Crypto could threaten financial system, Federal risk panel warns

Cryptocurrencies remain largely unregulated by the federal government, leaving investors without protections from fraud and market manipulation that come with many other types of investments (Photo: Bloomberg)
Cryptocurrencies remain largely unregulated by the federal government, leaving investors without protections from fraud and market manipulation that come with many other types of investments (Photo: Bloomberg)

Summary

Regulators’ report in response to President Biden’s order highlights cryptocurrency vulnerabilities

WASHINGTON : Risks tied to cryptocurrencies could grow rapidly and eventually threaten the broader financial system, a panel of senior U.S. officials warned Monday, calling for tougher oversight of digital assets.

The Financial Stability Oversight Council, chaired by Treasury Secretary Janet Yellen, said the crypto industry remains small compared with the overall financial system, but that could change quickly and exacerbate potential systemic risks.

“The financial stability risks of crypto-assets would be substantial if those vulnerabilities were to remain in place while the scale of crypto-asset activities and interconnectedness with the traditional financial system were to grow rapidly," the risk panel said in a 120-page report.

Monday’s report is the latest response to a March executive order from President Biden, which called a number of federal agencies to evaluate the risks and opportunities posed by cryptocurrencies.

The industry initially hoped regulators would see promise in the asset class, but officials have recently warned about the potential for disruption posed by financial innovation without sufficient regulation.

“As we have painfully learned from history, innovation without adequate regulation can result in significant disruptions and harm to the financial system and to individuals," Ms. Yellen said ahead of a unanimous vote by the FSOC to release Monday’s report.

The FSOC said large parts of the cryptocurrency industry fall under the jurisdiction of the existing financial regulatory laws. It called for Congress to consider legislation to address any gaps, such as over the “spot" market for cryptocurrencies that don’t meet the definition of a security overseen by the Securities and Exchange Commission.

Cryptocurrencies remain largely unregulated by the federal government, leaving investors without protections from fraud and market manipulation that come with many other types of investments.

The report highlighted several vulnerabilities in the market. Those include interconnectedness that can quickly spread losses across the crypto ecosystem, and the likely presence of “very high and excessive amounts of leverage," or borrowed money that could exacerbate shocks to the industry. A lack of fundamental economic uses for crypto has contributed to wild swings in pricing that might otherwise be anchored, the report said.

“In addition, prices may be affected by the prevalence of fraud and market manipulation," the report said.

Mr. Biden’s directive for government agencies to improve their understanding of crypto came at a turbulent time for the industry. Two months after the executive order, the implosion of a so-called algorithmic stablecoin, TerraUSD, and a related token destroyed a combined $40 billion of value. Then over the summer, the crypto-focused hedge fund Three Arrows Capital Ltd. collapsed, dragging into bankruptcy a number of platforms that held assets for individual investors.

Still, cryptocurrency advocates say the assets have the potential to make payments faster and cheaper than in the traditional banking system. Supporters of bitcoin, the largest cryptocurrency, see an advantage over government-issued money in the fact that its supply is capped by software code rather than adjusted by policy makers.

“Similar to the other executive order reports and summaries, FSOC’s report overstates the risks—and understates the opportunities—crypto networks present," said Kristin Smith, head of the Blockchain Association.

The reports stemming from the executive order come as Washington wrestles with how to regulate the cryptocurrency industry and federal agencies battle over who will be responsible for them. The competition heated up in recent months as a meltdown in crypto markets underscored the need for guardrails in the eyes of many policy makers.

A Treasury Department report released in September emphasized risks to consumers, financial stability and rule of law stemming from cryptocurrencies, while assessing the practical uses of digital tokens to be limited. It called for agencies like the SEC to rigorously enforce existing regulations in the cryptocurrency market, dealing a blow to the industry’s hopes of getting a more tailored rule set.

Lawmakers have also been moving to assign jurisdiction. In the House, a bipartisan pair of lawmakers is negotiating over legislation that would subject the issuers of stablecoins to federal scrutiny. The pair face long odds for getting a deal this year.

An unrelated Senate plan aims to assign oversight of the two largest tokens, bitcoin and ether, to the Commodity Futures Trading Commission. A separate pair of senators offered a proposal that would create special exemptions to federal law for some cryptocurrencies.

 

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