By: Federal Reserve Vice Chairman Michael S. Barr
Compilation: Carol Wu said blockchain
Here today we discuss what we have learned from the recent turmoil in the crypto industry, and what role oversight and regulation should play in helping banks manage their interactions with the industry and the innovative technologies that support it. Despite recent events, we have not lost sight of the potentially transformative impact these technologies can have on our financial system. At the same time, we need to be careful lest regulation locks in the power of incumbents or stifles innovation. However, the benefits of innovation can only be realized if appropriate guardrails are in place. I will talk about how we are trying to give the banks we supervise a clear understanding of what we have learned and our supervisory expectations. Finally, I will share some thoughts on stablecoins.
In fact, it is not difficult to find enough evidence to demonstrate the necessity of encryption. First, I can start with my recent personal experience. I visited the Mississippi Delta last month to talk about financial inclusion and community development, and I spent the morning talking to a group of college students, and when I asked and found that most of the students I met had some crypto assets, let I was shocked, because in my experience as a professor, most students are usually on a tight budget. However, I am not surprised that many people who own crypto assets also said that they lost money.
This reminds me that crypto assets are not exclusive to the well-funded and speculative. About one in five Americans say they already own some form of cryptocurrency. And, over the past year, problems in the cryptocurrency space have affected a large portion of the public.
When I think about what to do with crypto assets, the technology behind them, and the interplay between the crypto industry and the traditional financial system, I find it helpful to put recent innovations in historical context. The long history of innovation in financial markets raises questions about 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, the public also needs to be protected from fraud and other abuses and influences.
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 also take time for market participants to understand the attendant risks and figure out ways to manage them. Similarly, regulation involves a deliberative process, as it needs to balance the risk that over-regulation may stifle innovation with the risk that under-regulation may cause significant damage to households and the financial system.
Long before cryptocurrencies became an issue of regulation and public policy, I struggled with how to think about cycles of innovation in the context of the global financial crisis. New products often start out slowly, with market participants unsure of their value or risks, but excitement and enthusiasm lead to rapid growth, and new products flood the market. If the participants at this time have not been tested by market pressure, they may prematurely think that they know how the new product works, and that the new product looks safe and profitable. The innovation cycle turns when the actual potential risks become a clear mismatch.
While I’m talking about the ins and outs of the financial crisis, new types of financial products have become so intertwined with banks and the wider financial system that the turn in the innovation cycle has been devastating to 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.
Potential benefits of innovative technologies
Before discussing how we respond to developments in the crypto space in our approach to surveillance and regulation, I want to understand the potential public interest in the technology underlying crypto assets. It is often said that these technologies will have a wide range of beneficial applications that go beyond crypto assets themselves.
We all know that payment systems are critical to the daily lives of Americans. The payment system is highly resilient, but at the same time it is slow and expensive, especially when it comes to cross-border payments. The technology of crypto assets, such as technology to achieve programmability, can bring new functions 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. While this is difficult to achieve with our current financial infrastructure, the use of this technology can lead to potential operational efficiencies and cost reductions. Currently, the Federal Reserve has devoted significant resources to exploring and understanding these technologies, their potential benefits, and the risks associated with these innovations.
Some Lessons from “Cryptocurrency Winter”
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 even devastating losses. Robert Shiller describes how Bitcoin is a classic example of a contagious economic narrative. The story of Bitcoin’s value proposition exploits 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 actual intrinsic value other than the beliefs of their owners. Experience has shown that crypto assets may be exposed to the same basic liquidity and credit risks as traditional assets, and may be highly correlated with other traditional risks.
While providers of crypto assets represent to clients that they are protected by the decentralized nature of the underlying technology, clients often face greater risk as these providers often find ways to operate outside of robust oversight and regulatory systems. In the absence of regulation, customers do not have access to the information they need to assess and mitigate risk. And investors don’t have the structural protections they’ve relied on for decades. As a result, many have fallen victim to classic cases of fraud and abuse, some of which are aptly classified as high-tech Ponzi schemes. Furthermore, while cryptoassets are hyped as “decentralized,” new and rather centralized intermediaries have emerged that do not or do not comply with proper regulation and oversight, causing long-term harm to consumers . To further complicate matters, these entities tend to seek out jurisdictions with loose or underdeveloped legal and regulatory frameworks for financial activities. In fact, due to the lack of unified home country supervision and coordination with host country regulators, banking regulators have long ago stopped this abuse. While this type of regulatory arbitrage across jurisdictions is not new, the Crypto nature of these activities presents greater opportunities to expand the reach of such entities to global clients.
