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FSOC: Unregulated crypto could pose threat to financial system

The Financial Stability Oversight Council warned that cryptocurrencies could pose risks to the financial system if their overall scale or link with traditional banking grows without regulation and oversight.

“The rapid growth of digital asset activities, including stablecoins and lending and borrowing on digital assets trading platforms, is an important emerging vulnerability,” the FSOC said in a new report Monday.

The FSOC — created following the financial crisis to monitor threats to the financial system — says potential drops in asset prices, financial exposures between crypto firms, funding mismatches and the risk of runs, and the use of leverage are all risks to the financial system.

Many crypto-asset activities lack basic rules to protect against the risk of runs or prevent high levels of leverage, according the report. Regulators say there are major gaps in the regulation of crypto assets. And since crypto firms lack consistent, uniform regulations, authorities say they can take advantage of gaps in the regulatory system.

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“Crypto-asset prices appear to be primarily driven by speculation rather than grounded in current fundamental economics,” the report says.

Cryptocurrency & Bitcoin on U.S Currency Investments Background with the United States Capitol Building. Digital currency is used for verified transactions while  maintaining a digital record in  a decentralized system using cryptography, rather than by a centralized authority.
(Getty Creative) (Douglas Rissing via Getty Images)

The council — composed of the heads of major federal financial regulatory agencies, including Treasury, the Federal Reserve, and the Securities & Exchange Commission — views stablecoins as the most pressing risk. Regulators, who have voiced concerns about stablecoins as far back as last November, say stablecoins are susceptible to runs if not regulated with capital and liquidity standards. Officials point to the run on algorithmic stablecoin TerraUST this spring that led to a separate, though less severe run, on Tether, the largest stablecoin measured by market cap.

Authorities also see vulnerability where stablecoin issuers hold assets in the traditional financial system. They say traditional asset markets could experience dislocations if stablecoin activities were to reach significant scale and if runs on stablecoins were to lead to fire sales of traditional assets like Treasuries or commercial paper backing the stablecoins.

The report notes that while interconnections with the traditional financial system are relatively limited, they could potentially increase rapidly. Officials offer the example where banks could increase exposures to crypto markets through lending and securing loans with crypto assets. It notes, though, that overall, the level of involvement by the banking system in crypto is “relatively low” right now and banks’ overall balance sheet exposure to crypto remains limited.

Another area regulators point to as a glaring gap: limited direct federal oversight of the spot market for crypto assets that are not securities. The report notes markets may not have strong rules to ensure orderly and transparent trading, prevent conflicts of interest and market manipulation, and protect investors and the economy more broadly.

Given the risks, FSOC offers 10 recommendations to rein in the risks of crypto, including Congress passing new legislation to give regulators authority over the spot market for crypto assets that aren’t securities; legislation to regulate stablecoins; and legislation that would give regulators authority to see across a crypto firm’s full business that has multiple subsidiaries operating under different regulations.

The report also encourages agencies to continue to enforce existing rules and regulations and coordinate with each other to regulate crypto companies, such as stablecoin issuers or crypto-asset platforms, particularly in cases where different players with similar activities may be subject to different regulations.

This report comes at the direction of President Biden’s executive order in March that tasked federal government agencies with studying cryptocurrencies and proposing how to best regulate them. The U.S. Treasury warned in three new reports last month that cryptocurrencies pose meaningful risks for consumers, investors, and businesses if not properly regulated. The FSOC has been monitoring cryptocurrencies and distributed ledger technology since 2015.

The FSOC says it will continue to monitor risks posed by crypto.

Jennifer Schonberger covers the Federal Reserve, policy, and cryptocurrencies for Yahoo Finance. Follow her at @Jenniferisms.

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