The Federal Reserve’s View: How to Balance the Regulation and Innovation of Cryptocurrency?

Federal Reserve Vice Chairman Michael S. Barr’s view:

I am here today to discuss what have we learned from the recent turmoil in the crypto industry?

And what role should the regulatory level play in supporting innovative technologies.

Despite recent events, we have not lost sight of the potentially transformative impact these technologies can have on our financial system. We need to be careful lest regulation stifles innovation. But the benefits of innovation can only be realized with proper regulation. I will talk about how to make regulatory expectations clear to banks. Finally, I will share some thoughts on stablecoins.

It’s not hard to find evidence discussing the need for encryption, but let me start with a recent personal history. Last month, I visited the Mississippi Delta to talk about financial inclusion and community development, and I spent a morning talking to a group of college students. When I asked, it turned out that most of the students I met had some crypto assets. This surprised me, because in my experience as a professor, most college students are usually strapped for money. To my surprise, many people who claimed to own crypto assets also said that they lost money, and they were not very happy about it.

This reminds me that crypto assets are not just held by people with enough money to speculate. One in five Americans say they own some form of cryptocurrency. Problems that have arisen in the cryptocurrency space over the past year may have affected a large portion of the public.

I find it better to understand financial innovations by putting them in a historical context, crypto assets, the technology behind them, and how the crypto industry interacts with the traditional financial system. Innovation in financial markets has long called into question the appropriate role of regulation. Of particular interest is how the regulatory framework can encourage innovation while supporting the safety and soundness of financial institutions and wider financial stability. Equally important is the need to protect the public from fraud and other abuses.

How to balance regulation and innovation and benefits and risks?

The challenge here starts with the timing mismatch. Innovation usually comes quickly, but it takes time for consumers to realize that they can make or lose money on new financial products. It may take time for market participants to understand the attendant risks and to come up with tools to manage them. Likewise, regulation involves a deliberative process—and it should because it needs to balance the risk that over-regulation will stifle innovation with the risk that under-regulation will cause significant damage to households and the financial system.

Long before cryptocurrencies became a regulatory and public policy issue, I struggled with how to think about innovation cycles in the context of the global financial crisis. New products are often developed slowly at first, with market participants unsure of their value or risks, but excitement and enthusiasm then lead to rapid growth, with new products flooding the market as a result. Participants are too quick to assume that they know how new products appear to work. New products may appear to be both safe and profitable, especially if they have not been tested by market pressures. When this mismatch between perceived understanding of risk and actual potential risks becomes apparent, the innovation cycle turns.

At the time, I was talking about some of the causes and consequences of the financial crisis. At the time, new types of financial products were so intertwined with the banking industry and the wider financial system that the shift in the innovation cycle had devastating consequences for homeowners, workers, businesses and our economy. Today, while the cryptoasset industry is still in its infancy and less prevalent, questions about how new financial products will affect the public, the economy, and financial stability are similar. Innovation has surged, and regulation has followed, trying to balance benefits and risks.

What are the benefits of cryptographic innovations?

Before discussing how we respond to developments in the crypto space through a regulatory approach, I would like to understand the potential public benefits of the underlying technology of crypto assets. These technologies will have a wide range of beneficial applications beyond crypto assets themselves.

Payment systems are critical to the average American. It’s highly resilient, but can also be slow and expensive. This is especially true for cross-border payments.

The underlying technologies of cryptoassets, including those enabling programmability, can bring new functionality or efficiencies to payment systems.

Proponents claim that distributed ledger technology, encryption and new methods of verifying transactions can be used to facilitate faster reconciliation, clearing and settlement, and reduce the cost of trading various traditional assets.

For example, by linking securities and cash markets in ways that are more difficult to achieve with our current financial infrastructure. Some actions can be automated using smart contracts, further increasing efficiency. The use of this technology could result in potential operational efficiencies and cost reductions. The Federal Reserve has devoted significant resources to exploring and understanding these technologies and their potential benefits, as well as the risks associated with these innovations.

Lessons from the “Crypto Bear Market”

In stark contrast to the potential benefits of these technologies, many people’s hopes and enthusiasm for crypto assets have been met with disappointment and sometimes devastating losses.

