be understood through careful analysis. 

5. 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?

Regarding stablecoins and cryptocurrencies, HSBC supports innovation in payments, but as described earlier, we think it critical that regulatory environments are developed to manage the additional risks that these specific innovations create. We think that principle of ‘same activity, same risk, same rules’ should apply. This would enable a regulatory approach matching that for commercial bank money at a bare minimum but that also goes beyond it in several significant and appropriate respects, to deal with these additional risks. These specific additional measures are mentioned in answers to previous questions.

Without appropriate regulation, stablecoins and other types of digital money could undermine confidence in the financial system. The risks that new forms of digital money pose to liquidity, credit and the money market could be serious and are, of now, untested. Great consideration should be given to the interactions of existing systems with new forms of digital money.

It will be critical to explore in detail the impacts that stablecoins may have on the banking ecosystem, which will impact bank balance sheets, encumbrance, regulatory liquidity and funding ratios. In addition, if behaviour changes fundamentally, this will be picked up by the bank’s internal ratios and may well lead to a reduction in funding risk appetite and therefore affect credit availability and cost.

Stablecoins and cryptocurrencies are not subject to resolution requirements nor backed by a deposit guarantee scheme. As such, if a stablecoin issuer or a part of the stablecoin arrangements such as a wallet provider or asset-backing custodian were to fail, coinholders would need regulatory safeguards guaranteeing they could recover their funds rapidly and in full. This will likely need to include arrangements to hold adequate reserves and transparent records of coin ownership. As mentioned previously, backing assets used for stablecoins should be subject to regulation to ensure sufficient quality and liquidity. Depending on the degree of associated liquidity risk and the systemic nature of the stablecoin/s in question, direct access to the Bank of England lending facilities and also capital requirements may be necessary to address concerns over financial stability.

Regarding tokenisation, we believe that this technology offers real opportunities for improving asset ownership and transfer, and the overall virtualisation of assets. Where such assets are economically non-fungible, such tokens would be NFTs by definition.

Tokenisation can increase the speed of asset transfers, and lessen transfer costs, supporting economic activity and growth. To support tokenisation, we believe that the UK should introduce a comprehensive legal regime for digital assets. Other jurisdictions are rapidly proceeding with ‘pilot regimes’ to test these concepts. The UK should pay particular regard to international developments, and move ahead as soon as possible with such a pilot regime, and then a full regime, so as to not negatively impact the UK’s competitiveness in this growing area.

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

Distributed ledger technology (DLT) is a set of technological infrastructure and applications. It allows simultaneous access, validation, and record updating in a secure and unchangeable way across a network spread across multiple entities or locations. This may be compared to a central ledger, where a single entity records transactions and ownership. [1]

Examples of this are DLT-based platforms that enable the creation of digital payment undertakings (e.g. e-letters of credit) or DLT storage of executed master agreements (e.g. International Swaps and Derivatives Agreement, Global Master Stock Lending Agreement), DLT storage of customer asset-related data, or DLT-based platforms that allow customers to see their positions or custody asset holdings with other custodian banks.

DLT technology can increase operational synchronisation, and thus reduce errors and costs. It can support more rapid and final asset transfer. HSBC has also employed distributed ledger and ledger technology to increase operational efficiencies in conventional fiat currencies and conventional assets, as well as to digitise traditional trade finance products. We are currently developing increased tokenisation capabilities across several of our businesses.

7. 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?

In 2021 the Chancellor announced the CBDC Taskforce, bringing together HMT and the Bank of England, to coordinate the exploration of a potential UK CBDC. Under this remit, The Bank and HMT are jointly chairing the CBDC Engagement and Technology Forums, where relevant stakeholders from industry, civil society and academia provide strategic and technical input to the UK’s work on a possible CBDC. HSBC is a member of the CBDC Engagement Forum.

The PRA has published a Dear CEO letter reminding firms of their obligations with respect to crypto-assets exposures, while the FCA has published a statement reminding firms of their obligations when interacting with, or exposed to, crypto-assets.

The Government and its associated bodies have been actively engaging with industry and stakeholders on the future regulatory landscape for crypto-assets. However, as previously stated, we believe that the UK could accelerate the introduction of a pilot, and then a full, regime for digital assets, so as not to negatively impact the UK’s competitiveness in this growing area.

The UK government (HMT) set out a plan to make UK a global crypto-asset technology hub, which includes (but is not limited to):

• Recognise stablecoins as a valid form of payment;
• Legislate for a ‘financial market infrastructure sandbox’;
• Enhance the competitiveness of the UK tax system to encourage further development of the crypto-asset market.

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

Delivering real time payments to government for tax purposes is an opportunity that could be accelerated by using programmable payments. It is relevant to the current discussions on split-VAT at a UK (HMRC) and European level. This is a clear use case for further research, including how it could or would be integrated into other forms of payments for businesses and aligned to their required tax returns.

9. 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?

HSBC UK does not currently offer retail customers any direct exposure to crypto- assets, so it is difficult to assess the efficacy of the existing advertising regime.  

