Crypto-Asset Activities Not Paired with Regulation

The U.S. Department of the Treasury through its Financial Stability Oversight Council issued a press release presenting its Report on Digital Assets Financial Stability Risk and Regulation on 10/3/22 highlighting how 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 adherence to or being paired with appropriate regulation, including enforcement of the existing regulatory structure”.  The press release includes a Fact Sheet that highlights how consumers and investors are confused due to the misrepresentations by crypto-asset firms regarding:

• whether a given crypto-asset product is regulated to the same extent as other financial products
• the impression that a crypto-asset is protected by the government safety net when it is not

According to the Report, these false and misleading statements, made directly or by implication, are violations of the law.

Moving forward, the message from the U.S. Government is clear.  There will be regulation of crypto-asset activities and regulations relating to the crypto-asset interconnections with the traditional banking systems (banks, credit unions, trust companies) as well as third-party service providers, insurance companies, funds, commodity pools, advisers, the securities market, and the commodities market.

Who is the Financial Stability Oversight Council?

The Council is composed of ten voting members who head the of U.S. Treasury, the Federal Reserve Board, the OCC, the Consumer Financial Protection Bureau, the SEC, the FDIC, the Commodity Futures Trading Commission, the Federal Housing Finance Agency, the National Credit Union Administration and one independent member with insurance expertise.

Crypto-asset activities pose financial stability risks because they:

• lack basic risk controls to protect against run risk or to help ensure that leverage is not excessive
• appear to be primarily driven by speculation rather than grounded in current fundamental economic use cases, and prices have repeatedly recorded significant and broad declines
• have sizable interconnections with crypto-asset entities that have risky business profiles and opaque capital and liquidity positions
• have operational risks that may arise from the concentration of key services or from vulnerabilities related to distributed ledger technology

The Report identifies three gaps in the regulation of crypto-asset activities in the United States

1. Spot markets for crypto-assets that are not securities are subject to limited direct federal regulation. As a result, those 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.
2. 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 business.
3. 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. 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

The Council’s Recommendations to address regulatory gaps are:

• Passage of legislation providing for rulemaking authority for federal financial regulators over the spot market for crypto-assets that are not securities
• Address regulatory arbitrage including coordination, legislation regarding risks posed by stablecoins, legislation relating to regulators’ authorities to have visibility into, and otherwise supervise, the activities of all of the affiliates and subsidiaries of crypto-asset entities, and appropriate service provider regulation
• Study of potential vertical integration by crypto-asset firms

Take Away

There will be continued enforcement on behalf of Financial Regulators as it relates to crypto-assets existing rules and regulations, market participant registration requirements, banking laws, anti-fraud laws, securities laws, commodities and derivates laws, anti-money laundering laws, sanctions and consumer and investor protection laws; as well as coordination with law enforcement.

All financial entities that participate in the crypto-asset ecosystem ought to evaluate their interactions with crypto-assets that could generate risk and threaten the financial stability of the U.S.

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