Regulatory Issues for UK and EU Banks To Consider

Episode Summary

In the inaugural episode of “The Capital Ratio” podcast, host Sebastian Barling introduces the series, which will explore key regulatory topics in banking and finance. Joined by colleagues Eva Legler and Wilf Odgers, Sebastian examines the emerging world of stablecoins, discussing why these digital tokens are gaining traction among financial institutions. The panelists discuss current regulatory frameworks in the U.K. and EU, highlighting capital treatment challenges, liquidity management considerations and client protection obligations. As they explain, despite promising opportunities, institutions must update legacy systems to properly address this relatively new asset class.

Voiceover (00:02):
Welcome to the Capital Ratio where Skadden explores the dynamic world of financial institution regulation, offering insights for institutions navigating the regulatory environments in the UK, EU, and US.

Seb Barling (00:18):
Hi, and welcome to the inaugural podcast for the Capital Ratio, a series in which we’ll be looking at the key regulatory topics relevant to the banking and financial sector. I am your host, Sebastian Barling, Head of the UK and European Financial Regulatory Practice here at Skadden’s, and I am delighted to be joined today by two of my colleagues, Eva Legler, European Counsel in our team based in Frankfurt, and Wilf Odgers, Senior associate here in London.

(00:40):
So what are we going to be talking about today? Well, we’re going to be discussing an aspect of one of 2025’s very hot topics, crypto. And in particular we’re going to be looking at some of the key considerations which UK and European financial institutions, and in particular banks, need to be thinking about when they’re looking to engage further with stablecoins. Why are we focusing on stablecoins? Well, three main reasons. First of all, the regulatory regime is developing rapidly around these, which we’ll unpack a bit later. And secondly, this is an area where we are seeing increased interest from clients, both as a product to launch themselves, which is a tool they can use in conjunction with some of their other offerings. So the adoption of stablecoins is increasing at the same time as the regulatory regime is developing.

(01:21):
Thirdly, these stablecoins will form the backbone of both the current and likely future crypto ecosystem, these are the digital cash that greases the other parts of the crypto world. But before we get going, let’s just remind everyone here as to what at a high level stablecoins are. These are digital tokens stored on a distributed ledger that aims to maintain a stable value by references to one or more underlying real-world assets, most commonly a currency. And two of the better known stablecoins are USDC and USDT, both of which reference US dollars and try and maintain a stable value against them. So that is what they are, but before we look at how they are regulated, I’m going to ask Wilf to jump in, and outline why financial institutions may want to start looking at these now.

Wilf Odgers (02:03):
Thanks. I think there are a few key drivers behind the growing interest from financial institutions in holding stablecoins. First, the use of distributed ledger technology or DLT opens up the potential for near instantaneous settlement of transactions. That’s a big shift from the traditional model where settlement times can stretch to t + 2 or beyond, particularly across borders. Stablecoins can dramatically reduce that friction, which in turn frees up liquidity and reduces counterparty risk.

(02:35):
Secondly, stablecoins are designed to be natively digital, which means they can seamlessly interface with other digital assets and participate in smart contracts. That’s important as financial institutions increasingly look at tokenization, whether that’s tokenized securities, funds, or other real world assets, and want to build infrastructure that can fully support automated programmable transactions. And finally, from a commercial standpoint, stablecoins are already gaining real traction both in the crypto native world, and increasingly in mainstream payments and treasury use cases. Clients are beginning to expect that their banks and service providers can handle stablecoins in the same way they would traditional fiat currency. So there’s also an element of needing to keep pace with client expectations and future-proof the business.

Seb Barling (03:24):
So thanks Wilf. There are clearly some really good reasons here to ensure financial institutions can handle stablecoins. So assuming a financial institution wants to, Wilf again, can you give us an overview of the regulatory framework we have in the UK, those institutions that are either looking to issue or use stablecoins as part of their business? And in particular, are they even permitted to do so?