Consumers, including those who may be considered vulnerable / less knowledgeable, may have suffered financial loss and been subject to unfair fees/pricing with such an investment strategy. Other consumers may have experienced affordability issues as they have invested in unregulated tokens from borrowed funds/life-savings as a response to promotion and media speculation.

HSBC recognises that enhancing the existing UK Regulatory approach for crypto-assets is necessary to improve consumer protection. We welcome recent regulatory developments for crypto-assets such as the proposed expansion of the FCA’s existing financial promotion regime to include certain crypto-assets.

We support the development of laws, regulations and guidance which provide a balance of consumer protection and broader public access to future crypto-assets developments. By way of example, Financial Action Task Force (FATF)’s guidance in 2000 entitled "Virtual Assets Red Flag Indicators of Money Laundering and Terrorist Financing" provides guidance to virtual asset service providers and financial institutions dealing with crypto-assets to identity suspicious transactions. This guidance also provides insight for financial institutions that do not deal directly with crypto-assets-related activities. This has helped firms enhance established monitoring and controls in identifying suspicious activity from payments with crypto-assets and services providers.

There is, however, no consistent or established approach for financial institutions that have no direct exposure to crypto-assets in tracking the origins (and destination) of funds derived from crypto-asset transactions occurring outside a financial institution’s payment infrastructure. HSBC welcomes more regulatory guidance on measures and practices to enhance AML and CTF monitoring and associated control frameworks.

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

While competition and innovation should be encouraged and supported, authorities must also ensure the continued resilience and stability of the financial system, as well as the proper conduct of all market participants. Striking the right balance is vital.

For instance, if a CBDC is adopted, an indirect approach would ensure the continuation of division of labour between central banks and the market. This would see the private sector continue to perform customer-facing activities and operational tasks and enable the potential for greater innovation and competition. Assuming the central bank grants access to existing payment systems for appropriately regulated and licensed firms, these firms could compete to provide both CBDC wallets for consumers and/or a myriad of overlay services.

We think that an initial technology neutral approach to the development of any CBDC is essential. It is not yet clear which technical approaches (for example, decentralised or centralised, DLT or traditional) may be most appropriate.

New forms of payment should promise, credibly and consistently, to be fully interoperable with existing domestic and international payment systems and fully interchangeable with fiat. Interoperability of digital money should be pursued at both domestic and international levels. There are existing governance frameworks and standards setting bodies at both levels that could work to facilitate the development of principles and standards necessary to ensure that funds move securely and efficiently. This will all help to ensure continuing and effective competition, and meaningful innovation.

Internationally, it is essential that global bodies like the FSB and related groups like the CPMI continue to maintain a focused agenda on cross-border payments that facilitates interoperability between existing payment systems and new forms of money. The UK should continue to contribute to and, where possible, lead those discussions. There are also existing partnership models for central banks exploring interoperability of digital money across borders.

Domestically, the UK should continue to collaborate with standards setters like Pay.UK to ensure that any CBDC can be integrated into existing payments infrastructure approaches for Real Time Gross Settlement, Faster Payment Services and payment systems used across the country. Bringing CBDCs into the existing framework will reduce implementation-related friction, while facilitating interoperability.

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

Yes. We think that the regulatory steps already specified in this response are essential to manage the risks created, while continuing to allow the benefits of innovation to be realised. This will improve trust, resilience and confidence, supporting adoption. We also note HMT’s proposal to launch a FMI sandbox in 2023 for testing DLT projects under control of regulators.

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

The Financial Stability Board has published high-level recommendations for stablecoins regulation. These principles represent a common platform for an agreed international approach and will help avoid divergence in the regulatory approaches of different jurisdictions. The FSB is working in close coordination with standard-setting bodies, to identify and address any potential gaps or overlaps in relevant standards and its recommendations to prevent regulatory arbitrage and market fragmentation.

In addition, in October 2021, CPMI-IOSCO issued guidance for public consultation on how the international Principles for Financial Market Infrastructures (PFMIs) apply to systemically important stablecoin arrangements used for payments. The final guidance will help to support the regulation and supervision of stablecoin operators in the future.

Aligned with these international efforts, we particularly note and welcome the US President’s Working Group on Financial Markets Report and Recommendations on Stablecoins, and the introduction of comprehensive regulation for stablecoins in Japan this year. We think that the UK should follow a broadly similar approach for stablecoins.

As previously stated, to support tokenisation developments we strongly believe that the UK should introduce a comprehensive legal regime for digital assets. Other jurisdictions are rapidly proceeding with ‘pilot regimes’ to test these concepts, in particular the EU’s ‘pilot regime for market infrastructures based on distributed ledger technology’. Rapid and effective implementation of such a pilot regime, and then a full regime, based on similar principles, should be a priority for the UK to remain competitive.

13. The environmental and resource intensity of using crypto-asset technology.

These are vital questions to consider, and any claims should rely on clear research and evidence.

A contrast is often made between ‘proof of work’ designs, which have high energy usage, and more energy friendly ‘proof of stake’ approaches.

It is important that the individual designs of specific coins or systems are considered when reaching conclusions about environmental and resource intensity, rather than applying wide generalisation to the sector.

September 2022