Unregulated crypto could pose a threat to the financial system

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The Financial Stability Supervisory Board has warned that cryptocurrencies could pose risks to the financial system if their global scale or their link to traditional banks grows without regulation or oversight.

“The rapid growth of digital asset activity, including stablecoins and lending and borrowing on digital asset trading platforms, is a significant emerging vulnerability,” the FSOC said in a new report on Monday.

The FSOC – created in the wake of the financial crisis to monitor threats to the financial system – says potential asset price declines, financial exposures between crypto firms, funding mismatches and the risk of leaks, and the use of leverage are all risks to the financial system.

According to the report, many crypto-asset businesses lack ground rules to protect against the risk of leaks or prevent high levels of leverage. Regulators say there are major loopholes in the regulation of crypto assets. And since crypto firms lack consistent and uniform regulations, authorities say they can take advantage of loopholes in the regulatory system.

“Cryptoasset prices appear to be driven primarily by speculation rather than based on current fundamental economics,” the report said.

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The council — made up of the heads of major federal financial regulatory agencies, including the Treasury, Federal Reserve, and Securities & Exchange Commission — sees stablecoins as the most pressing risk. Regulators, who expressed concerns about stablecoins as early as last November, say stablecoins are likely to run wild if not regulated by capital and liquidity standards. Officials point to the run on algorithmic stablecoin TerraUST this spring that led to a separate, albeit less severe, run on Tether, the largest stablecoin measured by market capitalization.

Authorities also see vulnerability where stablecoin issuers hold assets in the traditional financial system. They say traditional asset markets could experience upheaval if stablecoin activity were to reach a significant scale and if stablecoin runs were to lead to fire sales of traditional assets like treasury bills or commercial paper. backing stablecoins.

The report notes that while interconnections with the traditional financial system are relatively limited, they could potentially increase rapidly. Officials provide an example where banks could increase their exposure to crypto markets by lending and securing loans with crypto assets. He notes, however, that overall, the level of involvement of the banking system in crypto is “relatively low” at present, and banks’ overall balance sheet exposure to crypto remains limited.

Another area that regulators are pointing to as a glaring shortcoming: limited direct federal oversight of the spot market for crypto assets that are not securities. The report notes that markets may lack strict rules to ensure orderly and transparent trading, prevent conflicts of interest and market manipulation, and protect investors and the economy more broadly.

Given the risks, the FSOC offers 10 recommendations to limit crypto-related risk, including Congress passing new legislation to give regulators authority over the spot market in crypto assets that are not titles ; legislation to regulate stablecoins; and legislation that would give regulators the power to see the entire business of a crypto firm that has multiple subsidiaries operating under different regulations.

The report also encourages agencies to continue to enforce existing rules and regulations and to coordinate to regulate crypto companies, such as stablecoin issuers or crypto-asset platforms, particularly in cases where different players with similar activities may be subject to different regulations.

This report comes to the management of President Biden’s executive order in March which tasked federal government agencies with studying cryptocurrencies and coming up with the best way to regulate them. The US Treasury warned in three new reports last month that cryptocurrencies pose significant risks to consumers, investors and businesses if not properly regulated. The FSOC has been monitoring cryptocurrencies and distributed ledger technology since 2015.

The FSOC says it will continue to monitor the risks posed by crypto.

Jennifer Schonberger covers the Federal Reserve, politics and cryptocurrencies for Yahoo Finance. Follow her on @Jenniferisms.

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Don F. Davis