.svg)
Despite hitting a market cap of $3trn last year, the vice chair of the US Federal Reserve has said that crypto-assets are not yet large enough to pose systemic risk to the financial system.
Speaking at the Bank of England (BoE) last week, vice chair Lael Brainard said the Fed has been closely monitoring recent volatility across the crypto markets and has observed “serious vulnerabilities” that must be addressed.
However, she stopped short of warning of contagion spreading to the non-crypto financial world, arguing that the crypto-asset markets are both too small and too separate from traditional markets to cause spillover effects.
But for regulators, that does not mean they can rest easy, she added. On the contrary, regulators should use this opportunity to impose new checks and balances on the crypto industry, lest it grow larger and more interconnected in future.
“This is the right time to ensure that like risks are subject to like regulatory outcomes and like disclosure”, she said, arguing this will “help investors distinguish between genuine, responsible innovation and the false allure of seemingly easy returns that obscures significant risk".
“This is the right time to establish which crypto activities are permissible for regulated entities and under what constraints, so that spillovers to the core financial system remain well contained.”
Brainard’s central argument is that the crypto-asset markets should not be able to hide behind a veil of promoting “financial innovation” to evade regulatory scrutiny.
It is in the interests of both consumers and investors, she said, that new technologies should be met with new forms of regulation, as opposed to a hands-off approach from regulators.
“Far from stifling innovation, strong regulatory guardrails will help enable investors and developers to build a resilient digital native financial infrastructure,” she said.
“Strong regulatory guardrails will help banks, payments providers, and financial technology companies (fintechs) improve the customer experience, make settlement faster, reduce costs and allow for rapid product improvement and customisation.”
Crypto’s weakest links: defi, stablecoins
Applying the principle of like risk, like regulatory outcome, Brainard identified stablecoins and decentralised (defi) platforms as two areas in need of greater transparency and oversight rules.
As an example of the worst of both worlds, Brainard pointed to the collapse of TerraUSD in May this year, where one could argue that a lack of regulation in both defi and stablecoins exposed investors to enormous risk, both known and unknown.
“The Terra crash reminds us how quickly an asset that purports to maintain a stable value relative to fiat currency can become subject to a run,” she said.
“The collapse of Terra and the previous failures of several other unbacked algorithmic stablecoins are reminiscent of classic runs throughout history.
“New technology and financial engineering cannot by themselves convert risky assets into safe ones.”
But TerraUSD was not the only type of stablecoin that came in for criticism from Brainard.
At present, Brainard sees much greater risk from asset-backed stablecoins due to their current size, growth trajectory and their gatekeeper role in the crypto-asset markets.
Without naming names, Brainard pointed out that the top three stablecoins account for almost 90 percent of stablecoin transactions, and the top two account for 80 percent of the total stablecoin market captialisation.
Stablecoins provide the “bridge” from fiat to crypto, and are also the unit of account within the crypto-asset markets, she said.
They are also the settlement asset of choice and can serve as collateral for other risk-taking activities such as lending and trading.
“For these reasons, it is vital that stablecoins that purport to be redeemable at par in fiat currency on demand are subject to the types of prudential regulation that limit the risk of runs and payment system vulnerabilities that such private monies have exhibited historically,” said Brainard.
To help protect investors, Brainard suggested that a central bank digital currency (CBDC) could be used as a “neutral trusted settlement layer” across the crypto-asset markets.
“A settlement layer with a digital native central bank money could, for instance, facilitate interoperability among well-regulated stablecoins designed for a variety of use cases, and enable private-sector provision of decentralised, customised and automated financial products,” she said.
“This development would be a natural evolution of the complementarity between the public and private sectors in payments, ensuring strong public trust in the one-for-one redeemability of commercial bank money and stablecoins for safe central bank money.”
Bank involvement in crypto activities
Brainard suggests the increasing involvement by banks in crypto-related activities is a double-edged sword. On the one hand, stronger bank involvement in the crypto-asset markets could bring the industry under closer scrutiny, but it could also expose more of the traditional financial system to crypto-related risks.
“Bank regulators will need to weigh competing considerations in assessing bank involvement in crypto activities ranging from custody to issuance to customer facilitation,” she said.
“Bank involvement provides an interface where regulators have strong sightlines and can help ensure strong protections.
“Similarly, regulators are drawn to approaches that effectively subject the crypto intermediaries that resemble complex bank organisations to bank-like regulation.”
Likewise, Brainard pointed to the need for tougher regulation on other intermediaries, such as exchanges, trading and lending platforms.
She noted that, in contrast to traditional markets, where these activities are required to be separate, some platforms combine market infrastructure and client facilitation with risk-taking businesses, such as asset creation, proprietary trading, venture capital and lending.
As reported by VIXIO, this overlapping of roles among crypto exchanges was one of the reasons cited by the Securities and Exchange Commission (SEC) for its rejection of a spot bitcoin exchange-traded fund (ETF) application last month.
As argued by the SEC, the closed nature of centralised crypto exchanges poses market manipulation risks, especially when such exchanges are based in offshore jurisdictions.
Turning to decentralised crypto exchanges, Brainard said different but no less dangerous risks apply.
“The permissionless exchange of assets and tools that obscure the source of funds not only facilitate evasion, but also increase the risk of theft, hacks, and ransom attacks,” she said.
“These risks are particularly prominent in decentralised exchanges that are designed to avoid the use of intermediaries responsible for know-your-customer identification and that may require adaptations to ensure compliance at this most foundational layer.”
Echoing calls from the US Treasury last week, Brainard said that interagency cooperation will be required to protect against these risks both on a domestic and international basis.
She pointed to the work of the Financial Stability Board (FSB), the Basel Committee on Banking Supervision, the International Organization of Securities Commissions (IOSCO) and US federal bank regulators as leading examples of actions to prevent regulatory evasion within the crypto-asset markets.
On Monday (July 11), the FSB published its latest statement on international regulation and supervision of crypto-asset activities, calling for similar measures as Brainard with regard to defi and stablecoins.
