At a glance:

  • As per the latest HM Treasury (HMT) proposals, the regulatory perimeter is due to expand to capture new types of systemic payment firms under the Bank of England (BoE)’s supervision.
  • These proposals seek to address the financial stability risks that are posed by new innovative players that now play a significant role in the payments ecosystem.                                                
  • The designation as a systemic firm is likely to be based on nature, number and value of transactions processed, relationships with other payment providers, and substitutability of services provided.                                                                                                                             
  • Systemic firms should be prepared for a step change in regulatory scrutiny including in relation to business and operating models and inherent risks, vulnerabilities in operating models, and prudential risk management arrangements.                                                                                     
  • These changes are part of a broader review of the UK regulatory approach to financial services and payments innovation. Payment firms of all size should prepare for a more dynamic UK payments framework and ensure capabilities are in place to track various policy developments and understand the implications for their strategy and operating models.

Background

On 20 July 2022, HMT published a consultation on reforms to the payments regulatory landscape, including the systemic payments perimeter of the BoE. This comes after HMT confirmed plans in October 2021 to future-proof the UK’s regulatory framework for digital payments, which you can read more about in our previous blog.

This blog explores the latest HMT consultation which sets out more details around how the regulatory perimeter is due to expand to bring payment firms deemed to be systemic within BoE oversight. Although the details of specific firms that will be captured are yet to emerge, the broader designation criteria are emerging, and it is already clear that firms who will be subject to BoE oversight will need to be ready for a significant uptick in regulatory scrutiny.

These proposals for systemic payment firms sit amongst broader reforms to the UK’s financial services regulatory landscape and the overall approach to innovation and digitisation. This means that in the years ahead payment firms of all sizes should prepare for an evolving regulatory framework.

New systemic payment firms set to come into BoE regulation and supervision

Innovation in the payments sector means that firms other than banks and payment systems – some Financial Conduct Authority (FCA) regulated, others unregulated – are increasingly conducting payments activities. Although these firms are becoming more important in payment chains and have the potential to create systemic risk, they are not currently supervised from a financial stability perspective. Therefore, as expected, HMT proposes to bring new types of systemically important firms in payment chains within BoE oversight.

HMT proposes to do this by extending the Banking Act 2009 – the framework through which the BoE is responsible for supervising payment systems designated as systemic – to include an additional category of payments ‘providers’. These are firms within payments chains that pose systemic risk in their own right. The distinguishing feature of this new category is that the source of risk is in relation to the provider itself, not its relationship with an already-recognised payment system. It would capture other firms that perform an essential role in payments, where disruption to their services could materially affect financial stability or have serious economic consequences.

HMT will set out recognition criteria to guide its judgment on whether a payments firm should be subject to BoE oversight. Its starting point is that these criteria should follow closely the existing criteria under s.185 of the Banking Act. This includes considering the nature, number and value of transactions processed, relationships with other payment providers, and substitutability of services provided. This is aligned with the approach to systemic stablecoins, set out in the Financial Services and Markets Bill.

Notably the criteria to designate payment systems and the proposed criteria for stablecoin service providers (e.g. issuers, exchange and custody providers) do not include absolute thresholds. We expect HMT to take a similar approach to other systemic payment firms, looking more holistically across a payment firm’s business model and its systemic risk profile.

It is not yet clear which specific firms HMT will designate as systemic, although it has committed to maintaining a “high bar”. It remains our view that the expanded BoE perimeter could capture firms conducting activities regulated solely by the FCA or unregulated activities. This could include large payment processors, acquirers, facilitators and pass-through digital wallets.

Firms made subject to BoE oversight will experience a significant increase in regulatory scrutiny. We can expect the focus areas to be similar to designated payment systems - legal and operational structure; management, governance and risk management processes; and prudential requirements, including capital and liquidity management, and activity limits where necessary. Some of these areas of many payment firms’ business and operating models are already subject to FCA supervision. But if designated as systemic, the additional emphasis around financial stability will result in a step change in the level of regulatory scrutiny and challenge across the focus areas.

Consequently, payment firms who will be caught by the expansion of the perimeter should:

  • document, and be ready to explain, their business and operating models in detail, including inherent risks;
  • identify and address vulnerabilities in their operating model, with particular focus on third parties and outsourced solutions, including technological solutions; and
  • establish appropriate governance and capabilities around prudential risk management arrangements, in particular stress testing programmes and wind-down plans.

