• A recent digital asset report (“Report”) issued by the Financial Stability Oversight Council (“FSOC”) criticized many digital asset market activities and market participants for lacking sufficient risk controls or amplifying financial instability. FSOC seems to be laying the groundwork to subject certain digital asset activities and/or firms to additional regulation at a later date.
• The Report identified and pointed out issues with a number of crypto-asset market structure features, including automation of financial transactions through smart contracts (particularly in futures markets), pseudonymity, liquidity fragmentation, and the fact that single crypto-asset market entities may each perform a wide variety of financial market activities.
• The Report also reiterated concerns on stablecoin risks previously established by the President’s Working Group on Financial Markets, Office of the Comptroller of the Currency (“OCC”), and Federal Deposit Insurance Corporation (“FDIC”) in 2021. It called for the establishment of a comprehensive federal prudential framework for stablecoin arrangements that covers entities performing services “critical to the functioning of the stablecoin arrangement.”
• The Report calls for Congressional action on a number of crypto-asset issues, including: (i) defining federal rulemaking and enforcement authority over markets for crypto-assets that are not securities; (ii) establishing a federal regulatory framework for stablecoin arrangements; and (iii) establishing a supervisory framework for activities of affiliates and subsidiaries of crypto entities that incorporates groupwide risk management requirements.
• If Congress fails to pass legislation on any of these areas and the digital asset market continues to grow, this could lead to FSOC designation of crypto-asset activities or entities.

Background

On October 3, FSOC met and voted to release a report on digital assets. President Biden requested the report in his March 2022 Executive Order 14067 on Ensuring Responsible Development in Digital Assets. Notably, if an FSOC member agency voted to approve the release of the Report, this does not necessarily signal that the agency approves of each individual component or recommendation in the report.

While requested by the President in March 2022, a report has been long anticipated with the FSOC starting to monitor digital asset risks in 2015 and escalating related efforts since.

FSOC was established by the 2010 Dodd-Frank Act, and its voting members include the Treasury Secretary, the Chairman of the Federal Reserve Board, the heads of various U.S. financial regulatory agencies, and an independent member with insurance expertise. The FSOC has the authority to “designate” nonbank financial companies or activities relating to payment, clearing and settlement as, or as likely to become, “systemically important.”

FSOC designation can subject an entity or activity to additional federal supervision and regulation without additional Congressional action. Accordingly, if Congress stalls in negotiations regarding crypto-asset spot market regulation or establishing a federal regulatory framework for stablecoins, certain FSOC members may push for the body to designate certain crypto activities, leading to new regulations by FSOC member agencies. For example, FSOC member and Bureau of Consumer Financial Protection (“CFPB”) Director Rohit Chopra stated that “[s]uch a designation would give federal regulators greater visibility into the stablecoin ecosystem and allow for the application of heightened safeguards, where appropriate.”

FSOC Report: Notable Findings and Recommendations

The Report stated that financial stability vulnerabilities related to crypto-assets fall into two categories: (i) crypto-asset interconnections with the traditional financial system; and (ii) financial stability issues “primarily confined” to the crypto-asset markets.

Crypto-asset interconnections with the traditional financial system – and the FSOC Report’s Proposed Response

FSOC Believes Interconnectedness Between Crypto-Assets and Traditional Finance is Minimal, but is Watching Key Areas: The Report emphasized the relatively small size of digital asset markets and limited interconnectedness with the traditional financial system. Relatively minimal interconnectedness with traditional financial firms contributed to FSOC’s decision not to designate any crypto-assets as systemically important. However, the Report warned that interconnections between crypto-asset markets and the traditional financial system could rapidly increase, and highlighted several areas of potential risk (particularly with regard to stablecoins), including:

• The potential impact of stablecoin markets on commercial paper and Treasury markets.
• Concerns over the potential for “runs” on stablecoins to lead to fire sales of assets held by other financial institutions.
• Banks’ direct involvement in crypto-asset activities, including the potential issuance of “tokenized deposits” or bank-issued stablecoins.
• Partnerships between banks and non-banks to facilitate customer access to crypto-asset markets.
• Opacity regarding traditional private fund and high-frequency trading firm exposure to crypto-asset markets.

Interconnectivity Concerns Help Explain the Report’s Call for Heightened Regulation of Stablecoin Arrangements: To address issues related to interconnectivity between stablecoins and the traditional financial system, the Report recommended that Congress pass legislation to create a “comprehensive federal prudential framework for stablecoins issuers.” The Report did not explicitly name a preferred supervisory agency. Several regulators appear to be auditioning for this role, including the Federal Reserve, which raises concerns for market participants.

