Oct 5, 2022 - Economy

Financial stability watchdogs note crypto's regulatory gaps

Illustration of a caution sign with a person falling off of a cube.

Illustration: Shoshana Gordon/Axios

A Treasury-chaired council charged with flagging risks to U.S. financial stability said the crypto industry poses several risks, without really conjecturing on what crypto could break beyond itself, or how bad it could get.

Why it matters: The report from the Financial Stability Oversight Council this week is the latest response to President Biden’s executive order, “Ensuring Responsible Development of Digital Assets.” The issues it raised — some old, some new — could have an impact on new pivotal regulations to come.

First, the obvious: "Currently, crypto-asset entities do not have a consistent or comprehensive regulatory framework," the report notes.

  • It's kind of a mess who supervises what, as the report details.

The intrigue: This is a threat to traditional institutions, the council argues.

  • Crypto firms can take advantage of the murkiness (despite the fact that many industry stakeholders complain about a lack of clear rules).
  • "Crypto-asset firms may also obtain competitive benefits and undermine traditional institutions by failing to comply with applicable regulations," the authors note (our emphasis added).

The big gap: What is or isn't a security in the digital asset market. But that issue has been well documented.

  • But the report illuminates how the uncertainty is dangerous for crypto exchanges as well as token issuers.

Of note: The report flags an interim report from the Basel Committee on Banking Standards, a global standard setter for bank regulation, which has been out since June. That report basically breaks crypto assets into four categories:

  • Tokens that represent some kind of real asset. There aren't many of these. Equity, for example, has rarely been tokenized, but maybe Pax Gold would count.
  • Tokens that track a peg, such as the dollar. Basically, stablecoins.
  • Cryptocurrencies that are big and regulated (basically, bitcoin and ether, for now)
  • Everything else. These "would be subject to more stringent prudential standards," the report explains.

The big question on every entrepreneur's mind now is, will the regulations for that last category be so intense that no one can run a business that might grow into the third bucket.

Other gaps they noted:

  • Run risks. Obviously the report worries about stablecoins backed by dollars or other currencies, but it also notes that there could be runs on exchanges, which is a seldom discussed issue.
  • Credit union vendors are unsupervised. "As a result, interconnections with crypto-asset activities may be able to grow more easily through [credit union service organizations], relative to banks," the report warns.
  • Private funds' crypto investments aren't really supervised. The report seems to hint that this might need to change because funds do business with banks and banks might not know how much crypto exposure funds have.
  • Accounting. American firms' standards haven't caught up to crypto which could cause some disconnect looking at the same assets on the balance sheets of different kinds of firms.
  • In addition, risks around hidden and unchecked leverage, and shortcomings in the monitoring of markets for bitcoin and ether it calls them "crypto-assets that are not securities," but those are likely what they mean).

What's missing: The report seems to ignore the inherent transparency of blockchains. Obviously not everything in crypto is in the open (see Three Arrows and Celsius), but there's so much about the market that is.

Our thought bubble: The report says what it's afraid of, but not really why. Without even taking a stab at that piece, it's harder to take the threat seriously.

  • For example, let's say there is a run on a stablecoin. How do they see that rippling out to the rest of the economy?
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