On 6 November 2023, the Prudential Regulation Authority (PRA) issued new guidance to the UK deposit-taking sector in a ‘Dear CEO’ letter. The letter sets out the PRA’s approach to ensuring continued consumer confidence in the safety and security of UK deposits amid development of innovative financial products which might look or feel similar to deposits.
The new guidance impacts both on UK deposit-taking businesses and on issuers of e-money and regulated stablecoins. Read our Knowledge Hub article to find out more about what the PRA letter means for your business, or reach out to our financial services solicitors for more information and support.
Contents:
- Why is consumer confidence in UK bank deposits so important?
- What measures currently exist to ensure bank deposits are safe?
- Why is the PRA concerned about innovations in the deposit-taking sector?
- What is an example of a bank deposit-based innovation which might pose this risk?
- Which other ‘store of value’ financial products could consumers confuse with deposit tokens?
- My firm is a deposit-taker. What does the PRA letter mean for me?
- My firm issues e-money or regulated stablecoins. What does the PRA letter mean for me?
- Conclusion
Why is consumer confidence in UK bank deposits so important?
The UK money supply (sometimes referred to as ‘M1’) is made up of sterling cash (banknotes and coins) and sterling held on deposit with banks. The principle of ‘singleness of money’ means there should be no material difference in terms of the safety of funds between holding cash and keeping your money on deposit in a bank (or similar institution such as a building society or credit union). The ‘singleness of money’ relies on confidence in the safety of deposits remaining high.
A bank deposit is regarded as a ‘store of value’ financial product, or a product where funds can be held safely until they are needed. Interest paid on deposits helps to ensure that the value of the money stored is maintained until the time comes for the money to be spent. The continued confidence of consumers (both individuals and micro, small and medium-sized enterprises) in being able to store their money safely in banks is important for the health of the UK economy. This is because money held on deposit by consumers can then be on-lent by deposit-takers to provide credit to those who need it, creating funds for investment and growth in the UK economy.
A sudden loss of confidence in deposits with a particular bank can result in a ‘bank run’ or a rush by customers to withdraw their money. A bank run can cause an individual bank to fail because banks’ business models often rely on being able to attract short-term deposits to fund longer-term lending such as mortgages or commercial loans.
Loss of confidence in deposit-takers and the safety of deposits more widely also presents challenges for the growth of the economy and stability of the UK financial system. If people do not feel confident placing their money with banks, there are increased risks to consumers from the loss or theft of cash and less capital available for banks to lend. Monetary policy levers available to the Bank of England such as interest rate changes to influence spending or borrowing may also be less effective if large sums of money are held in cash.
What measures currently exist to ensure bank deposits are safe?
As confidence in bank deposits is vital to a healthy economy, the UK regulatory system includes a range of measures to ensure that bank deposits are safe and that consumers continue to have confidence in them.
The deposits of consumers and smaller businesses are protected by the Financial Services Compensation Scheme (FSCS). The FSCS, which is funded by levies on banks and other financial firms, guarantees to pay back any deposit which may be lost if the deposit-taker in which it is held was to fail. The FSCS guarantee operates up to a limit of £85,000 per person per banking licence.
The FSCS guarantee is backed up by regulatory requirements which ensure that the guarantee can be quickly and efficiently delivered in practice. This includes an obligation on deposit-taking institutions to maintain a ‘single customer view’ (or list of all current eligible consumer deposits) to allow claims on the FSCS to be paid out promptly, usually within 7 days.
In addition to the FSCS, confidence in deposits is also underpinned by wider measures to keep banks safe. UK deposit-takers must hold suitable levels of regulatory capital, or capital which is available to absorb losses which the firm might suffer. Regulatory capital ensures that banks have a degree of resilience against poor market outcomes. In addition, deposit-takers have emergency recourse to funds from the Bank of England if they face short-term liquidity challenges. The Bank of England also has powers to manage the ‘resolution’ of banks which get into longer-term difficulty. All these measures make it less likely that consumers or other commercial customers will lose money held on deposit at a bank.
Why is the PRA concerned about innovations in the deposit-taking sector?
The PRA recognises that innovations are now affecting the traditional market for bank deposits. The PRA is not in principle adverse to innovation because new technology and products can lead to more choice in how consumers store the value of their money. However, the PRA is concerned that some new deposit-based products may look and feel the same as other non-deposit-based ‘store of value’ financial products.
As non-deposit-based ‘store of value’ financial products may not enjoy the same level of consumer protection as bank deposits, consumers could easily become confused as to which financial products are deposit-based (and so are protected by FSCS cover or banking regulatory protections) and which are not. If a provider of a non-protected financial product was to fail and consumers were to lose their money, this could in turn damage confidence in the safety of deposits.
What is an example of a bank deposit-based innovation which might pose this risk?
An innovation which the PRA’s ‘Dear CEO’ letter specifically highlights is the ‘tokenisation’ of deposits. The PRA explains that forms of tokenisation are still evolving and that there is, as yet, no formal definition of the technique. However, ‘tokenisation’ generally refers to circumstances where a saver is issued with a digital ‘token’ which represents their claim against a bank for return of the money they have deposited there. The digital token can then be used to carry out transactions in blockchain systems.