Wilf Odgers (03:42):
Sure. So in the UK, we need to make a clear distinction between the current regulatory framework and what we can expect to see shortly. So currently, there are no direct prohibitions on financial institutions holding or using digital assets in their business, including stablecoins. That doesn’t, however, mean that they can just start to use stablecoins in their business tomorrow. Under both the FCA and PRA’s overarching rules, regulated firms must disclose any material changes in their business to the relevant regulators. If a proposed stablecoin offering represents a new business line, it should be disclosed to the FCA or PRA. On the marketing side, since October, 2023, the UK’s financial promotion regime now applies to qualifying crypto-assets. That means firms can’t advertise or promote crypto-assets or services relating to crypto-assets to UK consumers unless they’re authorized, AML registered, or the promotion is approved by an authorized firm. The FCA has made it clear that they’re taking this pretty seriously, and we’ve already seen enforcement action where firms have fallen short.

(04:46):
And then there’s the AML and KYC angle. Crypto-asset firms operating in the UK need to be registered with the FCA under the money laundering regulations, and that brings with it obligations around customer due diligence, transaction monitoring, and reporting suspicious activity. We’ll talk about this element a bit more later. In addition, stablecoins will need to be stitched into a financial institution’s existing compliance frameworks and suites of systems and controls, and ensure the risks they pose are correctly captured and managed. We’ll talk about some of these in more detail shortly.

Seb Barling (05:19):
Okay, thank you. And you mentioned the current, or rather lack of regulatory regime in the UK. What does the future regulatory regime look like? How much do we know about it?

Wilf Odgers (05:27):
So in terms of what we’ve seen to date, the treasury and the FCA previously set out their proposals for the regulation of the issuance and custody of stablecoins in October and November, 2023 respectively. We’ve also seen a crypto roadmap published by the FCA, and that indicated that we can expect to see a consultation paper covering backing assets and the redemption of stablecoins in the first half of this year. We can also expect to see a paper on the prudential treatment of crypto around that time too. However, it’s worth flagging there may be some regulatory headwinds in the UK around the future of stablecoins regulatory regime, particularly compared to the US and EU. The Bank of England in 2024 warned that a significant financial stability risks arise from use of stablecoins for wholesale transactions. With these risks being judged as an order of magnitude greater than those of retail use cases, the Bank of England are continuing to explore how these risks can be mitigated. But UK banks should be aware that stablecoins continue to be viewed cautiously by the bank.

Seb Barling (06:29):
So slow and steady here in the UK. Thanks Wilf. Moving across the channel and let’s turn to the EU. Eva, what’s the current state of play in the EU in respect to stablecoins?

Eva Legler (06:39):
Thanks Seb. In Europe, crypto-assets such as stablecoins are regulated by the Markets in Crypto-Assets Regulation or MiCA or since December, 2024. MiCA is modeled after existing European legislation such as MiFID II, the Prospectus Regulation and Market Abuse Regulation. That being said, the implementation of MiCA in the individual member states remains patchy at the moment. For example, in Belgium, the bill implementing MiCA has not yet been published, and a competent regulator has not been designated. Therefore, MiCA license applications cannot be made in Belgium at the moment, driving a move to other EEA jurisdictions. Also, crypto-asset services providers that were active before MiCA came into force, can avail themselves of a grand-fathering period to apply for a MiCA license. This grand-fathering period lasts until 1st of July, 2026. Most member states we found landed on the grand-fathering period of 12 to 18 months. However, some states such as Latvia, Hungary, and Poland, but also the Netherlands opted for a much shorter transitional period of only six months. These are mainly driven by incumbent member states regimes not being sufficiently comparable with MiCA.