Clarifying the BoE’s powers for systemic payment entities

As we explore above, the BoE currently has a broad mandate under the Banking Act to direct recognised payment systems on how they should be organised, operationalised and managed. HMT proposes to provide more clarity in legislation on how the BoE will exercise its powers to oversee payment systems and – if progressed – other types of systemic payment firms proposed by this consultation. It proposes doing so in two key areas.

First, HMT considers that there may be exceptional scenarios where the BoE needs to limit the activity of a recognised payments entity (e.g. via upper/lower transaction or value limits) and will set out the circumstances under which limits could apply in legislation. While firms may not agree with those limits, we expect they will broadly welcome transparency about the circumstances under which they could be applied. These will be a helpful guide to firms when reviewing and updating their controls and risk management capabilities, to not breach the relevant conditions.

Second, while HMT is not proposing to create an automatic requirement under the Banking Act for a systemic payments firm to be established in the UK, it is likely to clarify that the BoE already has the power to require this where it deems necessary. Part of the rationale behind this is that certain location requirements already exist through the Payment Services and E-money Regulations (currently overseen by the FCA). This means that in practice, many payment firms will still require some form of UK presence.

The BoE/FCA approach to co-supervision of systemic payment firms

If the systemic payments perimeter is extended as proposed, systemic firms could be dual-supervised by the BoE and FCA. It is worth noting that firms authorised under payment services and e-money frameworks are already subject to conduct and prudential supervision by the FCA.

HMT intends to use the model proposed for systemic stablecoins as a basis for supervisory cooperation across systemic payment firms more broadly. This includes a duty of cooperation and requires the BoE to set out how it would replace the FCA as lead authority in setting certain rules and making directions for specific firms. Firms will broadly welcome this structured cooperation, especially where it helps to clarify how to manage any potentially overlapping BoE/FCA regulatory requirements.

Payment firms should prepare for a dynamic regulatory environment

These changes proposed to the systemic payments regulatory perimeter should be considered alongside the broader reforms to the UK’s approach to financial services regulation. There are two key changes in particular. First, the Future Regulatory Framework Review (FRFR) to reform the UK’s overarching FS regulatory framework in light of the UK’s departure from the EU, and second, the emerging post-Brexit policy approach to innovation.

The consultation sets out HMT’s approach to applying the outcomes of the FRFR to the payments regulatory landscape. Notably, this includes providing the FCA with a general rulemaking power for payments and e-money. Once granted, this power will reduce the time it takes to amend these frameworks, giving the FCA the tools to shape a competitive and effective framework for payments that responds quicker to market trends.

The extent to which the FCA may or may not use this power to reform the UK’s payments framework and any potential divergence from the EU regulatory framework should be closely monitored. In any case the ultimate level of alignment between the UK’s and EU’s long-term payments frameworks is, in part, dependent on the outcomes of the EU’s ongoing PSD2 review. We expect more clarity on this in H1 2023. But it is already clear that firms operating in the EU and UK will need to monitor changing and potentially diverging (at least in timing, if not in detail) regulatory developments.

Like the future payments regulatory framework, over the next two years we expect the UK’s broader post-Brexit policy approach to innovation to take shape. The introduction of the recent Data Protection and Digital Information Bill marks a key milestone in this process. For example, UK GDPR reforms, the emergence of Smart Data schemes (including Open Finance) and the emerging UK approach to AI regulation will likely have implications for the business and operating models of payments firms that rely heavily on the free flow of customer data.

Firms need to ensure they have capabilities in place to monitor these developments and understand the implications for their business and operating models.

Conclusion and next steps

Overall the proposals are an important step towards ensuring that the UK’s future payments regulatory framework can more easily respond to the rapid pace of change in the sector.

However, we do not expect many of these changes – especially those relating to the systemic perimeter – to take effect in the short to medium-term. The Government will publish its response to the consultation in 2023, after which many of the proposals will require primary and secondary legislation, and detailed regulatory policy.

But the direction of travel is becoming clearer – new types of systemic payment firms will be subject to significantly increased regulatory scrutiny. In any case, irrespective of size and systemic importance, all payment firms should prepare for a dynamic regulatory environment in the UK in the years ahead.