As the market for stablecoins continues to evolve in sophistication and scale, financial institutions in the UK and EU are increasingly exploring whether and how to engage with them, whether for treasury, payments, settlement or client service purposes.
Stablecoins, which are digital tokens pegged to fiat currencies or other assets, are often presented as a bridge between traditional finance and the emerging world of digital assets. These are more formally defined in the EU’s Markets in Crypto-Assets Regulation (MiCAR) as “asset-referenced tokens” (ARTs) or “e-money tokens” — broadly cryptoassets that purport to maintain a stable value by referencing another value such as an official currency (or basket thereof).
Whilst stablecoins present opportunities for innovation in areas such as payments and settlement, they also raise complex legal, regulatory and prudential considerations for banks that go to the heart of prudential soundness, operational resilience and regulatory compliance.
Unlike unregulated entities, banks are subject to stringent and interlocking frameworks covering areas such as capital adequacy, liquidity, conduct, anti-money laundering (AML) and systemic risk management. The potential for stablecoins to introduce credit, market, liquidity, operational and reputational risks means that regulators are closely scrutinising how banks might engage with these instruments, whilst also being mindful of their potential benefits.
Recent moves by regulators in the UK and EU — for instance, MiCAR in the EU and the UK government’s announcement of its plans for a UK digital assets regime — underscore the regulatory focus on ensuring that stablecoins (as with all digital assets) are treated with robust safeguards. HM Treasury (HMT) and the UK Financial Conduct Authority (FCA) previously set out their proposals for the regulation of the issuance and custody of stablecoins in October 2023 and November 2023, respectively. Additionally, the FCA has stated that it is due to publish a consultation paper covering backing assets and the redemption of stablecoins in the first half of this year.
For banks, the integration of stablecoins into their operations could have far-reaching implications for balance sheet management, risk profiles and client relationships. In this note, we explore the key implications that UK and EU banks must consider before holding stablecoins, focusing on both the regulatory frameworks and practical risk considerations.
Permissibility
Before banks can contemplate holding stablecoins, there is a threshold question of whether they are permitted to do so under current law and regulation.
In the UK, there are currently no prohibitions on financial institutions holding digital assets, including stablecoins. However, under the FCA’s Principles for Businesses and the Fundamental Rules of the Prudential Regulation Authority (PRA), regulated firms must disclose any material changes in their business to the relevant regulator(s). If a proposed stablecoins offering represents a material new business line, it should be disclosed to the FCA or PRA.
In addition, the Bank of England (BoE) has warned that significant financial stability risks arise from the use of stablecoins for wholesale transactions, with these risks judged to be an order of magnitude greater than those of retail use cases. The BoE continues to explore how these risks can be mitigated, but UK banks should be aware that stablecoins continue to be viewed cautiously by the BoE.
In the EU, existing credit institutions do not need an additional licence to provide crypto-asset services, such as custodying stablecoins or exchanging cash for stablecoins. However, they must comply with a regulatory notification regime before providing these services. 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 communications technology systems, and security arrangements.
Risk Management and Standards
Holding stablecoins can give rise to a range of risks that are not always present in traditional fiat holdings or securities. Banks must therefore carefully assess how these risks fit within existing prudential and operational risk management frameworks. Stablecoins may suffer from technical vulnerabilities, lack of transparency around reserves, operational dependencies on decentralised networks or third-party issuers, and governance risks. Banks, as prudentially regulated institutions, face heightened expectations from supervisors to identify and mitigate such risks.
UK banks holding stablecoins must implement robust risk management frameworks to address financial, operational, legal, cybersecurity and reputational risks. These frameworks are subject to regular evaluation by the FCA or PRA. Supervisory criticisms can lead to adverse consequences, such as limitations on activities or additional capital and liquidity requirements.
Similarly, 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 is reviewed regularly by a 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 ARTs, MiCAR requires the issuer to monitor and evaluate on a regular basis the adequacy and effectiveness of the procedures for risk assessment and to take appropriate measures to address any deficiencies in that respect. Infringements could be subject to administrative measures or penalties by the competent authorities and, in case of significant ART issuers, the European Banking Authority.
KYC/AML Obligations
One of the most acute regulatory concerns around digital assets including stablecoins is their potential use as vehicles for financial crime. While banks already operate under stringent AML, counter-terrorist financing and sanctions regimes, stablecoins introduce additional complexity, particularly when tokens are transferred across anonymous or poorly supervised networks.
Both UK and EU banks holding stablecoins must apply a risk-based approach to know-your-customer (KYC) and customer due diligence (CDD) obligations. 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 UK Joint Money Laundering Steering Group (JMLSG) produced detailed guidance on the AML factors firms should consider when undertaking this risk-based assessment. Institutions must also screen transactions against UK and EU sanctions lists (as applicable) and ensure compliance with Financial Action Task Force recommendations, including the Travel Rule.
