FSOC Issues Report on Financial Stability Risks of Digital Assets | Practical Law

FSOC Issues Report on Financial Stability Risks of Digital Assets | Practical Law

The Financial Stability Oversight Council (FSOC) issued a report on digital asset financial stability risks and regulation in response to President Biden's executive order on ensuring responsible development of digital assets. The Federal Reserve Bank of New York also issued a report addressing the financial stability of digital assets.

FSOC Issues Report on Financial Stability Risks of Digital Assets

Practical Law Legal Update w-037-1491 (Approx. 8 pages)

FSOC Issues Report on Financial Stability Risks of Digital Assets

by Practical Law Finance
Published on 07 Oct 2022USA (National/Federal)
The Financial Stability Oversight Council (FSOC) issued a report on digital asset financial stability risks and regulation in response to President Biden's executive order on ensuring responsible development of digital assets. The Federal Reserve Bank of New York also issued a report addressing the financial stability of digital assets.
On October 3, 2022, the Financial Stability Oversight Council (FSOC) issued a report (FSOC report) on financial stability risks and regulation of digital assets in response to President Biden's Executive Order 14067 on ensuring responsible development of digital assets (see Legal Update, President Biden Signs Comprehensive Executive Order on Digital Assets Including Exploration of US CBDC). The FSOC report reviews financial stability risks and regulatory gaps posed by various types of digital assets and provides recommendations to address these risks. The FSOC report focuses on crypto assets, which it defines as private sector digital assets that depend primarily on cryptography and distributed ledger (DLT) or similar technology, including assets commonly referred to as digital coins or tokens by market participants (see FSOC Report on Financial Stability and Crypto Assets).
In September 2022, the Federal Reserve Bank of New York also issued a report (NY Fed report) on financial stability implications of digital assets, focusing on risks posed by stablecoins (see Federal Reserve Bank of New York Report on Financial Stability and Digital Assets).

FSOC Report on Financial Stability and Crypto Assets

According to the FSOC report, crypto-asset activities could pose risks to the stability of the US financial system if their interconnections with the traditional financial system or their overall scale were to grow without adherence to or being paired with appropriate regulation, including enforcement of the existing regulatory structure. As the scale of crypto-asset activities has increased significantly in recent years, participants in both the crypto-asset ecosystem and the traditional financial system have explored or created a variety of interconnections. These interconnections could increase rapidly with crypto assets providing a wide variety of services, including leveraged trading and asset custody.

Crypto Asset Instability and Vulnerabilities

The FSOC report outlines specific characteristics of crypto-asset activities have "acutely" amplified instability within the crypto-asset ecosystem, including that:
  • Crypto-asset activities lack basic risk controls to protect against run risk or to help ensure that leverage is not excessive.
  • Crypto-asset prices appear to be primarily driven by speculation rather than grounded in current fundamental economic use cases, with prices repeatedly recording significant and broad declines.
  • Crypto-asset firms or activities have sizeable interconnections with crypto-asset entities that have risk business profiles and opaque capital and liquidity positions.
  • Despite the distributed nature of crypto-asset systems, operational risks may arise from the concentration of key services or from vulnerabilities related to DLT. These vulnerabilities are partly attributable to choices made by market participants to not, or refuse to, implement appropriate risk controls, arrange for effective governance, or take other available steps that would address the financial stability risks of their activities.
FSOC reports that vulnerability to financial stability in crypto assets falls into two categories:
  • Interconnections between the crypto-asset ecosystem and the traditional financial system, broadening the effect of shocks originating in the crypto-asset ecosystem.
  • Vulnerabilities primarily confined to the crypto-asset ecosystem, including:
    • potential drops in asset prices, which may be affected by the prevalence of fraud and market manipulation. Crypto-asset prices are consequently subject to the risk that a shock could induce significant drops in prices.
    • financial exposures via interconnections inside the crypto-asset ecosystem, which could facilitate the spread of losses if a shock causes the default of an interconnected entity and its counterparties then incur knock-on losses. When a crypto-asset platform acts as a sizable market maker or provides significant trading leverage to counterparties, its failure could have material impacts on the market. Crypto-asset markets have also shown clear risks can arise from concentrated exposures to single large counterparties or investors (see Practice Note, Crypto Chapter 11 Proceedings: Overview and Legal Update, Cryptocurrency Lenders File for Chapter 11 Bankruptcy Protection).
    • vulnerabilities in the operational activities or infrastructures that appear to underpin the functioning of the crypto-assets market, including DLT and mining, validation, and blockchain maintenance. Crypto-asset market providers tend to rely on a small number of infrastructure providers, which entails significant operational risk if the infrastructure providers do not conform to current standards for cybersecurity and operational resilience.
    • funding mismatches and risks of runs, including stablecoin vulnerability to runs if not paired with appropriate governance, risk management, financial reporting, auditing and internal control standards, capital and liquidity standards, and regulation. Run risk may exist in varying degrees depending on the stabilization method or the assets purportedly backing the stablecoin.
    • use of leverage, as the exact nature of leverage present in crypto-asset markets is challenging to quantify, given opacity regarding the actual use of leverage. Nevertheless, very high and excessive amounts of leverage are likely present in the crypto-asset system, as judged by the impact that episodes of widespread deleveraging appear to have had on crypto-asset market conditions. Episodes of major crypto-asset price drops have tended to coincide with unusually large levels of liquidations on large crypto-asset trading platforms.
The FSOC report notes that these vulnerabilities can operate independently but are likely to interact with one another, as they do in the traditional financial system. The impact of these vulnerabilities is also dependent on the scale of the risk; crypto assets could directly pose financial stability risks regardless of interconnections with the traditional financial system if the crypto asset ecosystem attains a large enough scale.
Per the FSOC report, shocks to any financial system are inherently difficult to predict. They are, however, likely to appear in the crypto-asset ecosystem due to vulnerabilities, including:
  • Cyber-attacks.
  • Collapse of speculative or fraudulent schemes.
  • Technology-related disruptions.
  • Governance or decision-making breakdowns.

