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US’ FSOC report:  The Financial Stability Oversight Council’s Report on Digital Asset Financial Stability Risks and Regulation

US_Financial_Conduct_Risks

On October 3rd, 2022, the Financial Stability Oversight Council (FSOC) issued its Report on Digital Asset Financial Stability Risks and Regulation in response to President Biden’s Executive Order 14067 on Ensuring Responsible Development of Digital Assets.

The report reviews financial stability risks and regulatory gaps stemming from various types of crypto assets and provides recommendations to address them.

A) Financial Stability Risks

This section expands on two primary identified vulnerabilities:

  • Crypto-asset activities’ interconnectedness with the fiat financial system

The threat posed by transacting in crypto assets to the overall financial system is linked to the recent and rapid growth of crypto-asset activities, paired with their interconnectedness with the traditional fiat financial system. Granted, currently these risks are manageable to a degree due to the limited linkage, however, threats can increase proportionally to the expanded use of crypto assets. Identified crypto asset types and activities as threatening the stability of the traditional financial system mentioned in the report are the use of stablecoins by the public, banks adopting crypto asset products and services, crypto investment opportunities (public and private), on-ramp services, crypto insurance opportunities, payments in crypto-assets for tax, mortgage collateral.

  • Instability of the crypto-asset ecosystem

Crypto-assets have innate characteristics that render them volatile by nature, such as prices being based on speculation and can be deeply affected by market manipulation tactics as well as other factors, such as users holding a large portion of a crypto asset on a given blockchain, known as “whales”. Operational risks may arise from the concentration of crypto market players (such as exchange platforms) or from vulnerabilities related to distributed ledger technology which can spread due to interconnected crypto services.

B) Regulation of Crypto-asset Activities

Current crypto regulations revolve around AML and consumer protection requirements. The report emphasises that there are no regulations to mitigate financial stability vulnerabilities arising from activities undertaken by crypto service providers. The report identifies three gaps in the U.S. regulation of crypto-asset activities:

  • Federal regulation is limited in reach over crypto-assets that don’t qualify as securities. Such markets “may not feature robust rules and regulations designed to ensure orderly and transparent trading, prevent conflicts of interest and market manipulation, and protect investors and the economy more broadly.”
    • The regulatory framework of crypto-asset service providers is fragmented. Operators of crypto services may engage in different activities that do not fall under the same regulator and no single regulator has visibility into the risks across different business sectors.
    • Crypto-asset trading platforms integrate services provided by intermediaries (e.g. broker-dealers or futures commissions) and offer retail customers direct access to such markets.

“Financial stability and investor protection implications may arise from retail investors’ exposure to certain practices commonly proposed by vertically integrated trading platforms, such as automated liquidation.”

Recommendations

  1. Continuation of enforcing existing rules and regulations
  2. Develop federal regulations for crypto-assets that are not securities
  3. Address regulatory arbitrage
  4. Pass legislation allowing regulators to supervise the activities of all affiliates and subsidiaries of crypto-asset service providers
  5. Analyse potential vertical integration by crypto-asset firms

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