Five Takeaways from the FSOC Report on Crypto-Assets

Background

The Dodd-Frank Act established the Financial Stability Oversight Council (FSOC) in 2010 [cite]. FSOC is chaired by the Secretary of the Treasury and includes federal financial regulators, state regulators, and an independent insurance expert. It is responsible primarily for monitoring the financial services marketplace, facilitating regulatory coordination and consultation with other financial regulators regarding potential risks to the U.S. financial system, facilitating information sharing, designating nonbanks for consolidated supervision, designating systemically important financial market utilities, and recommending new or stricter regulatory standards.[1] Consistent with its mandate to research, identify, and monitor trends in the financial markets that may pose a substantial risk to financial stability, Executive Order 14067 (Ensuring Responsible Development of Digital Assets) called on FSOC to issue a report on the potential risks to financial stability posed by crypto-assets. In addition to its risk analysis, the FSOC Report on Digital Asset Financial Stability Risks and Regulation ("the Report") makes a number of recommendations and marks the first report issued by FSOC solely focused on crypto-assets.

Takeaways

Though the Report does not find that the crypto-asset market currently poses a threat to financial stability, that could change in the future. The Report suggests that an increase in scale, such as widespread adoption and/or significant volumes in crypto-assets trading, could pose a risk to U.S. financial stability.[2] Notably, the Report is a strong, public signal that U.S. financial regulators have concerns about crypto-assets and are in support of more legislation and more aggressive regulatory actions.

Below, we highlight five takeaways you should know.

1. Gaps in Regulation May Present Risks to Financial Stability

   The Report identifies three gaps in regulation that could pose a risk to U.S. financial stability. FSOC's recommendations addressing these gaps are discussed in detail in Part 5 of the Report.

   1. The absence of a consistent and comprehensive regulatory framework across the crypto-asset industry permits regulatory arbitrage. Without a comprehensive framework for regulation, inconsistent standards and supervision across the industry have become the norm. Under the current regulatory structures, entities engaged in similar or identical activities can nevertheless legally operate under different regulatory frameworks. Financial stability could be threatened if regulators lack the visibility to assess and authority to respond to broad-scale or systemic risks across the entire crypto market.[3]
   2. Crypto-assets that are not securities lack oversight to mitigate fraud, manipulation, and self-dealing. Crypto-asset spot markets are subject to limited oversight and regulation and, therefore, could pose risks to investors and the economy at large. Lack of transparency into these markets allows market manipulation to flourish and makes conflicts of interest difficult to detect.[4] Notably, the Report does not define which crypto-assets are not securities.
   3. Crypto-asset trading platforms that offer multiple products and services without consumer-protection safeguards could exacerbate systemic risk. Trading platforms that provide direct market access to retail investors could pose a threat to financial stability as increased vertical integration provides broad access to ever more complex products and services, including automated liquidation. These platforms lack the consumer-protection oversight applied elsewhere in the financial market to sophisticated or high-risk products and services. The concentrated activity on these integrated platforms could threaten liquidity conditions and the greater financial market. [5]


2. Innovative Features Could Become Novel Risks to Financial Stability[6]

   While the Report agrees that blockchain technology could provide some valuable benefits to consumers, investors, and institutions, it advises that the novel features of the crypto-asset market described below could become vulnerabilities that could put financial stability at risk.

   • Novel technology, such as DLT, used by the crypto-asset market may foster speculation and pose operational risks
   • Transaction immutability may cause financial risk if enhanced protocols and regulation are not in place to address and reverse erroneous transactions or malicious actors.
   • Automation (e.g., smart contracts) could lead to mass liquidation or simultaneous procyclical trading that could harm financial stability, especially if opportunities for intervention by private or public actors is limited in times of such stress.
   • Instantaneous transactions could cause misalignments between the DeFi and TradFi markets in payments, clearing, and settlement activity.
   • Pseudonymity could increase costs of supervision and risks exploitation by malicious actors.
   • Liquidity fragmentation (pools of liquidity held across multiple locations in the ecosystem) could threaten to further disrupt the market in times of stress if asset transfer from one venue to another is difficult or if prices are inconsistent across venues. This risk is exacerbated by the absence of liquidity backstops like deposit insurance or discount access to a lender of last resort.[7]
   • Broad access to products and services provided by crypto-asset platforms could expose retail investors to sophisticated, high-risk products, access to which is traditionally limited or monitored for investor protection.[8]


3. Price Volatility is a Key Vulnerability That Could Present Risks

   The demonstrated volatility of prices in the crypto-asset market could present a risk to financial stability.[9]

   • Speculation According to the Report, crypto-assets lack a "clear, fundamental economic use to anchor their price," making the market highly speculative and vulnerable to shocks and price drops. [10]
   • Trending Correlation with Traditional Risky Assets The Report notes that cypto-asset prices have increasingly been observed to track those of traditionally risky financial assets (e.g., broad equity indexes) diminishing their value as a diversification tool against the TradFi markets. [11]
   • Lack of Diversification Opportunities within the Crypto-Asset Market Crypto-asset prices have been shown to be highly correlated with each other, increasing the likelihood that a single participant's failure could pose a substantial risk to the market.[12]


