Other Authors Danielle Marino
On October 4, 2022, the US Financial Stability Oversight Council (FSOC) released its Report on Digital Asset Financial Stability Risks and Regulation (FSOC Report). The report is the latest in a series of reports issued pursuant to Executive Order 14067, Ensuring Responsible Development of Digital Assets. (See our prior Legal Updates on the Executive Order and recent Treasury reports on digital assets). The executive order requested the secretary of the Treasury to convene the FSOC to produce a report outlining specific financial stability risks and regulatory gaps related to digital assets and recommendations to address these risks. Weighing in at over 120 pages, the FSOC Report provides a thorough discussion of the regulation of crypto-assets and their potential financial stability risks.1 Most importantly, the report sets forth several policy reform recommendations and, in doing so, provides a clearer view of the Biden administration’s policy priorities with respect to crypto-assets.
Financial Stability Risks
The FSOC Report concludes that crypto-asset activity could create risks to the financial stability of the US financial system by amplifying or propagating financial shocks through two channels: (1) “interconnections between the crypto-asset ecosystem and the traditional financial system” and (2) “vulnerabilities primarily confined to the crypto-asset ecosystem.” The FSOC Report recognizes that currently these risks to financial stability are limited but emphasizes that they have the potential to grow very rapidly.
Interconnections with the Traditional Financial System
With respect to financial stability risks arising from interconnections with the traditional financial system, the FSOC Report focuses on the risks of potential runs on stablecoins and their instability due to asset-liability mismatches. The report emphasizes that runs on stablecoins could trigger fire sales of traditional financial assets by not only other stablecoin issuers but also traditional financial institutions (such as money market funds). Moreover, the report notes that a run on a stablecoin could also cause instability in traditional financial institutions that hold those stablecoins, causing further fire sales of assets. In addition, the report notes that the increase in stablecoin issuance may be creating new demand for short-term assets (commercial paper) and distorting yields in money markets.
The FSOC Report also discussed a variety of other interconnections that could transmit shocks from crypto-asset activities to the traditional financial system. These interconnections include the use of traditional banking and investment products by crypto-asset firms and their supporting companies (miners, blockchain service providers) as well as the development of specialized crypto-asset financial products such as blockchain-based crypto-asset transactions, crypto-asset custody, and loans secured by crypto-assets. Crypto-asset trading platforms also may provide leveraged trading to retail and institutional investors, including high-frequency traders. As the crypto-asset ecosystem grows, the report expects that there will also be more investments in the securities in publicly traded companies with significant crypto-asset activities, including by retail investors, pension funds, municipalities, insurance companies, and other investment companies. Collectively, these interconnections, the report maintains, could transmit shocks in crypto-asset markets to traditional financial institutions and could expose institutions to earnings volatility, liquidity risks, and increased legal or reputational risks.
Interconnections within the Crypto-Asset Ecosystem
With respect to the financial stability risk arising from within the crypto-asset ecosystem, the FSOC Report highlights the risks associated with crypto-asset prices. The report takes the view that crypto-asset prices are “largely based on speculation” and “may be affected by the prevalence of fraud.” Combined with the fragmentation of liquidity across multiple crypto-asset platforms, leveraged transactions, and asset-liability funding mismatches, the volatility and instability of crypto-asset prices could amplify shocks to crypto-asset prices and expose crypto-asset firms to heightened financial risks. The FSOC Report also raises concerns about the interconnected nature of the crypto-asset ecosystem, where many significant crypto-asset firms have connections with trading platforms, mining businesses, and blockchain technologies. As a result, the report contends that the failure of a significantly interconnected entity could have substantial, negative ripple effects within the crypto-asset ecosystem.
The FSOC Report also discusses the operational vulnerabilities associated with the technological infrastructure on which the crypto-assets are based, including distributed ledger technology. In a permissionless system, the report argues that market participants may be exposed to potential disruptions caused by bugs in the underlying code, while in a permissioned system, participants may be exposed to disruptions created by coding changes implemented by the central entity that controls the system.
Finally, the FSOC Report stresses the risks arising from the absence of prudential regulations for crypto-asset firms, particularly capital and liquidity requirements, governance, risk management, and internal audit standards. This regulatory gap permits market participants to build up high amounts of leverage, including through the use of derivatives and margin loans. Automated liquidation protocols embedded in certain trading platforms may further intensify the impact of a shock on highly leveraged crypto-asset market participants. The report also highlighted that some crypto-asset firms have sought to give the impression that they are prudentially regulated even when they are only regulated as money transmitters (which is a regulatory regime that is not designed to enhance market integrity or mitigate risks related to failures of large, interconnected platforms). The report also notes that some firms have falsely stated that their products are covered by federal deposit insurance. To the extent consumers believe crypto-assets are covered by the federal safety net, a shock could be amplified when consumers realize that they may suffer financial losses and seek to convert their crypto-assets into dollars, thereby igniting runs and fire sales.
Sources of Financial Shocks
The FSOC Report discusses how crypto-asset activities could potentially be the source of an economic shock. Although the report stresses the difficulty of predicting where and when a shock could materialize, it does point to malicious acts, technology breakdowns, governance breakdowns that result in the theft of crypto-assets, or impairment of the operation of key technologies as possible shocks arising from crypto-activities.
