In the wake of the recent turmoil, a host of regulators and policymakers have called for tighter oversight of the crypto sector to protect investors and ensure financial stability
The spillover of crypto markets into traditional financial markets remains limited, but there is an urgent need for the “rapid development and implementation” of consistent and comprehensive regulation for crypto asset issuers and service providers with regard to crypto asset holdings, including Stablecoins will meet the same standards as the rest of the financial system, the G7 group recently announced in its latest statement.
Meanwhile, the Bank for International Settlements (BIS) argued in a paper that the crypto sector is increasingly being used for speculation by less experienced retail investors and that the lack of crypto adoption by traditional banks has caused the growth of a “shadow crypto financial system.” . in which crypto exchanges played a dominant but largely unregulated role.
“The downside of limited bank adoption is a dominant role for novel ‘crypto exchanges,'” the paper said. “Compared to existing regulated exchanges for ‘traditional’ financial assets, regulatory and regulatory oversight of crypto exchanges — including consumer protection, market integrity, trading, disclosure, oversight and anti-money laundering, counter-terrorism financing — remains patchy at best.”
Retail investors generally did not believe in the libertarian ideas behind crypto assets like bitcoin and accepted that crypto exchanges have held their assets in custody, unlike blockchains, the paper argued. Major crypto exchanges such as Binance and Coinbase do not write every transaction to the blockchain due to the cost and energy required, and instead maintain an internal transaction ledger on a traditional programming language-type standardized database.
“Instead of relying on a trustless — ie, on-chain environment, a new set of agents has come to the fore, providing these markets with convenience, market access, transaction size, and liquidity in a manner similar to commercial banking and securities trading, albeit without the same level of regulatory and Oversight,” the paper says. “Crypto intermediaries … should be subject to the same types of regulation and oversight as intermediaries in economically equivalent asset classes. The purportedly decentralized nature of cryptocurrencies does not negate the need for these critical public policy functions.”
More data required
To counter future risks to the broader financial system, the BIS paper proposed improving the collection and publication of cryptocurrency trading data in more rigorous ways, such as through “embedded oversight” that collects information in distributed book-based finance and decentralized finance would aim to improve the quality of data available to regulators. “Data gaps could undermine authorities’ ability to holistically monitor and regulate cryptocurrencies.”
In fact, data gaps in the fight against money laundering have also been identified as regulators try to gather more information about the parties involved in crypto transactions. A recent proposal tabled in the European Parliament was for the introduction of the Financial Action Task Force (FATF) “travel rule” for purposes of crypto transaction surveillance, a move backed by the recent G7 statement.
Stablecoins in the mix
The G7 statement also called for greater disclosure and regulatory reporting for reserve assets that back stablecoins like Tether and the recently crashed TerraUSD. “The G7 remains committed to high regulatory standards for global stablecoins and adheres to the principle of equal activity, equal risk and equal regulation,” the G7 statement said. “No global stablecoin project should go live until it adequately meets relevant legal, regulatory and regulatory requirements through appropriate design and compliance with applicable standards.”
The BIS paper also warned of the potential of stablecoins to pose a systemic threat to the broader financial system, saying that risks in the “shadow” corners of the financial system could quickly find their way to regulated institutions. Left unaddressed, in the evolving crypto landscape, conventional and regulated intermediaries would increasingly be associated with an unregulated crypto financial system, the paper said. Therefore, the basic policy choice has been to either focus on a framework that allows for such linkages but enforces a level playing field in relation to the regulation and supervision of financial services, or to limit the degree of linkage between the two systems.
“The separation of both systems could prove to be a challenge on a global scale and make the former solution inevitable,” the paper reads. “Initiatives to promote regulatory clarity in addressing these potential risks … could help ensure a level playing field and ensure prudent risk management from a micro- and macroprudential perspective. In practice, this would mean applying stricter regulatory and regulatory oversight to crypto exchanges in relation to the provision of financial services…while applying a conservative prudential regulatory treatment of cryptocurrency risk.”
Meanwhile, Charles Randell, chairman of the UK’s Financial Conduct Authority, said in a recent speech that despite the UK government’s drive to create a world-leading market for cryptocurrencies, the regulator is unwilling to end oversight of the crypto sector in the UK to take on crypto assets, citing the speculative and volatile nature of the market.
Separately, the European Central Bank (ECB) said in its semi-annual Financial Stability Review that exposure to crypto by banks and other financial institutions could pose a large-scale threat to capital and damage investor confidence, lending and financial markets. “Systemic risk is increasing in line with the degree of interdependence between crypto assets and the traditional financial sector,” the ECB stated, adding that the highly leveraged trading offered by crypto exchanges has caused investors to withdraw funds have borrowed to buy greater exposure to crypto, which also increases risks to financial stability.
Additionally, data deficiencies in the industry are also hampering the assessment of financial risks, the ECN noted, warning that publications from crypto exchanges and data aggregators should be treated with caution.
Additional coverage by Reuters’ Francesco Canepa.