Capital Treatment
From a balance sheet and prudential perspective, one of the most important issues banks face in relation to stablecoins is how they will be treated for capital purposes. The Basel Committee on Banking Supervision (BCBS) has established a differentiated framework for cryptoassets, distinguishing between “Group 1” (lower risk) and “Group 2” (higher risk) assets. Whether a stablecoin qualifies as a Group 1 asset — and therefore more favourable capital treatment — depends on stringent conditions regarding stabilisation mechanisms, redemption rights and reserve assets. Although the BCBS has published its framework, it has not yet been implemented in full in the UK or EU.
In the meantime, both UK and EU banks must continue to hold risk-weighted capital against assets on their balance sheet, including stablecoins.
In the UK, financial institutions must consider the capital treatment of stablecoins within the existing prudential regulatory frameworks. Currently, direct holdings of cryptoassets are generally deducted from Common Equity Tier 1 capital on the basis they are considered to be intangible assets, making them largely unattractive for banks to hold. In addition, the PRA has stated that it expects banks to treat cryptoasset exposures as subject to 100% risk weighting. The forthcoming Basel-based reforms will introduce new capital requirements for stablecoins, distinguishing between those with effective stabilisation mechanisms and those deemed unreliable. They are likely to make holding stablecoins more attractive for UK banks from a regulatory capital perspective.
In the EU, until the prudential treatment of cryptoasset exposures is finalised, EU banks are subject to a transitional regime that treats stablecoins as “tokenised traditional assets”. These exposures are subject to existing own-funds requirements under the CRR II.
Consumer Protection
If banks hold stablecoins on behalf of clients, or integrate them into client-facing products and services, they must consider their consumer protection obligations. For banks, this means ensuring clients are properly informed of the risks, how client funds are safeguarded, and how regulatory conduct and disclosure obligations are met.
Currently, services and activities relating to stablecoins are unregulated in the UK, resulting in limited application of consumer protection laws. Once stablecoin-related services and activities become specifically regulated, banks will need to consider how the FCA’s Consumer Duty applies to their holdings of stablecoins and adapt their business practices accordingly.
Meanwhile, the marketing of stablecoins in the UK is restricted and may only be carried out by an authorised firm or a cryptoasset service provider that has registered with the FCA for AML purposes. In addition, the marketing, distribution and sale of cryptoasset derivatives to retail consumers is prohibited in the UK.
In the EU, banks must act honestly, fairly and professionally in the best interests of their clients when providing cryptoasset-related services. Marketing communications must be fair, clear and not misleading. Banks are required to warn clients of the risks associated with stablecoin transactions.
Collateral Eligibility
As banks explore potential use cases for stablecoins — including for payments, settlement and as collateral in financial transactions — a key question is whether they will be accepted within existing financial market infrastructures. For many banks, the ability to use stablecoins as collateral, e.g., in repo transactions, would be a key value proposition. However, this depends on whether regulators and clearing houses are prepared to treat stablecoins as high-quality and sufficiently stable assets for such purposes.
In the absence of any industry-wide approach on this, UK and EU financial institutions holding stablecoins must determine the extent to which they can be used as eligible collateral with their counterparties and whether they are treated at a discount to cash or other highly liquid assets.
Liquidity Treatment
In addition to capital considerations, banks must also consider how stablecoins will be treated for liquidity management purposes. Both UK and EU banks are required to maintain stable funding and liquid assets sufficient to cover outflows during a hypothetical stress event. They must conduct internal liquidity stress testing to ensure their ability to meet outflows. Although they are often described as being “cash equivalent”, clarity is needed on whether stablecoins can be used to satisfy liquid asset requirements. A key issue is whether they can be redeemed for cash under stress.
Resolution Planning
Both UK and EU banks are subject to resolution planning requirements, which mandate the adoption of a formal plan to ensure adequate capital and liquidity for material operating entities in the event of a crisis. These plans are subject to regulatory review, and firms need to understand how stablecoins will be treated by regulators. 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.
Conclusion
The integration of stablecoins into the operations of banks in the UK and EU presents both significant opportunities and complex challenges. Though stablecoins offer potential benefits in areas such as payments and settlement, the potential risks associated with them — such as credit, market, liquidity, operational and reputational risks — require robust risk management frameworks and compliance with evolving regulatory standards. Stablecoins are also likely to form the backbone of the financial services architecture that develops along with the further shift to the digitalisation of existing financial assets.
While banks should not shy away from considering innovations that allow them to harness the potential benefits of stablecoins, they must also consider any regulatory implications to mitigate potential risks.
This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state laws.
For further information, please contact:
Sebastian J. Barling, Partner, Skadden
sebastian.barling@skadden.com