4. Increased TradFi Exposure to Crypto-Assets Could Introduce Systemic Risk

   The Report is concerned with the risks of interconnectedness, meaning the extent to which the "crypto-asset ecosystem" interacts and intertwines with the traditional financial markets.[13] This concern is not new nor specific to crypto-asset risk; rather, assessing risks caused by financial interconnectedness is central to FSOC's mandate and origins in the wake of the 2008 financial crisis. Consistent with the council's role as a watchdog for systemic risk, the Report lists a number of avenues through which the traditional financial system could be or is currently exposed to crypto-asset risk. [14]

   These include:

   • Stablecoins and their capacity to affect the price and volatility of traditional assets by, for example:
     • Causing runs on their underlying traditional assets
     • Increasing demand for short-term assets causing stress to short-term money markets[15]
     • Siphoning retail customers from traditional depository institutions, disrupting the flow of funding to these institutions and harming credit creation.[16]
   • Bank entrance into crypto-asset market through the provision of crypto-related products and services.[17]
   • Growing number and demand for publicly offered crypto-asset investment products.[18]
   • Institutional exposure to private funds like hedge funds or other private funds that increasingly hold crypto-assets.[19]
   • Retail investor and consumer access to sophisticated crypto-asset products through crypto-asset platforms that lack intermediation or a regulatory framework tailored to a retail investor context.[20]
   • Insurance company exposure to crypto (a small but growing phenomenon according to the Report)[21]
   • Municipalities and businesses involved in crypto-related activities who receive loans from banks could create credit risks to those banks and the market at large.[22]


5. FSOC's Recommendations

The final section of the Report contains FSOC's recommendations. Recommendations 1, 2, 4, and 7-10 are directed at regulators, while recommendations 3, 5, and 6 speak to Congress. Out of all the recommendations, number 6 stands out—it calls for sweeping legislative action and would give federal regulators comprehensive authority across the entire crypto-asset market.

• Rec. 1: Agencies should be guided by key principles in considering applicability of current authorities (e.g., same activity, same risk; tech neutrality; fostering transparency through disclosures).
• Rec. 2: Agencies should continue to enforce existing rules and regulations.
• Rec. 3: Congress should pass legislation providing for rulemaking authority for federal financial regulators over spot market for crypto-assets that are not securities, with enforcement and exam authority. [Note: Boozman-Stabenow Digital Commodities Consumer Protection Act of 2022 bill addresses this concern.]
• Rec. 4:[23] Continued coordination across regulators is key, including for the supervision of crypto-asset entities (where entities are subject to different regulatory regimes), or when no one regulator has visibility across the entity (e.g., affiliates, subsidiaries, service providers).
• Rec. 5: Congress should pass legislation that would create a comprehensive federal prudential framework for stablecoin issuers (addressing market integrity, investor and consumer protection, and payment system risk). Federal and state regulators should coordinate on the supervision of stablecoin issuers as appropriate. [Note: A number of proposed stablecoin bills have addressed these and related concerns.]
• Rec. 6: Congress should develop legislation creating authority for regulators to have visibility into and examination authority over all affiliates and subsidiaries of crypto-asset entities (to the extent authority does not already exist). This includes authority over entities that assert decentralization. To address regulatory arbitrage, FSOC wants legislation to cover, e.g., restrictions on entity and affiliate activities; capital and liquidity requirements across a crypto-asset entity (and all its affiliates and subsidiaries); cyber and data security practices, including third-party risk management; licensing, applications, and charters; data and disclosures; competition; and supervision, examination and enforcement.
• Rec. 7: FDIC, Federal Reserve, OCC and state bank regulators should use their existing authorities to review services provided to banks by crypto-asset service providers and other entities.
• Rec. 8: Member agencies should assess the risk of vertical integration (direct-market access to markets by retail customers) on conflicts of interest and market volatility, and whether or not this structure should be accommodated under existing laws and regulations.[24]
• Rec. 9: Government agencies should coordinate to share data in order to insure regulation is informed by accurate and up-to-date information.[25]
• Rec. 10: FSOC members should continue to build expertise and direct resources to analyze and monitor crypto-asset activities and risk. Congress should assist in this effort by appropriating resources and personnel to FSOC and member agencies for this purpose.[26]

Conclusion

FSOC's Report provides a detailed overview of perceived vulnerabilities in the crypto-asset market. With real-world examples taken from crypto's short history, the Report expands on how current risks could present future threats. Primary concerns include the volatility of crypto-asset markets (unstable pricing and associated run-risk) as well as fraud and market manipulation risks (which are exacerbated by the absence of a comprehensive regulatory framework to address consumer protection, market transparency, and regulatory arbitrage). Though FSOC does not find that these risks currently pose a threat to the stability of the U.S. financial markets, they emphasize that increasing interconnectedness with traditional markets could create circumstances where the risks do pose such threat. FSOC's subsequent recommendations call for more aggressive intervention by regulators and greater cooperation among agencies. They also call on Congress to enact sweeping legislation to clarify regulators' authority over virtually every aspect of the crypto-asset market.