Robert Shiller has described how Bitcoin has become a prime example of what he calls a contagious economic narrative. The story of Bitcoin’s value proposition touches on people’s fear of government control and promises that through technological excellence, a new product can generate untold wealth. But when it comes to certain crypto assets, some of them have no intrinsic value beyond their value. Their owners believe that the laws of gravity will eventually apply, just like the tulip mania in Holland more than 400 years ago. Experience has shown that crypto assets may be subject to the same fundamental liquidity and credit risks as traditional assets and may be highly correlated with other traditional risks rather than being hedged against such risks.

While providers of crypto assets represent to clients that they are protected through the decentralized nature of the underlying technology, clients are often at greater risk because these providers often find ways to operate outside of robust oversight and regulatory systems.

Without compliance, customers do not have access to the information they need to assess and mitigate risk. Investors lost the structural protections they had relied on for decades.As a result, many people fall victim to typical cases of fraud and abuse

Some of them are aptly classified as high-tech Ponzi schemes. Furthermore, while cryptoassets are hyped as “decentralized,” new, rather centralized intermediaries have emerged that do not, or do not abide by, proper regulation and oversight, causing long-term harm to consumers. To further complicate matters, these entities often seek out jurisdictions with loose or underdeveloped legal and regulatory frameworks for financial activities. The lack of harmonized home country supervision and coordination with host country regulators reignites the kind of abuses that banking regulators have long since abolished. While this type of cross-jurisdictional regulatory arbitrage is not new, the Crypto nature of these activities presents a greater opportunity to extend the reach of such entities globally.

For example, the notable crash of the FTX crypto asset trading platform has reportedly wiped out the assets of a million people, costing them billions of dollars. Unfortunately, this is not the only example. Since last summer, we have seen one crypto intermediary after another fail. As these cases progressed through bankruptcy court, we saw signs of misuse of client funds, misrepresentation, confusion about the availability of deposit insurance, and potential fraud.

Cryptocurrencies have also been involved in many cases of illegal financing. Cryptoassets pose significant money laundering and terrorism financing risks due to the anonymous participants that are parties to the transaction, the ease and speed of transfers, and the general irrevocability of transactions — all of which make cryptoassets attractive for money laundering and terrorism financing. Indeed, law enforcement agencies — including the Financial Crimes Enforcement Network and the Department of Justice — have taken numerous public enforcement actions against entities or individuals dealing in cryptoassets.

Such conduct can cause significant damage to investors and consumers, as well as our financial system. Federal banking regulators, including the Federal Reserve Board, have a statutory duty to ensure that the activities of the entities we regulate are conducted in a safe and sound manner and in compliance with all applicable laws. While events in the crypto space have so far had limited overall impact on Fed-regulated banks, recent experience suggests that crypto may pose risks to these banks. In response, we have worked with other federal banking regulators to provide clarity and guidance on what is permissible, safe, consistent with anti-money laundering and counter-terrorism financing laws, and consumer and investor protections. We have developed regulatory expectations for banks engaging in new product types and activities. As noted above, this is not just a domestic issue. We also work with our international counterparts to minimize the potential for regulatory arbitrage across jurisdictions.

Fed Regulates Banks’ Approach to Cryptocurrencies

An overarching principle of the Fed’s financial regulation is that substantially the same activities should be subject to the same regulation regardless of where or how they occur or the terminology used to describe them. We have a somewhat complex financial services regulatory framework in the US with several regulators overseeing financial services activities. But we know how important it is to participate on a level playing field for entities interested in using new technologies to provide financial services. This is why we work closely with other banking regulators to develop a consistent approach. Our overall position is that at this stage of development, banks should take a prudent and prudent approach to engaging in crypto-asset-related activities and the crypto industry.

An overview of recent Fed actions

For decades, federal banking regulators have articulated supervisory expectations for managing, monitoring, and controlling security and soundness risks. These expectations are often principle-based—meaning they can apply to a wide range of circumstances. Given the growing interest in crypto asset activity, we strive to provide clear and transparent guidance. Last August, we published a supervisory guidance letter for banks engaging in or seeking to engage in crypto-related activities. 9 In our letter, we remind companies that the first step in considering engaging in encryption-related activities is to determine that these activities are legally permissible and that there are adequate controls in place to ensure that they can be conducted in a safe and robust law. Against the backdrop of possible crimes that some cryptocurrency companies are being investigated for, this is not a box-checking exercise. Our letter also lets banks know that they should notify the Fed if they intend to engage in activities related to crypto assets and engage in a robust regulatory dialogue.

The letter effectively says, “Stay out of the way and think about risk management later.” It states, “Banking organizations regulated by the Federal Reserve should have systems and controls in place to carry out activities related to crypto assets.”

