On October 3, 2022, the Financial Stability Oversight Council (“FSOC”) – a collaborative body formed under the Dodd-Frank Act composed of state and federal regulators and tasked with identifying risks and responding to emerging threats to financial stability – released its 100+-page Report on Digital Asset Financial Stability Risks and Regulation (the “Report”). In the Report – a response to President Biden’s Executive Order 14067 on digital assets, which, among other things, directed various agencies to promote innovation and R&D while calling for measures to mitigate risks – the FSOC reviewed what it deems to be, “specific financial stability risks and regulatory gaps posed by various types of digital assets.”

At the core, the FSOC Report is a call to arms, with the council citing what it sees as a host of regulatory and industry shortfalls that have not kept up with the rapid growth of digital asset activities.  For example:

• The FSOC report noted that stablecoins and the lending and borrowing on digital asset trading platforms are now an “important emerging vulnerability.”
• The Report’s basic thesis is that crypto-asset activities “could pose risks to the stability of the U.S. financial system if their interconnections with the traditional financial system or their overall scale were to grow without being paired with appropriate regulation, including enforcement of the existing regulatory structure.” This point was reiterated in the Federal Reserve’s November 2022 “Financial Stability Report,” which presents the Federal Reserve Board’s current assessment of the stability of the U.S. financial system.
• The FSOC Report also expresses the position that federal comprehensive digital asset legislation is needed to address complex, systemic economic risks, as, in its opinion, “many crypto-asset platforms are not registered or chartered under regulatory frameworks that would address these risks.”

Note:  The FSOC Report is a fairly extensive examination into the background and current place digital assets have in the financial sector, as well as a detailed rundown of the regulatory and legislative shortfalls (at both the state and federal level) and the potential systemic risks and sometimes-opaque financial interconnections between the digital asset industry and the economy at large. The Report culminates with a list of recommendations that FSOC believes can lead to “appropriate” regulation of crypto-asset activities. Given the length and breadth of the Report, this blog post will only highlight some of the salient financial risks and potential solutions discussed.

The Report comes amidst the “crypto winter” (that is, for the uninitiated, significant turmoil) in the digital asset industry. An oft-volatile industry has experienced wild volatility this year, with the total market capitalization that spiked to $3 trillion in November 2021 and now hovers around $1 trillion. The stormy crypto seas have resulted in serious losses for professional and retail investors.  Still, as stated in the President’s digital assets executive order, advances in blockchain technology for financial services can help achieve a number of important national policy goals and reinforce U.S. leadership in the global financial system, yet only if digital asset technologies and the digital payments ecosystem are “developed, designed, and implemented in a responsible manner.”

In this environment, the Report examines the potential vulnerabilities to the financial system that are posed by the growth of digital assets and decentralized finance (DeFi) innovations. First off, the FSOC again focused on stablecoins, which we’ve previously discussed in past posts. Stablecoins are digital assets designed to maintain a stable value by pegging the digital asset to a national currency or another reference asset (i.e., a commodity like gold, silver, or oil). Using reference assets to stabilize price, stablecoins seek to become the alternative payment mechanism to bitcoin and other cryptocurrencies, and have also been used to facilitate trading and lending of other digital assets. Some stablecoins use algorithms to maintain their value and in its 2021 Annual Report, the FSOC asserted that the algorithmic variety of stablecoin may be subject to volatility due to market pressures, operational failures, and other risks.

In addition to the FSOC’s view on stablecoins, the FSOC took a wider view of the digital asset ecosystem, warning that “crypto-asset activities” could pose risks to the traditional financial system (i.e., “TradFi”) if crypto-assets became increasingly interconnected with TradFi or their use further blossomed without appropriate regulation and coordination among state and federal regulators. While the Report states that the overall level of involvement of the banking system in crypto-assets activities “remains relatively low,” the FSOC states that banks are beginning to assess and consider offering crypto-asset services that might subject such banks to small exposures, yet will only increase the interconnection between DeFi and traditional finance.  The Report similarly documents a growing set of private investments in crypto-asset entities, more on-ramps for consumers and retail investors to interact with crypto-assets, and some municipalities announcing plans to accept crypto-assets for payments.

The Report highlights certain characteristics that magnify what the FSOC sees as the unsteadiness within the crypto-asset ecosystem. For example, the Report suggests that “the absence of strong fundamental economic use cases to date” and a lack of an extensive price history or disclosures by crypto-asset promoters lead to volatility and a lack of an anchor for many crypto-assets; it also points to the many instances of fraud and manipulation in the crypto-asset markets as a factor shaping asset prices.  Given its prudential mission, the Report unsurprisingly views the crypto-asset use cases surrounding DeFi with skepticism while pushing the narrative that crypto-assets, like cryptocurrency and NFTs, are driven by speculation, seemingly (and regrettably) forgetting to consider use cases in the realms of collectibles, art, music, fashion, gaming, luxury goods, supply chain, ticket sales and real estate.

