Crypto recommendations amid risk rises

January 2023 | FEATURE | FINANCE & INVESTMENT

Financier Worldwide Magazine

January 2023 Issue

On 3 October, the US Financial Stability Oversight Council (FSOC) released its ‘Report on Digital Asset Financial Stability Risks and Regulation’. As called for by Executive Order 14067, ‘Ensuring Responsible Development of Digital Assets’, the report reviewed financial stability risks and regulatory gaps posed by various types of digital assets and provided recommendations to address such risks.

The Executive Order called for a report from the FSOC that “should consider the particular features of various types of digital assets and include recommendations that address the identified financial stability risks posed by these digital assets, including any proposals for additional or adjusted regulation and supervision as well as for new legislation”.

It is the first major report on cryptocurrencies by the FSOC, which was created after the 2008 financial crisis to help identify and mitigate threats to the financial system, and is led by the US Treasury Department.

According to the report, there is an urgent need for legislative action. Three key regulatory gaps were identified: (i) the limited direct oversight of the spot market for crypto assets that are not securities; (ii) opportunities for regulatory arbitrage; and (iii) whether vertically integrated markets can or should be accommodated under existing laws.

In the report, the FSOC noted that many crypto activities do not have risk controls against runs or the use of excessive leverage, that crypto values are driven by speculation, are volatile and may not be tied to current profits or cash flows, that crypto firms are interconnected with each other, and that a limited number of firms provide key services to the digital assets market.

“Digital asset markets harbour serious issues which can dramatically impact retail investors. The industry has seen significant fluctuations in price and serious losses.”

The report also noted that limited direct federal regulation of spot markets for crypto assets that are not securities results in weaker rules, and inconsistent or inadequate regulatory frameworks that allow for regulatory arbitrage.

Based on these gaps, three legislative proposals were put forward in the report. First, legislation providing rule-making authority for federal financial regulators over the spot market for crypto-assets that are not securities. Second, legislation regarding risks posed by stablecoins. And third, legislation relating to regulators’ authorities to have visibility into, and otherwise supervise, the activities of all of the affiliates and subsidiaries of crypto asset entities, and appropriate service provider regulation.

“This report provides a strong foundation for policymakers as we work to mitigate the financial stability risks of digital assets while realizing the potential benefits of innovation,” wrote Janet L. Yellen, secretary of the treasury, in a press release announcing the report. “It is an important contribution to the set of reports that Treasury and our interagency partners have produced as part of President Biden’s executive order. The report concludes that crypto-asset activities could pose risks to the stability of the US financial system and emphasizes the importance of appropriate regulation, including enforcement of existing laws. It is vital that government stakeholders collectively work to make progress on these recommendations.”

According to the FSOC, agencies, including the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), should prioritise enforcement of the crypto sector, echoing a similar call made by the White House in September.

In addition, the report calls on regulators to study the potential vertical integration of crypto asset firms.

In total, there were seven recommendations in the report, including a set of general principles that regulators should consider in their deliberations over applicable authority, a recommendation that US agencies continue their enforcement of existing rules and regulations for digital assets, and efforts toward coordination among the different regulators.

The measures suggested by the FSOC come amid growing calls globally for additional crypto regulation. Mairead McGuiness, EU financial services commissioner, has called upon the US to forge ahead with crypto regulations that could apply worldwide. She expressed concern at the European level about not regulating crypto, pointing to potential financial stability problems as this market grows, as well as lack of certainty for investors. Ms McGuiness was keen to see others legislating toward a common objective, even if there were differences in approach.

The International Monetary Fund (IMF) has also called for a comprehensive regulatory framework for digital assets in the future.

Digital asset markets harbour serious issues which can dramatically impact retail investors. The industry has seen significant fluctuations in price and serious losses. The collapse of the TerraUSD stablecoin, for instance, jeopardised the accounts of retail investors at brokerages and lending platforms.

Accordingly, action is required to ensure that investors are protected, and the wider cryptocurrency market is better governed going forward.

Richard Summerfield