Report Signals Heightened Regulation of Banks’, Credit Unions’, and Trust Companies’ Interactions with Crypto-Assets:  The Report identified bank services provided to crypto companies as one of the primary interconnections with the traditional financial system. The Report stressed that banks can only engage in activities “that are permissible under law and conducted in a safe and sound manner.” With regards to the potential impacts of crypto-assets on banking system safety and soundness, the Report highlighted capital and liquidity requirements being developed by the Basel Committee on Banking Supervision for the prudential treatment of bank crypto-asset exposures. The Report also highlighted supervisory expectations with respect to managing third-party risks posed by crypto companies and stated that “bank regulators generally have regulatory and examination authority over certain services provided to banks to the same extent as if the bank conducted the activity itself.”

The Report recommended that state and federal banking regulators use their existing authorities to review services provided by banks to crypto-asset entities, and evaluate whether existing authorities are sufficient. Further, in the report’s recommendation regarding “continued enforcement” of existing rules and regulations, the Report reiterated that it expects for banks and credit unions that engage in crypto-asset activities “do so in a safe and sound manner and in compliance with applicable laws and regulations.”

Report Warns Market Participants on Securities Regulation Issues:  The Report emphasized that “the determination of whether a crypto-asset is a security has important implications for the interactions of that crypto-asset with traditional financial markets,” and encouraged banks and investors specifically to be cautious when engaging with crypto-asset entities given potential securities laws implications. In determining whether a crypto-asset is a security, the Report highlighted the Howey and Reves tests and commentary from the SEC, which suggest that U.S. federal securities law may apply to distributed ledger technology “based on the particular facts and circumstances,” and also to the activities of decentralized organizations. The Report recommended continued enforcement of securities laws in the crypto space but did not provide further guidance on how to determine whether a crypto-asset is a security.

Financial stability issues “primarily confined” to the crypto-asset markets

The Report stated that “crypto-assets could directly pose financial stability risks regardless of their interconnections with the traditional financial system if they were to attain a large enough scale.” The Report identified numerous areas where FSOC believes that characteristics of crypto-asset activities are acutely amplifying instability within the crypto-asset markets. Important areas highlighted include the effects of speculation on crypto prices, a lack of controls to mitigate run risk or excessive leverage, “opaque” capital and liquidity positions at many crypto firms which have “risky business profiles,” and operational risks related to the use of blockchain technology, such as malicious attacks or flawed governance structures.

Report Identifies Numerous Interconnections within the Crypto-Asset Ecosystem: The Report stated that major crypto platforms typically offer an integrated suite of services and may have significant interconnections, which “may exacerbate the impact of interconnections compared to traditional financial institutions.” The Report suggested that the failure of a major crypto platform could have a variety of consequences across interconnected entities, including abrupt reductions in liquidity, increases in lending rates, capital losses for assets associated with the platform (such as a native stablecoin), or customers being unable to access funds. To illustrate the interconnections within the crypto-asset ecosystem, the Report described the effects of the collapse of Three Arrows Capital on various market participants.

“Data Gaps” Pose a Challenge to Regulators: The Report suggested that interconnection risks within the crypto-asset ecosystem may depend on particular institutions’ respective capital and liquidity buffers, but that those buffers are challenging to evaluate due to limited publicly available information about the structure of crypto platform operations and risk management.

In response, the Report recommended a coordinated government approach to address data gaps related to crypto-assets. The Report also recommended that Congress pass legislation to address “regulatory arbitrage,” which could include capital and liquidity requirements across a crypto-asset entity and all of its affiliates and subsidiaries as well as risk management requirements.

Regulators are Paying Attention to Crypto-asset Market Participants’ Leverage Levels: FSOC’s Report signaled significant regulatory concerns over high levels of leverage in crypto-asset markets through significant emphasis on this topic. The Report identified that leverage is available to crypto-asset market participants through crypto-asset platforms and protocols, CFTC-registered exchanges, prime brokerage-type services, and loans to crypto-asset miners. The Report expressed particular concern with leverage at large overseas digital asset trading platforms, in perpetual futures markets, and on certain platforms branded as “decentralized.”

Regarding prime brokerage-type services, the Report noted that institutional investors have reportedly focused on gaining long exposure to established crypto-assets like Bitcoin to date. The Report warned that as these investors seek higher returns, they may turn to a prime brokerage-type services to facilitate crypto-asset lending and borrowing, synthetic exposure to crypto-assets, and access to complex and leveraged trading strategies.

The Report did not make a recommendation specifically pertaining to leverage, but it stated that guardrails on leverage obtained through loans depend on the regulation to which the lending institution is subjected. The Report suggested that loans made by a prime brokerage-type entity may be subject to fewer guardrails than those made by a bank, since those entities are not subject to prudential regulation and supervision requirements.

