Regulators have set their sights on cryptocurrencies as a potential risk to the financial system. |
Regulators are taking a harder look at the cryptocurrency sector and warning that its volatile ascent poses risks to broader financial stability.
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The Financial Action Task Force, an intergovernmental agency that sets global standards on anti-money laundering, has called for increased oversight of backed decentralized finance, or DeFi, apps, while the G-20 has raised concerns about both DeFi and stablecoins, which act as a bridge between fiat currencies like the U.S. dollar and cryptocurrencies.
Federal agencies across the U.S. government are sounding alarm bells about the need to mitigate and better understand the risks posed by digital assets for consumers, businesses, the broader financial system and the climate. Most notably, U.S. President Joe Biden issued an executive order in March that called for a whole-of-government approach to dealing with cryptocurrency risks.
Cryptocurrency assets are a small but fast-growing portion of global financial assets with market capitalization growing by 3.5 times in 2021 to $2.6 trillion before falling back to $2.04 trillion in 2022. The potential for DeFi and associated stablecoins to become a key part of financial markets poses risks as cryptocurrency assets are highly volatile and susceptible to fraud. The interconnectedness of the traditional financial system poses an additional vulnerability. High-profile investors such as Warren Buffett and Bill Gates have warned that cryptocurrency assets are a bubble doomed to burst.
"Regulators, as well as legislators at a variety of levels, are contemplating how to apply the regulations we already have and the frameworks we already have to companies that deal in digital assets," Gil Luria, a technology strategist at D.A. Davidson and cryptocurrency expert said in an interview.
The cryptocurrency sector does not present a significant financial stability risk today, but its rapid rise and the obscurity of its inner workings means stepped-up oversight is appropriate, said Timothy Massad, a former chairman of the Commodity Futures Trading Commission, or CFTC, which oversees U.S. derivatives markets. Improving current regulations would help mitigate the risks.
"Stablecoins are growing quickly, so they could become financial stability risks," Massad said in an interview.
Governments move
The SEC and CFTC have already taken a number of actions in the cryptocurrency space. The SEC on April 27 sued a cryptocurrency venture, alleging fraud linked to an automated digital asset trading bot. That came just two months after the SEC reported that a cryptocurrency lending platform agreed to pay $100 million in penalties for failing to register the offers and sales of its retail product.
The CFTC, meanwhile, is weighing whether to approve a cryptocurrency exchange's request to clear derivatives trades as a clearing organization. Cryptocurrency lobbying efforts have risen from $2.2 million spent in 2018 to $9 million in 2021, and the number of lobbyists rose to 320 in 2021 from 115 in 2018, according to a March 8 report by Public Citizen, a consumer advocacy nonprofit.
Regulators face the challenge of understanding the sheer number of cryptocurrency assets and the fast-moving technology involved, in addition to figuring out the different responsibilities of governmental agencies. Finding consensus on such issues poses its own challenges, especially on Capitol Hill where partisan gridlock is the norm.
U.S. regulators — including the CFTC, the Federal Reserve Bank of Boston, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency — referred requests for comments to public statements on cryptocurrency, while others did not return inquiries from S&P Global Market Intelligence.
Opponents to regulation have said the proposed rules are too hard to implement and would strangle the industry or create undue burdens on cryptocurrency holders. There is also concern that regulation becomes outdated as the technology changes or becomes obsolete, said Lindsey Kelleher, a senior policy manager for Blockchain Association, a lobbying group that is actively fighting a proposed cryptocurrency mining ban in New York.
"It's a signal that we're entering the mainstream," Kelleher said of the regulatory attention on the industry.
DeFi's rapid growth
DeFi allows users to lend, borrow and trade directly in cryptocurrencies to retail investors, most commonly ethereum. Stablecoins provide the advantages in transaction speed of a digital currency and remove the volatility in value associated with cryptocurrencies like bitcoin.
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DeFi grew rapidly in 2021 as the opportunity to participate in direct lending or trading without the time and fees associated with intermediaries, such as brokers, banks or exchanges, proved attractive to holders of cryptocurrency to earn interest through lending.
Transactions are instead completed by "smart contracts," a computer code that automates the process of transactions on a blockchain, a digital ledger that does not need the approval of a central authority.
"This is a serious long-term challenge to traditional financial institutions," said Charlotte Principato, financial services analyst at decision intelligence company Morning Consult. "It could lead to deterioration of [financial institutions'] relationships with customers if they begin to manage their finances through decentralized means."
The total value locked in — the amount of cryptocurrency committed to smart contracts —
Cyberthreats pose a serious risk to cryptocurrency assets.
Hackers stole a record $3.2 billion in cryptocurrency in 2021 and are poised to take even more in 2022, according to blockchain data company Chainalysis. In the first three months of the year, hackers have taken $1.3 billion from cryptocurrency exchanges, platforms and private holders.
"The market is developing better custody tools and security tools around digital assets, but they're not as robust as the security tools that we have around our traditional banking system," said Luria. "The exposure to losses based on cybercrime [is] higher for digital assets."
Stablecoin and financial stability
Another risk posed by cryptocurrency products is the potential for a run on stablecoins. Investment in stablecoins has grown sharply, but there are widespread concerns about regulatory compliance, quality and sufficiency of reserve assets, and standards of risk management and governance.
A run on stablecoins risks destabilizing cryptocurrency markets and amplifying the effects of other shocks to broader financial systems and the economy, according to a 2021 U.S. government interagency report.
As the market grows, connections between cryptocurrency assets and both financial markets and systemically important financial institutions will grow.
"Were a major stablecoin to fail, it is possible that liquidity within the broader crypto-asset ecosystem (including in DeFi) could become constrained, disrupting trading and potentially causing stress in those markets," the Financial Stability Board wrote in its report to the G-20. "This could also spill over to short-term funding markets if stablecoin reserve holdings were liquidated in a disorderly fashion."
The largest stablecoin is Tether, which is run by Tether Ltd. and has a market cap north of $80 billion. Tether issues tokens that are pegged to the U.S. dollar on a one-to-one basis and are backed by Tether's reserves, which include assets like Treasury Bills, commercial paper and certificates of deposit and money market funds. In 2021, the CFTC ordered Tether to pay $41 million for misleading claims that the company had sufficient U.S. dollar reserves to back all of its tokens in circulation. Tether said in a statement at the time it has always maintained adequate reserves and there was no finding that its tokens were not fully backed at all times.
Tether has never refused a redemption and has the highest trading volume and liquidity of all the stablecoins, the company said in an email. Tether said it has diversified its exposure with limits on individual issuers of commercial paper and on regional exposure and noted the most recent report on its reserves showed a reduction in commercial paper investments.
"The reduction in commercial paper exposure comes as a response to community feedback and is consistent with Tether’s investment policy and risk framework," the company said.
Consumer support
Consumers generally favor regulation of cryptocurrency assets, according to research by Morning Consult. A survey of 4,400 U.S. consumers found that 18% wanted regulation of cryptocurrency assets to be tighter than for traditional assets, with 28% wanting equally strong regulation and just 12% preferring lighter touch regulation.
"The main reason consumers own cryptocurrency is to make money," Principato said. "As long as they are able to do that, even if there is more regulation, they will continue to purchase it and the sector will grow."