Deposit tokens may have more flexible uses than traditional deposit products and can reduce the time and costs of different financial transactions. For example, people who may not be able to access traditional deposits might be able to hold digital tokens, especially if they can hold a token which represents a fraction of a large original deposit. Deposit tokens might also be used to gain access to cash before a deposit matures, either by monetising the future claim or by the token acting as collateral for borrowing.
However, despite these innovative applications, digital deposit tokens still ultimately represent a deposit with a deposit-taking institution and therefore still form part of ‘M1’. Deposit tokens would usually be expected to benefit from the same consumer protections as traditional deposits. This preserves the principle of ‘singleness of money’ for digital deposit tokens.
Which other ‘store of value’ financial products could consumers confuse with deposit tokens?
The PRA letter points out examples of other ‘store of value’ financial products which it worries that consumers might confuse with deposit-based products like deposit tokens. These other products may not have the same level of consumer protection as deposits.
One example is ‘e-money’. E-money includes pre-paid payment products where a consumer places money with an e-money provider and receives a card or digital account which allows them to make payments using their balance. E-money is not protected by the FSCS and e-money customers instead generally rank as unsecured creditors if an e-money firm fails. E-money is also offered by e=money institutions regulated by the FCA which are subject to different rules than PRA-regulated deposit-takers. Therefore, holding e-money may not be as secure as holding cash. Hence e-money does not offer the ‘singleness of money’ associated with bank deposits.
The other main example cited by the PRA is a ‘stablecoin’. A stablecoin is broadly a digital asset which is intended to be readily exchangeable at its par value back into a base currency such as the pound sterling. Although an issuer of a stablecoin will back the ‘pegging’ of a stablecoin to its base currency with investment in a pool of assets, it is not guaranteed that a stablecoin can always be redeemed on demand for its par cash value. In practice, some stablecoins trade at a premium or discount to their par value depending on market sentiment and historically not all stablecoins have been able to maintain their pegs.
Stablecoins are not FSCS protected. Although changes brought in by the Financial Services and Markets Act 2023 give the Bank and the FCA new powers to regulate some stablecoin issuers, the regulatory regime for these firms still differs from that in place for deposit-takers. So again, stablecoins, even if they are regulated stablecoins, do not usually fulfil the ‘singleness of money’ principle.
My firm is a deposit-taker. What does the PRA letter mean for me?
If your business is taking deposits, the PRA letter sets out how it expects you to act to protect consumer confidence in deposits.
Firstly, the PRA letter stresses that if you are offering deposits, you should not also be offering e-money or stablecoins under the same brand. This is because offering these products under the same brand increases the risk that consumers become confused about the differences between products and the different levels of consumer protection associated with them. If you want to offer e-money or stablecoins, you should only do so from a separate legal entity which is insolvency remote from your deposit-taking business and which does not itself take deposits. This separate entity must use its own differentiated branding.
Moreover, if you choose to offer innovative deposit-based products such as digital deposit tokens to consumers, you must ensure that these products enjoy the same protections as traditional deposits. Deposit tokens offered to consumers must attract FSCS cover in the same way as traditional deposits. You must also comply with related regulatory obligations such as ‘single customer view’ rules.
The PRA recognises that compiling a single customer view might be more difficult where a token facilitates the transfer of rights to claim return of a deposit from one person to another. This is because the token recipient would then become a deposit customer of the bank for the purposes of FSCS cover. Therefore, deposit-takers considering offering this type of token should discuss it with their PRA supervisor in advance.
Finally, the PRA sets expectations for how deposit-takers should manage any new risks associated with innovative deposit-based products. Annex 3 of the PRA letter discusses potential risks around money-laundering and terrorist financing, liquidity and funding risks and operational risk and resilience, including around outsourcing and third parties providing deposit aggregation or e-wallet services.
My firm issues e-money or regulated stablecoins. What does the PRA letter mean for me?
If your business currently issues e-money or regulated stablecoins but does not offer deposits, and you decide to apply to the PRA for a regulatory permission to take deposits, the PRA will expect you to so via a new regulated entity. You must then transition your existing UK customers to deposits with this new entity as soon as practicable, involving your new PRA supervisor in your plans to move customers across. This transition will allow your customers to take advantage of the enhanced protections offered on deposits.
Conclusion
The PRA’s November ‘Dear CEO’ letter emphasises the importance that the PRA places on consumer confidence in bank deposits and confirms that preserving this confidence will be a key focus for UK prudential supervision.
The product landscape for firms offering deposits, deposit tokens, e-money and regulated stablecoins is constantly evolving and regulators will aim to ensure that associated risks are properly managed. Harper James’ experienced financial services solicitors are on hand to help your business keep up with all the latest business and regulatory developments for ‘store of value’ financial products. Please get in touch if you’d like to understand more about this latest PRA guidance or any other aspect of deposit-taking, e-money or stablecoin markets.
