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Financial regulators take aim at crypto-finance

September 13, 2023

Over the summer, the Bank for International Settlements (BIS) and the Financial Stability Board (FSB) published important reports about the risks inherent in crypto-finance.  They make unpleasant reading for those crypto-bro’s who, despite the implosion of FTX and the travails of Binance, remain convinced that it is only a matter of time before crypto-finance supplants traditional finance and old-style financial institutions.

The crypto ecosystem, key elements and risks, published by the BIS in July, concludes that, “crypto’s inherent structural flaws make it unsuitable to play a significant role in the monetary system”.  Meanwhile, the FSB, after stating that its particular focus relates to the risks posed to financial stability, proceeds to list ten other risks arising from crypto-assets, including Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT), data privacy, cyber security, and consumer and investor protection.  The FSB’s document is entitled Global Regulatory Framework for Crypt-Assets Activities.

The two key themes that run through both the BIS and the FSB documents are that what happens in the crypto-finance can (and does) effect what happens in traditional financial markets, and that crypto-finance replicates many of the functions of traditional finance and faces the same risks as those seen in traditional finance.

For the FSB, the conclusion is obvious: “Crypto-asset activities must be regulated based on their economic functions and the risks they pose, irrespective of the technological means used.” The FSB is working with other standard setters to facilitate the creation by national financial supervisors of comprehensive and globally consistent regulations on crypto-asset activities.  The Board divides its own recommendations into two areas: crypto-asset activities and global stable coins (GSCs).  Stable coins are covered by the first area, but stable coins that could be widely used as a means of payment and/or store of value across multiple jurisdictions (‘global’) will be subject to separate, additional regulations, if the FSB has its way.

The BIS paper provides a comprehensive overview of the risks that, it believes, arise from crypto finance.  These include weak controls and governance, the vulnerability of underlying blockchains to disruption, the immutability of smart contracts (and so the inability to correct errors after they have occurred), and the risk that developing countries could unwillingly import exchange rate risks through stable coins that are pegged to other countries’ fiat currencies. The BIS is scathing in its conclusion that ‘crypto has so far failed to harness innovation to the benefit of society”, and that it remains “largely self-referential.”

But crypto enthusiasts can take some encouragement from a third paper, published in July by the Bank for International Settlement’s Innovation Hub (BISIH): “Lessons learnt on CBDCs” (Central Bank Digital Currencies). Ninety-three per cent of countries are engaged in some form of CBDC work, the BISIH says, with almost a quarter of central banks piloting a retail CBDC.

BISIH has a series of projects running in parallel to test the viability (technical, legal, ease-of use, etc) of different types of CBDCs (retail, wholesale, domestic, cross border, etc).  The results will be available to national authorities developing their own digital currencies.

So, how should board directors and risk professionals respond to the latest work from the BIS and the FSB?  I suggest that there are three points to take away.

Firstly, regulation of crypto based activities is coming, and it will be intrusive, just as regulation of traditional finance is intrusive.  Bleating by crypto-firms that crypto has no physical presence (and so cannot be regulated by national authorities), and that crypto finance is so ‘different’ that it must lie beyond the regulatory perimeter will fall on deaf ears.  The regulators have heard it all before.  And when new financial activities are regulated, that regulation creates winners and losers.  Some high-flying firms lose their swagger when they have to adjust to the new regulatory and legal regime, while others may thrive in a more structured market. So, now is the time for directors and risk professionals to start working out which firms will benefit, and which will lose in a heavily regulated crypto financial system.

Secondly, the interface between crypto and traditional finance is porous, and as crypto finance expands the risks that it will pose to traditional finance will increase.  Directors and risk professionals need to understand the channels through which risks can be transmitted from crypto finance to traditional finance, and the likely impact of those transmissible risks on their own balance sheets and profitability.

Finally, CBDCs will become a reality in major economies.  Regulated banks already have strong and multi-faceted relationships with their central banks that are vital to the functioning of financial systems and to the health of the banks themselves.  Directors and risk professionals need to be thinking how aspects of that relationship will be enhanced, changed, and perhaps diminished, when central banks add a new method of issuing currency, alongside the printing of cash and the creation of monetary assets.

 

Andrew Cunningham is the Chairman of ARC Ratings Ltd and ARC Ratings SA, and a Visiting Professor at the London Institute of Banking and Finance.  He is currently writing a Guidance Note for the Council for Islamic Banks and Financial Institutions (CIBAFI) on the role that Digital Finance can play in Shari’ah-compliant banks.

Tags: Andrew Cunningham
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