A lot happened in the crypto world over the next few months, including the previously discussed turmoil. On January 3, after learning of these developments, the board and other bank regulators issued another statement advising banks to focus on a list of several key risks. The list ranges from fraud and scam risks for cryptocurrency players to money laundering and terrorism financing, stablecoin operating risks.

In late January, the Commission issued a policy statement making it clear to the banks we supervise that the Commission will apply the same licensing standards to activities, including cryptoasset-related activities, regardless of a bank’s deposit insurance status.

The statement makes it clear that we may not consider it safe and secure for banks to directly own crypto assets on their balance sheets. Additionally, we clarified that banks that we oversee that seek to issue stablecoins or USD tokens must demonstrate that they have controls in place to do so in a safe and robust manner, and that they need to obtain a No Objection Notice from the Federal Reserve before proceeding director.

On 23 February, we further clarified our supervisory expectations through another statement issued jointly with other banking regulators. 13 The statement also draws on recent regulatory experience. This statement underscores to our regulators that they need to understand the liquidity risks associated with certain crypto industry-affiliated deposits. We always expect banks to assess and manage the liquidity risk of their funding sources. As the statement makes clear — and has become apparent over the past few months — depositors in the crypto industry may own assets that could be affected by volatility in the industry. Such volatility can lead to unpredictable, rapid, correlated deposit inflows and withdrawals, so the liquidity risk of their deposits certainly requires extra attention. These liquidity problems are particularly acute for banks whose balance sheets are largely funded by such deposits.

Likewise, we take these steps to make it clear that we have the same expectations of all agencies we oversee and all agencies seeking to engage in new activities. These expectations are not new. We expect regulated entities to ensure that they conduct their activities in a safe and sound manner and comply with all relevant laws, including anti-money laundering laws. These public statements are transparent and provide the same information to everyone, including smaller banks that may not have large teams of analysts assessing industry developments, larger banks with more resources, and of course the public. We plan to continue issuing such guidance as we continue to review the industry’s activities.

In addition to continuing to share what we learn with the public, we have increased our oversight of these activities. We are creating a dedicated team of experts who can help us learn from new developments and ensure we keep up with innovations in the field.

Special risks associated with stablecoins

I want to end today’s discussion by talking about stablecoins. As Chairman Powell said, stablecoins are a type of private currency, and the long and chaotic history of private currencies in the United States demonstrates the need for strong regulation and oversight. Any entity that issues dollar-denominated currency and invokes the Fed’s trust is subject to federal prudential oversight. I’m not saying anything new here. This is what we have always done.

Stablecoin issuers seek to own, but do not have the same characteristics as federally insured bank deposits. Stablecoin issuers say their liabilities can be redeemed on demand at par, or dollar-for-dollar. In reality, however, the value of the assets backing the liability can fluctuate. Even if the assets backing the claims are of high quality, they may not be realized immediately, and the operational risk is quite high. As we see so often, savers sometimes want or need their money right away, especially during times of stress. This mismatch of value and liquidity is the root of a typical bank run. The issuer is not regulated by the Federal Reserve and lacks capital and liquidity to back it up. In contrast, the banks we supervise are well protected from bank runs through a robust set of supervisory requirements.

Consider the consequences of widespread adoption of a stablecoin as a payment method without proper oversight and regulation, which some stablecoin developers target. Stablecoins have the potential to scale rapidly due to network effects. An unregulated, unregulated, deposit-like asset could be hugely disruptive, not only for financial institutions, but also for those who might depend on it if it were widely adopted. We must learn from the past to ensure that we do not allow new forms of unregulated private money to be exposed to the classic forms of run risk, with associated spillover and systemic effects on households, businesses and the wider economy.

in conclusion

This brings me back to the central point of my statement, which was the need to strike a balance between innovation and security. Our goal is to build guardrails while making room for innovations that can benefit consumers and the financial system more broadly. We are working with other banking regulators to consider whether and how certain crypto asset activities can be carried out in a manner consistent with the safety and soundness of banks. We are also working to further articulate our views on risk and effective risk management practices across a range of crypto-related events. We will continue to be transparent with the banking industry and the public about our expectations. We will also work with other agencies to adapt our approach to ensure the same risks are treated in the same way. As we continue our efforts, we will support innovation by building the regulation that is essential to sustainable, safe and transparent markets. Thanks.

Article from the Board of Governors of the Federal Reserve System

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