FSOC Report Recommendations
The FSOC Report identified three gaps in the regulation of crypto-asset activities:
(1) The limited direct federal oversight of the spot market for crypto-assets that are not securities
(2) The absence of a consistent or comprehensive regulatory framework for crypto-asset firms, which creates opportunities for regulatory arbitrage
(3) The potential for crypto-trading platforms to vertically integrated services to provide retail customers direct access to markets without using intermediaries such as broker-dealers or futures commission merchants
To address the first regulatory gap, the FSOC recommends Congress pass legislation that provides for explicit rulemaking authority for financial regulators over the spot market for crypto-assets that are not securities. The FSOC stated that the rulemaking authority should cover the broad range of traditional regulatory subjects (conflicts of interest, trading practices, investor protections, etc.) but should not interfere with or weaken any existing agency authorities. The FSOC also stated that such legislation should contain enforcement and examination authority.
To address the second regulatory gap, the FSOC made several recommendations, including:
- First, FSOC members should follow a specified set of regulatory principles in their deliberations on the applicability of their authorities to crypto-assets. These principles include “same activity, same risk, same regulatory outcome”; “technology neutrality”; “transparency in technology”; and “addressing financial stability risks before they impede the economy.”
- Second, federal agencies should continue to enforce existing rules and regulations and coordinate with each other in the supervision of crypto-asset entities.
- Third, Congress should pass legislation that would create a comprehensive prudential framework for stablecoin issuers. The legislation should address the financial stability risks of stablecoins as well market integrity regulation, investor and consumer protections, and payment system risk. It should also provide authority over critical service providers that support stablecoins. Both federal and state regulators should coordinate on the supervision of stablecoins.
- Fourth, Congress should pass legislation to provide regulators with oversight and supervision authority (consolidated supervision) over the activities of the unregulated affiliates and subsidiaries of crypto-asset entities.
- Fifth, the Federal Deposit Insurance Corporation, Federal Reserve Board, Office of the Comptroller of the Currency, and state bank regulators should use their existing authorities, as appropriate, to review services provided to banks by crypto-asset service providers and other entities in the crypto-asset arena. Additionally, Congress should pass legislation to ensure the Federal Housing Finance Agency, National Credit Union Administration, and other relevant agencies have adequate examination and enforcement authorities to oversee these entities and third-party service providers.
To address the third regulatory gap, the FSOC recommends that “member agencies assess the impact of vertical integration (i.e., direct access to markets by retail customers) on conflict of interest and market volatility and whether vertically integrated market structures can or should be accommodated under existing laws and regulations.”
In an effort to reduce opacity of the crypto-asset ecosystem as a whole and provide regulatory data, the FSOC additionally recommends a coordinated government-wide approach to the analysis and monitoring of crypto-asset activity.
In contrast to the Treasury Department’s prior digital asset reports, the FSOC Report sets forth the Biden administration’s policy priorities with respect to crypto-assets and signals where policy is likely headed in the near term. The FSOC Report’s recommendation for Congress to pass legislation to address the risks posed by stablecoins and provide federal regulatory authority over the spot market for crypto-assets that are not securities should bolster ongoing efforts in Congress to pass such legislation. However, it was curious that the report did not explicitly state that the Commodity Futures Trading Commission should be provided with the authority over the spot market as is currently contemplated by the US Senate Agriculture Committee’s bill (S. 4760, the Digital Commodities Consumer Protection Act).
However, the FSOC Report does not recommend any legislative changes to the federal securities laws to account for the unique characteristics of crypto assets. Instead, the FSOC Report merely states that the Howey and Reves tests apply (without analyzing how those tests should be applied to crypto-assets) and emphasizes “the importance of the continued enforcement of existing rules and regulation.” This effectively embraces Securities and Exchange Commission (SEC) Chair Gary Gensler’s position that “[n]othing about the crypto markets is incompatible with the securities laws.”2 Similarly, the FSOC Report references SEC Staff Accounting Bulletin 121 (which covers accounting and disclosure obligations for entities that hold crypto-assets for platform users) but does not discuss the concerns that have been raised about its practical implications.
Finally, it is worth noting that the FSOC Report does not call for the FSOC to designate crypto-asset activities or entities. The report merely discusses the FSOC’s statutory purposes and then states that the FSOC has not used its designation authority with respect to crypto-asset activities or entities. If the FSOC wanted to put market participants on notice that it was considering designations to address potential risks to financial stability arising from crypto-asset activities or entities, this was an opportune venue. The fact that the FSOC declined to do so should be a reasonable basis to conclude that the administration will instead focus on passing legislation to address crypto-asset financial stability risks. Indeed, the FSOC calls for legislation to authorize federal regulators to have consolidated supervision of crypto-asset firms, reinforcing the reasonable inference that the administration will try to pursue a legislative solution before resorting to FSOC designations. Yet, given the speed at which crypto-asset markets have developed and at which financial stability risks can emerge, plus the inherent unpredictability of federal agencies, it is probably the better part of valor to continue to keep a close eye on the FSOC.
1 The FSOC Report defines “digital assets” as composed of two categories of “products”: central bank digital currencies and crypto-assets. However, the report’s focus is largely crypto-assets.