Crypto financial system needs regulatory foundation now to minimize risks to financial system in future, Fed leader asserts

The foundations for sound regulation of the crypto financial system must be established now before the crypto ecosystem becomes so large or interconnected that it might pose risks to the stability of the broader financial systems, the vice chair of the Federal Reserve said Friday.

In a speech at the Bank of England Conference in London, Federal Reserve Board Vice Chair Lael Brainard asserted that financial innovation has the potential to make financial services faster, cheaper, and more inclusive and to do so in ways that are native to the digital ecosystem. However, she indicated, innovation must face regulation.

“Enabling responsible innovation to flourish will require that the regulatory perimeter encompass the crypto financial system according to the principle of like risk, like regulatory outcome, and that novel risks associated with the new technologies be appropriately addressed,” she said.

The Fed vice chair opened her remarks by pointing to recent volatility in the crypto financial system and the vulnerabilities she said were exposed as a result. “While touted as a fundamental break from traditional finance, the crypto financial system turns out to be susceptible to the same risks that are all too familiar from traditional finance, such as leverage, settlement, opacity, and maturity and liquidity transformation,” she said. “As we work to future-proof our financial stability agenda, it is important to ensure the regulatory perimeter encompasses crypto finance.”

She acknowledged that the crypto financial system, despite recent upheaval (which accounts for severe losses by some crypto investors), is not yet so large or interconnected with the traditional financial system to pose a systemic risk. The timing for crafting regulation, she indicated, is appropriate.

“So this is the right time to ensure that like risks are subject to like regulatory outcomes and like disclosure so as to help investors distinguish between genuine, responsible innovation and the false allure of seemingly easy returns that obscures significant risk,” she said. “This is the right time to establish which crypto activities are permissible for regulated entities and under what constraints so that spillovers to the core financial system remain well contained.”

She offered several approaches to potential regulation:

  • Basic protections should be in place for consumers and investors. “Retail users should be protected against exploitation, undisclosed conflicts of interest, and market manipulation—risks to which they are particularly vulnerable, according to a host of research. If investors lack these basic protections, these markets will be vulnerable to runs,” she said.
  • Regulatory noncompliance and any gaps that may exist must be addressed among trading platforms in crypto-asset markets. “We have seen crypto-trading platforms and crypto-lending firms not only engage in activities similar to those in traditional finance without comparable regulatory compliance, but also combine activities that are required to be separated in traditional financial markets,” she said. “For example, some platforms combine market infrastructure and client facilitation with risk-taking businesses like asset creation, proprietary trading, venture capital, and lending.”
  • Whether engaged in traditional finance or crypto finance, all financial institutions must comply with rules combatting money laundering and financing of terrorism and to support economic sanctions. “Platforms and exchanges should be designed in a manner that facilitates and supports compliance with these laws,” she said. “The permissionless exchange of assets and tools that obscure the source of funds not only facilitate evasion, but also increase the risk of theft, hacks, and ransom attacks. These risks are particularly prominent in decentralized exchanges that are designed to avoid the use of intermediaries responsible for know-your-customer identification and that may require adaptations to ensure compliance at this most foundational layer.”
  • Regulatory gaps and adaptation of existing approaches to novel technologies must be addressed. “While regulatory frameworks clearly apply to DeFi (decentralized finance) activities no less than to centralized crypto activities and traditional finance, DeFi protocols may present novel challenges that may require adapting existing approaches,” she said. “The peer-to-peer nature of these activities, their automated nature, the immutability of code once deployed to the blockchain, the exercise of governance functions through tokens in decentralized autonomous organizations, the absence of validated identities, and the dispersion or obfuscation of control may make it challenging to hold intermediaries accountable. It is not yet clear that digital native approaches, such as building in automated incentives for undertaking governance responsibilities, are adequate alternatives.”

More specifically regarding bank regulation, Brainard said regulators will need to weigh “competing considerations” in assessing bank involvement in crypto activities ranging from custody to issuance to customer facilitation.

“Bank involvement provides an interface where regulators have strong sightlines and can help ensure strong protections. Similarly, regulators are drawn to approaches that effectively subject the crypto intermediaries that resemble complex bank organizations to bank-like regulation,” she said.

However, she said, bringing risks from crypto into the heart of the financial system without appropriate guardrails could “increase the potential for spillovers” and holds uncertain implications for the stability of the system.

“It is important for banks to engage with beneficial innovation and upgrade capabilities in digital finance, but until there is a strong regulatory framework for crypto finance, bank involvement might further entrench a riskier and less compliant ecosystem,” she asserted.

Regarding a central bank digital currency (CBDC), which the Fed has not committed to issuing, Brainard said a “digital native form of safe central bank money” could enhance financial stability. She said a CBDC could do so by providing the “neutral trusted settlement layer in the future crypto financial system.”

“A settlement layer with a digital native central bank money could, for instance, facilitate interoperability among well-regulated stablecoins designed for a variety of use cases and enable private-sector provision of decentralized, customized, and automated financial products,” she said. “This development would be a natural evolution of the complementarity between the public and private sectors in payments, ensuring strong public trust in the one-for-one redeemability of commercial bank money and stablecoins for safe central bank money.”

Fed Vice Chair Lael Brainard: Crypto-Assets and Decentralized Finance through a Financial Stability Lens