(07:53):
Stablecoins are more formally defined by MiCA as asset-reference tokens or e-money tokens. Broadly, these are crypto-assets that purport to maintain a stable value by referencing another value such as an official currency or a basket thereof. In the EU, existing credit institutions do not need a new license to issue stablecoins or provide crypto-asset services such as custodying stablecoins or exchanging stablecoins for cash. However, they must comply with a regulatory notification regime before providing these services to expand their existing license to cover the newly envisaged crypto-asset services, which looks very much like an additional approval. Credit institutions must notify their competent authorities at least 40 working days before offering these services for the first time, including detailed documentation on risk assessment, information, and communication technology systems and security arrangements.

Seb Barling (08:52):
Okay, so banks can make this notification and then they’re good to go in respect to issuing stablecoins, or do they need to think about much else?

Eva Legler (08:59):
Unfortunately, they do. In particular, EU banks must integrate the holding of stablecoins into their risk management frameworks, addressing associated financial, operational, legal, cybersecurity, and reputational risks. The risk management framework must be reviewed regularly by the bank’s external auditor, and any deficiencies can lead to increased regulatory scrutiny from the supervising authority. Where EU banks issue stablecoins that qualify as a reference token, the issuer must on a regular basis monitor and evaluate the adequacy and effectiveness of the procedures for risk assessment, and take appropriate measures to address any deficiencies in that respect.

(09:44):
Infringements could be subject to penalties by the competent authorities, and in the case of so-called significant asset-reference token issuers, the European Banking Authority. Also, EU banks issuing asset-reference tokens have to maintain at all times a reserve of assets to cover the risks associated with the assets that the respective token references, and to address the liquidity risks associated with the permanent right of redemption the holders of the asset-reference tokens are entitled to. This reserve of assets is subject to particular requirements. For example, it has to be segregated from the bank’s estate, as well as from the reserve of assets for other asset-reference tokens. Additionally, EU banks have to ensure that the reserve of assets may not be used as a financial collateral arrangement, and they have to comply with specific conditions when investing parts of the reserve of assets.

Seb Barling (10:42):
Thank you, Eva. Wilf, you mentioned earlier that similar considerations would apply to UK financial institutions, notwithstanding the less developed current UK regime. How do these align?

Wilf Odgers (10:52):
Yes, so they’re similar. UK banks holding stablecoins must implement robust risk ranging frameworks to address financial, operational, legal, cybersecurity, and reputational risks. These frameworks are subject to regular evaluation by the FCA and PRA.

Seb Barling (11:09):
And could you elaborate on some of those general risks that banks need to manage?

Wilf Odgers (11:12):
Sure, so stablecoins can introduce several types of risks, some of which are not always present to the same extent in traditional cash holdings. So there are financial risks including credit risk where the issuer of the stablecoin might default, and market risk where the value of the stablecoin might still fluctuate from the underlying assets depending on how well-designed its underlying arrangements are. Operational risks and in particular, cyber risk involve the technical vulnerabilities of the stablecoin’s underlying technology, while legal risks pertain to the regulatory uncertainties and potential legal liabilities.

Seb Barling (11:48):
Thank you. And staying with risks for a moment, one of the recurrent topics and areas of concern that we’ve seen in respect of crypto has been AML. So let’s move on to KYC, know your customer, and AML anti-money laundering obligations. Wilf, why don’t you start by outlining those requirements for UK banks with regards to AML, and KYC, and stablecoins?

Wilf Odgers (12:06):
Sure. So both the UK and EU banks holding stablecoins are required to apply a risk-based approach to KYC and customer due diligence obligations. So this includes ongoing transaction monitoring, record keeping, and potential suspicious activity reporting to the relevant authority such as the Financial Intelligence Unit in the UK. The Joint Money Laundering Steering Group or JMLSG have produced specific guidance on the AML factors firms should consider when undertaking this risk-based assessment in respect of crypto. This includes unique considerations for crypto-assets reflecting the different risks they pose to traditional asset classes, and different network of participants involved. So existing systems will need to be upgraded to ensure they’re properly configured to address these concerns for stablecoins as an asset class. It won’t just be a case of plug and play into existing frameworks.

Seb Barling (12:58):
Thanks, Wilf. And is there anything additional in the EU, Eva?