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. And, since last summer, we have seen one crypto intermediary after another fail. As these cases progressed in 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 as 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 Financial Crimes Enforcement Network, Office of Foreign Assets Control, and the Department of Justice, have taken numerous public enforcement actions against entities or individuals dealing in cryptoassets.
But such actions 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 generally had limited impact on Fed-regulated banks so far, recent experience suggests that cryptocurrencies may pose risks to these banks. In response, we have worked with other federal banking regulators to provide clear guidance on what is permissible, safe, consistent with anti-money laundering and counter-terrorism financing laws, and consumer and investor protections. Currently, we have developed regulatory expectations for banks to engage in new product types and activities. As noted above, the potential for cross-jurisdictional regulatory arbitrage is minimized when cooperating with international counterparts.
Fed Regulates Banks’ Approach to Cryptocurrencies
One of the overriding principles of the Federal Reserve’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. That’s why we work closely and develop a consistent approach with other banking supervisors. Our overall position is that, at this stage of development, banks should take a cautious approach to engaging in activities related to crypto assets and the crypto industry in general.
An overview of recent Fed actions
For decades, federal banking regulators have articulated supervisory expectations for managing, supervising, and controlling security and soundness risks. These expectations are often principle-based, meaning they can apply to a wide range of situations. 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 cryptocurrency-related activities. In the letter, we remind businesses that when considering engaging in cryptocurrency-related activities, they should first determine that these activities are legally permissible and that there are adequate controls in place to ensure that these activities can be conducted in a safe and robust manner and in compliance with all applicable laws . Our letter also lets banks know that if they intend to engage in activities related to crypto assets, they should notify the Fed and engage in a robust regulatory dialogue. The letter states that “banking organizations regulated by the Fed should have systems and controls in place to conduct activities related to cryptoassets in a safe and secure manner prior to commencing such activities.”
A lot happened in the crypto world over the next few months, including the turmoil discussed earlier. On January 3, after learning about these circumstances, the board of directors and other bank regulators issued another statement advising banks to focus on a list of several key risks. The list ranges from fraud risks for cryptocurrency players to money laundering and terrorism financing to the risks of stablecoin operations.
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 made it clear that we do not believe it is safe and secure for banks to directly own crypto assets on their balance sheets. In addition, if the banks we regulate want to issue stablecoins or USD tokens, they must demonstrate that they have the controls in place to do so in a safe and robust manner, and they will need to obtain no objection notice from the Fed supervisors before issuing .
On 23 February, we further clarified regulatory expectations through another statement issued jointly with other banking regulators. This statement emphasizes to our regulated institutions that they need to be aware of the liquidity risk of deposits associated with certain crypto industries. We have always expected banks to be able to assess and manage the liquidity risk of their funding sources. As clearly stated in the statement, it has also become apparent over the past few months that depositors in the crypto sector own assets that can be affected by volatility in the sector. Such volatility can lead to unpredictable, rapid, correlated deposit inflows and withdrawals, so the liquidity risk of their deposits certainly requires additional attention. The liquidity problem is particularly acute for banks whose balance sheets derive a significant portion from such deposits.
Likewise, we take these steps to make it clear that we have the same expectations of all agencies we oversee and those seeking to undertake new activities. These expectations are not new and 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 general public. We plan to continue issuing such guidance as we continue to research and review the industry’s activities.
In addition to continually sharing what we learn with the public, we have increased our oversight of these activities. We are creating a dedicated team of experts to help us learn from new developments and ensure we are at the forefront of innovation in this industry.
Special risks associated with stablecoins
I want to end today’s discussion by talking about stablecoins. As Chairman Powell said, a stablecoin is a private currency, and the U.S. private currency has a long and messy history, which shows the need for strong regulation and oversight. Any issuance of dollar-denominated currency and the use of the Fed’s trust would be subject to federal prudential oversight.
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 may 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. Issuers are not regulated by the Federal Reserve and lack capital and liquidity to back them up. By contrast, the banks we supervise are well protected from bank runs through a robust set of supervisory requirements.
We can imagine the consequences if stablecoins are not properly supervised and regulated as a widely adopted payment method. Stablecoins have the potential to scale rapidly due to network effects, and this could be costly for deposit-like assets, not only for financial institutions, but also for those who rely on stablecoins. If it becomes widely adopted, we must learn from past experience to ensure that we do not have the typical operational risks of new forms of unregulated private money, with the associated spillover and Systemic impact.
Finally, back to the central point of the statement, which is the need to balance innovation and safeguards. Our aim is to create guardrails while leaving room for innovation to benefit consumers and the financial system more broadly. We are currently working with other banking regulators to consider whether and how certain crypto asset activities can be conducted 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 communicate our expectations with the banking industry and the public. 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 guardrails that are essential to sustainable, safe and transparent markets.