cryptoassets regulation

Cryptoassets could threaten financial system stability if they continue to grow unchecked, warns the U.S. Financial Stability Oversight Council (FSOC) in a new report.

In response to an executive order, the federal agency issued a report examining the financial stability risks and regulatory gaps posed by digital assets.

In that report, the FSOC warned that cryptoassets “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 adherence to or being paired with appropriate regulation, including enforcement of the existing regulatory structure.”

While those connections are currently limited, they have the potential to expand rapidly, the report said.

For instance, it pointed to the use of traditional assets to back the value of stablecoins, leveraged trading, custody arrangements, and increased participation by both retail investors and traditional financial firms, as sources of increased connections between the crypto sector and the mainstream financial system.

At the same time, the FSOC sees an array of risks in the fledgling crypto sector, including a lack of basic protections against liquidity and leverage risk, prices that are primarily driven by speculation rather than economic fundamentals, and an array of operational risks and vulnerabilities despite the supposed decentralized nature of crypto.

“These vulnerabilities are partly attributable to the choices made by market participants, including crypto-asset issuers and platforms, to not implement 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,” the FSOC said.

At the same time, enforcement of the existing regulatory structure has been spotty, the report noted. “Compliance with and enforcement of the existing regulatory structure is a key step in addressing financial stability risks,” it said.

However, the report noted there are several regulatory gaps when it comes to crypto: limited direct federal regulation of spot markets that leaves them vulnerable to conflicts of interest and market manipulation; the lack of a consistent, comprehensive oversight framework, which allows for regulatory arbitrage; and vertical integration with broker-dealers or firms that may create financial stability and investor protection risks.

To deal with those gaps, the FSOC called for legislation to give federal regulators rulemaking authority over the spot market for cryptoassets that are not securities and said there should be measures to address regulatory arbitrage opportunities.

It also called for a study of potential vertical integration by cryptoasset firms and for federal regulators to increase their capacity to collect and analyze data on crypto activities.

“The report concludes that cryptoasset activities could pose risks to the stability of the U.S. financial system and emphasizes the importance of appropriate regulation, including enforcement of existing laws,” said U.S. Treasury Secretary Janet Yellen in a release.

Gary Gensler, chair of the U.S. Securities and Exchange Commission, said that “SEC staff is working with market participants to help ensure that investors in the crypto market get time-tested protections that exist in other securities markets and that all market participants have a fair playing field.”

The challenge of crypto regulation is increasingly a concern for Canadian policymakers too.

At an Economic Club of Canada event later this week, Ontario Securities Commission CEO Grant Vingoe will address the importance of crypto regulation and outline the OSC’s plans under its new structure and expanded mandate.