Eva Legler (13:01):
Actually Seb, the requirements are very much the same in the EU. Banks must apply a risk-based approach to KYC and CDD obligations, including ongoing transaction monitoring. Like in the UK, EU institutions must report suspicious activities to the competent financial intelligence units and screen transactions against EU and US sanctions lists, ensuring compliance with the FATF recommendations.

Seb Barling (13:28):
Thanks Eva. I’m going to move on to talk about capital treatment, which is one of the most important issues that banks face in relation to stablecoins and crypto generally. And it is unfortunately, one of the more technical areas we need to look at. So as people may be aware, the Basel Committee on Banking Supervision published its 2022 standards on the financial supervision of crypto-asset exposures. And this set out a broad regime that differentiated it between two different types of crypto-assets. Group one, which were lower risk, and group two, which were higher risk. And stablecoins can qualify as group one asset, these therefore receive a more favorable capital treatment. But this comes with various conditions looking at stabilization mechanisms, redemption rights, and reserve assets being met.

(14:07):
And we’re not going to go into the weeds of that as part of this podcast. Although we have the Basel standards and its framework, these have not yet been implemented in full in the UK or the EU. So in the meantime, both UK and EU banks must continue under their existing regimes to hold risk-weighted capital assets on their balance sheet, including stablecoins against their regulatory capital requirements. Wilf, how does this currently work in the UK?

Wilf Odgers (14:29):
Sure. So in the UK, financial institutions must consider the capital treatment of stablecoins within the existing Prudential Regulatory Frameworks. So currently direct holdings of crypto-assets are generally deducted from CET1 capital, on the basis they are considered to be intangible assets, making them a largely unattractive asset for banks to hold. In addition, the PRA has stated they expect banks to treat crypto-asset exposures as subject to a 100% risk weighting. We would expect the updated prudential regime coming out later this year to follow the Basel-based standards. So this should introduce new capital requirements for stablecoins, distinguishing between those with effective stabilization mechanisms, and those deemed unreliable. They’re likely to make holding stablecoins more attractive for UK banks from a regulatory capital perspective.

Seb Barling (15:16):
And Eva, how about in the EU?

Eva Legler (15:18):
First of all, MiCA actually did not update the prudential rules for banks, this is governed by the Capital Requirements Directive and Regulation. In the EU, until the prudential treatment of crypto-asset exposures is finalized, EU banks are subject to a transitional regime under the CRR that specifies the capital treatment of tokenized traditional assets, including stablecoins such as asset-reference tokens and e-money tokens. These exposures are subject to existing own funds requirements under the CRR. The European Banking Authority is currently consulting on draft regulatory technical standards to specify the technical elements necessary for institutions to calculate their own funds requirements in accordance with the approaches set out in the CRR. We would expect these to align to the Basel standards to the extent possible, so hopefully we will see some uniformity here in due course.

Seb Barling (16:13):
Thanks Eva. So in addition to the capital considerations, banks need to also think about how stablecoins will be treated for liquidity management purposes. And it might be helpful to run through some of this. Wilf, would you like to take us through it?

Wilf Odgers (16:26):
Sure, happy to. So both UK and EU banks are required to maintain stable funding and liquid assets sufficient to cover outflows during a hypothetical stress event. So they must conduct internal liquidity stress testing to ensure their ability to meet outflows. Although stablecoins are often described as being cash equivalent, more clarity is needed on whether they can be used to satisfy liquid asset requirements. A key issue is whether they can be redeemed for cash under stress? Banks have to make sure that their liquidity management frameworks are robust enough to handle the unique characteristics of stablecoins, including their potential volatility and the operational dependencies on decentralized networks or third-party issuers. Related to this will be the acceptance of stablecoins as collateral by third parties, this is particularly important for activities like repo transactions. However, the acceptance of stablecoins as collateral depends on whether regulators and clearing houses are prepared to treat them as high-quality and sufficiently stable assets. In the absence of any industry-wide approach, UK and EU financial institutions holding stablecoins must determine the extent to which they can be used as eligible to collateral with their counterparties, and whether they are treated as a discount to cash or other highly liquid assets.