Moving onto to what it sees as other potential risks, the Report notes that some activities lack basic risk controls to protect against run risk or prevent excessive leverage, which has led to several bankruptcies. Specifically, the Report notes that interconnections inside the crypto ecosystem between platforms, investors, lenders and counterparties can spread losses such that a shock or a sharp price decline in common holdings of a crypto-asset can cause instability or default of one interconnected entity. It also notes that clear risks can arise from “concentrated exposures to single large counterparties,” or “whales,” which can create more significant interconnections and potential risks depending on the size of a whale’s position in relation to the size of their counterparties. Lastly, it notes that distributed ledger technology itself comes with its own potential operational vulnerabilities, including the “concentration of mining and validation and blockchain maintenance” and “bugs in the underlying code,” among other things.

The Report further discusses the opportunities for regulatory arbitrage, which occurs when the same activity can be done legally, and more favorably, under more than one regulatory framework. The FSOC is concerned that nonbank crypto-asset firms might take advantage of state money services business (MSB) laws, which generally focus on business services regulation like AML and consumer protection, allowing these firms to advertise themselves as regulated.  According to the FSOC, this regulatory arbitrage may impede other financial regulators from assessing the totality of an entity’s entire risk profile and sufficient visibility into the activities of affiliates or subsidiaries of the entities that are licensed or chartered under state law  In the FSOC’s view, “MSB regulation is not designed the purpose of comprehensively mitigating vulnerabilities arising from the potential failure of a large, interconnected platform, or for other purposes, such as market integrity.” Still, the Report notes that certain state regulatory regimes, such as New York’s BitLicense, impose capital requirements that vary depending on the business model and risk and contains provisions that address run risk.

The FSOC, however, is concerned that the lack of a federal framework leaves financial stability concerns unmitigated.

The Report goes on to discuss three regulatory gaps:

1. Spot Markets: The Report is concerned that spot markets for crypto-assets that are not securities are subject to limited regulation. A spot market, as opposed to a futures market where delivery is due at a later date, is a financial market in which financial instruments like securities, commodities, and currencies are traded for immediate delivery. The concern for the FSOC is that, without proper regulation, these markets lack orderly and transparent trading, investor protection, and could lead to conflicts of interest and market manipulation.
2. Regulatory Arbitrage: As alluded to above, the FSOC contends that regulators are unable to view risks across an entire business without a comprehensive federal framework. Due to this perceived limitation, crypto-asset firms may be able to operate affiliates or subsidiaries under different regulatory frameworks, without oversight from a single regulator monitoring firm-wide risks.
3. Vertical Integration of Financial Services: Some trading platforms have proposed offering direct access to markets by integrating services provided by intermediaries such as broker-dealers or futures commission merchants. FSOC states that certain investor protection concerns, such as automatic liquidations, could lead implicate financial stability principles.

The Report offers a number of recommendations that would seek to address financial stability risks before they impair the economy:

1. Agencies should continue to enforce existing financial rules and regulations and that bank and credit union regulators expect that such entities engage in crypto-asset activities in a “safe and sound manner.”
2. Congress should pass legislation empowering financial regulators with explicit rulemaking authority over spot markets for non-security crypto-assets (without weakening regulators’ current jurisdictional authority), including in the areas of trading practices, recordkeeping, reporting requirements, consumer asset segregation, cybersecurity, and investor protection, among others. Presumably, the Report hopes to instigate congressional action to create a comprehensive regulatory framework.
3. Financial regulators should address regulatory arbitrage by taking steps to improve cross-agency coordination and give regulators visibility and oversight across all affiliates and subsidiaries of crypto-asset firms.
4. Congress should pass a comprehensive framework for stablecoin regulation.
5. Federal regulators should use existing authority to review crypto-related services provided to banks by crypto-asset services providers.
6. Federal agencies should also study the potential impact and market volatility caused by vertical integration by crypto-asset firms.

The FSOC also generally recommended boosting data, analysis, monitoring, supervision, and regulation of crypto-asset activities capacities.

Indeed, whether motivated by the desire to capture the benefits of these breakthrough technologies or protect investors from a volatile market, regulators are certainly zeroing in on a technology and industry whose growth (and growing pains) are now certainly on the radar of federal financial agencies. What remains to be seen is how the current regulatory cornucopia will crystallize into a – hopefully thoughtful – regime.

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