Regulatory Gaps and Recommendations

According to the FSOC report, compliance with and enforcement of the existing regulatory structure is a key step in addressing financial stability risks in the crypto asset activities market. Although there are existing regulatory systems covering large parts of the crypto-asset ecosystem, FSOC identified three gaps in crypto-asset regulation:
  • The spot markets for crypto assets that are not securities are subject to limited direct federal regulation, resulting in these markets potentially not featuring 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.
  • Crypto-asset businesses do not have a consistent or comprehensive regulatory framework and can engage in regulatory arbitrage. Some crypto-asset businesses may have affiliates or subsidiaries operating under different regulatory frameworks, and no single regulator may have visibility into the risks across the entire crypto-asset market.
  • A number of crypto-asset trading platforms have proposed offering retail customers direct access to markets by vertically integrating the services provided by intermediaries such as broker-dealers or futures commission merchants (FCM). 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.
To address the above regulatory gaps, FSOC recommends:
  • The passage of legislation providing for rulemaking authority for federal financial regulators over the spot market for crypto assets that are not securities.
  • Its members take steps to address regulatory arbitrage including coordination, legislation regarding risks posed by stablecoins, legislation relating to regulatory authorities to have visibility into, and otherwise supervise, the activities of all affiliates and subsidiaries of crypto-asset entities, and appropriate service provider regulation.
  • Study of potential vertical integration by crypto-asset firms by its members.
  • The bolstering of FSOC member capacity related to data and to the analysis, monitoring, supervision, and regulation of crypto-asset activities.

Response of SEC Chair Gensler to FSOC Reports

On October 3, 2022, SEC Chair Gary Gensler delivered a speech in which he expressed support for the FSOC reports and noted that to the extent that crypto intermediaries may need to register with both the SEC and the CFTC, both the SEC and CFTC currently have dual registrants in the broker-dealer space and in the fund advisory space.

Federal Reserve Bank of New York Report on Financial Stability and Digital Assets

The NY Fed report identifies the following emerging vulnerabilities in the crypto-asset ecosystem:
  • Run risk in stablecoins, where issuers may dispose of reserve assets quickly to meet redemptions, potentially disrupting traditional financial markets.
  • Valuation pressures and risk appetite in crypto-asset markets.
  • Fragilities of decentralized and centralized platforms, including leverage and maturity, as well as liquidity transformation, and novel risks such as greater automation in decentralized finance (DeFi).
  • Interconnectedness across these vulnerabilities and a general lack of regulation in the ecosystem.
The NY Fed report does not make any specific recommendations, concluding that the current financial stability risks are not extensive because the crypto-asset ecosystem does not provide significant financial services and its interconnections with the traditional financial system are limited. The NY Fed report, however, warns that should the crypto financial system become more interconnected with the traditional financial system or expand its provision of financial services, financial stability risks could quickly become material.