Seb Barling (17:42):
Thanks Wilf. Now, let’s talk a bit about client protections. Because if a bank holds stablecoins on behalf of clients or integrates them into client-facing products and services, they would need to consider their client protection obligations. Eva is this governed by MiCA in Europe, and what does it say about this?

Eva Legler (17:57):
In the EU, banks must act honestly, fairly, and professionally in the best interest of their clients when providing crypto-asset-related services as implemented by MiCA. Marketing communications must be fair, clear, and not misleading, very much like for financial instruments regulated by MiFID II, banks are required to warn clients of risks associated with stablecoin transactions. This means for banks that they have to ensure clients are properly informed of risks, that they know they have a right of redemption against the issue at all times, and where they can find the published white paper.

Seb Barling (18:35):
Thank you. And Wilf, what are the current obligations for UK banks holding stablecoins, wanting to use them on behalf of clients?

Wilf Odgers (18:41):
So currently, as discussed earlier, services and activities in respect to stablecoins are unregulated in the UK, resulting in limited application of regulatory client protections. We’ll need to see how the UK regime develops, but it’s very likely that once stablecoins become regulated, banks will need to consider how the FCA’s consumer duty applies to their stablecoin-related services, including things such as value for money assessments. In the meantime, the marketing of stablecoins in the UK is restricted, and may only be carried out by an authorized firm or a crypto-asset service provider that has registered with the FCA for AML purposes. Also, the marketing and distribution sale of crypto-asset derivatives to retail consumers is prohibited in the UK.

Seb Barling (19:23):
Thanks Wilf, and perhaps moving on to our final topic, let’s speak a little bit about resolution planning requirements, which both EU and UK banks are subject to. This necessitates the creation of a formal plan to guarantee sufficient capital and liquidity for significant operational entities during a crisis. Eva, why do you expand on this and how it works with crypto-assets?

Eva Legler (19:42):
Of course, happy to. These formal plans that you’ve mentioned are subject to regulatory review, and firms need to understand how stablecoins will be treated by the regulator. If banks hold stablecoins on their balance sheets or facilitate large client exposures to stablecoins, those assets could affect the feasibility of executing a resolution strategy, maintaining critical functions, or ensuring continuity of client services during stress. The operational legal and liquidity uncertainties surrounding stablecoins, particularly in distressed market conditions, make it essential that banks reflect such exposures in their resolution planning.

Seb Barling (20:23):
Thank you, Eva. And I think on that note, let’s wrap up. There are clearly some great opportunities here for financial institutions in improving their stablecoin offerings, either as an issuer or service provider or just as a user. Considerable work, however, will be needed to uplift legacy policies and systems to address this relatively new asset class and the different risks it poses, and this can require a considerable institutional desire to push these reforms through. The current stablecoin rules and capital requirements may make moving into this area difficult though this should improve as the Basel standards burden.

(20:52):
And on that note, it’s worth mentioning a jurisdiction we haven’t spoken about, namely the US. Whilst regulatory announcements are coming thick and fast at the moment, not least, the announcement yesterday of the World Liberty Financial stablecoin, it looks like there is a clear appetite towards embracing stablecoins in the US with talk about introducing a federal regime. Hopefully you’ll see more details of the regulatory framework around this soon. And once we get clarity on this as well as the UK regime, we should see a material increase in the viability of scalable international regulated stablecoins. If you have any questions or comments on any of the topics we spoke about today or stablecoins in general, or crypto in general, please do feel free to contact us. Otherwise, thank you and we hope you’ll join us next time.

Voiceover (21:34):
Thank you for joining us for today’s episode of The Capital Ratio. If you like what you’re hearing, be sure to subscribe on your favorite podcast app so you don’t miss any future conversations. Additional information about Skadden can be found at skadden.com.