FSOC Says Digital Assets May Create System Risk
Commentary by Steven Lofchie
In a new report, issued pursuant to EO 14067 ("Ensuring Responsible Development of Digital Assets"), the Financial Stability Oversight Council ("FSOC") asserted that digital assets could pose risks to U.S. financial stability.
In the report, FSOC asserted that:
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many crypto activities do not have risk controls against runs or the use of excessive leverage;
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crypto values are driven by speculation, are volatile and may not be tied to current profits or cash flows;
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crypto firms are interconnected with each other; and
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a limited number of firms provide key services to the digital asset markets.
FSOC also identified regulatory issues including:
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the failure of crypto securities, brokers or markets to be registered with the SEC;
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fraud by market participants;
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the absence of a regulator for spot digital assets (presumably those assets that are not securities); and
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crypto organizations can operate through different legal entities and crypto legal entities may provide different services in the same legal entity.
FSOC recommended:
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establishment of regulatory authority for spot crypto-assets that are not securities (presumably under the CFTC);
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legislation to regulate stablecoins; and
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a study of digital asset financial groups.
Commentary
The White House recently issued a framework for the regulation of digital assets which highlights how digital assets can be implicated in every major problem in the world. (See prior coverage.) The FSOC report likewise associates digital assets with many of the world's current problems.
Digital assets markets have serious issues, including fraud on retail investors. This report makes no meaningful effort to distinguish between different types of digital assets such as true cryptocurrencies, stablecoins, smart contracts and those that may be traditional securities represented on the blockchain. It raises the concern that entities and products have not registered with the SEC, but says nothing about the SEC's failure to even attempt to develop a regulatory scheme appropriate to digital assets. It manages to find all kinds of systemic risk, but concedes that "financial institutions in the traditional financial system have had largely limited interconnections with the crypto-asset ecosystem" and that very few venture capital funds have meaningful exposures to digital assets. The report complains that related financial activities may be performed by the same legal entity or by related but different financial entities. (Isn't that equally true of traditional financial services organizations?)
At a time of very high inflation, rising energy and food prices, massive governmental deficits and disruptions in relative currency values, there is no shortage of systemic risks. To be blunt, an asset class that can lose 70 percent of its value without hammering a single bank, broker-dealer, registered investment company or member of the S&P 500 is not one of them.
The structure of FSOC - it is made up of members of one political party that may be incentivized to further the views of the current administration - may diminish its ability to serve as an independent watch dog of systemic risk. (See prior coverage.) The FSOC report does not alleviate those concerns. A wider variety of viewpoints would serve FSOC's stated goal. (See, e.g. FRB Governor Michelle R. Bowman's speech.) Had someone such as Governor Bowman been permitted to participate in the FSOC report, there might have been a thoughtful dissent.
There are, of course, many reasons for this report to be so skewed. Perhaps federal financial regulators disfavor decentralized finance - if so, it should make a forthright case; or, perhaps, the administration may be seeking to clear the playing field of potential competitors (i.e., stablecoins) as it paves the way toward issuing a central bank digital currency.