Report Calls for Tighter Federal Crypto-asset Spot Market Regulation – Doing So Will be Difficult to Achieve via Congress: The Report identified the lack of explicit rulemaking and enforcement authority in crypto spot markets as a “regulatory gap,” and as mentioned above, recommended Congress close this gap through legislation. At least four proposals exist on Capitol Hill to provide clarity on crypto spot market regulatory authority, though these may suffer from cross-jurisdictional challenges, since such markets may consist of both crypto securities and crypto commodities. The Senate Banking Committee and House Financial Services Committees share oversight authority over the SEC, while the House and Senate Agriculture Committees share oversight authority over the CFTC. Accordingly, a bill addressing both SEC and CFTC authorities – which is likely given attempts to define a crypto security and crypto commodity – would likely be referred to both committees. This in turn will necessitate multiple markups and negotiations between committee chairs regarding how the agencies will share jurisdiction. Accordingly, the Report could be read as laying the groundwork for future FSOC action with regards to crypto-asset spot market activities.

The Report Expresses Concerns with Trend Towards Vertical Integration:  The Report expressed particular concern with vertically integrated market structures which have been proposed by market participants. In other words, crypto-asset markets are characterized by entities that allow retail end-users to purchase crypto-assets directly on a trading platform, rather than through a regulated intermediary. The Report argued that the lack of these traditional intermediaries can exacerbate financial stability risks. Indeed, the Report found that the potential risk management practices of vertically integrated platforms, including automated liquidation of under-margined positions, could create “cascading liquidations and reduced capacity for human intervention during times of stress,” and that vertical integration could create conflict of interest concerns. Accordingly, the Report recommended that member agencies assess the potential impact and legality of vertically integrated structures.

Concern over a “Regulatory Race to the Bottom”: The report expressed concern that some crypto firms are engaging in a “regulatory race to the bottom, seeking to operate under whatever regulatory framework places the fewest limitations on funding mismatches.” It expressed particular concern with firms operating under state level money services business licenses, which the Report argued is not designed for facilitating comprehensive regulation of large crypto-asset platforms. The Report commented that some entities which have received crypto specific charters such as a Wisconsin SPDI or Nebraska digital asset depository institutions charter “may not be required to obtain deposit insurance and therefore they may not be regulated at the federal level.” The Report argued that the ability of crypto firms to perform the same type of activity under different licenses with different requirements across the U.S. is driving regulatory arbitrage.

To address these issues, the Report recommended legislation to grant regulators greater authority over crypto firms and their affiliates and subsidiaries, though it provided limited details on what such a framework would entail. The Report did cite the New York BitLicense as a framework that has more risk controls in place than other state frameworks.

Considerations for Crypto Companies

Members of Congress are working on crypto-asset regulation proposals that could address some of the concerns identified in the FSOC report. Companies should evaluate how the proposals may affect their business and then determine whether and how to engage on these legislative developments. Concurrently, companies operating in the crypto-asset space should assess whether any of their business characteristics or activities were identified by FSOC as causing, or likely to cause, financial stability risks. Given that Congress is unlikely to pass legislation that addresses many of Biden Administration regulators’ financial stability concerns regarding crypto-assets, businesses should develop strategies that anticipate potential FSOC action in this area. Generally speaking, even non-bank payments companies and broker-dealers not directly implicated in the Report should take note that the FSOC may soon be used again to designate certain non-bank financial activities as systemically important – an authority that has not been used since the Obama Administration.

In terms of immediate enforcement risk, crypto-asset companies should evaluate their marketing practices as well as relationships with banks. The Report warned about misrepresentations regarding how a crypto firm is regulated or whether a crypto product is regulated the same way as other financial products, and the FDIC and CFPB have also recently warned against misrepresentations about deposit insurance.

Banks should also expect increasing scrutiny from regulators. The Report recommended that banking regulators review services provided to banks by crypto companies. Regulators will expect banks to enhance third-party risk management to ensure prudent actions and policies exist to mitigate operational and compliance risks. As regulators pressure banks, this will result in heightened banking industry expectations of crypto-asset partners with respect to service agreements and documentation regarding risk management practices. Banks and crypto-asset firms alike should make sure they are prepared for the additional rigor expected from supervisors to achieve their business objectives.

Put Patomak’s Crypto Expertise to Work

Patomak has deep experience in helping financial institutions navigate emerging risks related to crypto-asset market trends and related public policy developments. We are prepared to help banks, crypto-asset firms, and numerous other market participants identify and assess market opportunities in the digital assets space, and also to develop tailored risk/compliance programs or guide overall regulatory strategy. Contact us to learn how Patomak can help you navigate these challenges and help you meet your business goals.

Links

• Press Release: Financial Stability Oversight Council Releases Report on Digital Asset Financial Stability Risks and Regulation
• FSOC Fact Sheet
• FSOC Report on Digital Asset Financial Stability Risks and Regulation
• Statement from Treasury Secretary Janet Yellen on FSOC Report
• Statement from SEC Chair Gary Gensler on FSOC Report
• Statement from OCC Acting Comptroller Michael Hsu on FSOC Report
• Statement from CFPB Director Rohit Chopra on FSOC Report