Crypto-Asset Platforms Are Getting More Integrated Into The Traditional Financial System – Financial Stability Report

On October 3, 2022, the Financial Stability Oversight Council (FSOC) released its report in response to US President Joe Biden’s Executive Order on “Ensuring Responsible Development of Digital Assets”, issued in March 2022. The FSOC is a federal government institution whose mandate includes identifying and monitoring risks and responding to emerging threats to the US financial system.

The FSOC report carried a number of recommendations including that its member agencies leverage existing authorities where appropriate, federal agencies to continue enforcement of existing rules and regulations, and the need for Congress to address regulatory gaps not covered by the existing regulatory system. 

Other recommendations in the FSOC report included the continued coordination by regulators in the supervision of crypto-asset entities, Congress to pass legislation for stablecoin issuers, different regulatory regimes for different crypto-asset entities, and state bank regulators to use their existing authority to review services provided by crypto-asset providers.

The FSOC report pointed out that crypto-asset entities interconnected with the traditional financial system could lead to significant financial exposure of investors. Crypto-asset platforms were noted for having the potential to cause distress due to their wide range of integrated financial services. 

“More broadly, failure of a major crypto-asset platform would likely lead to losses for persons and businesses with which it transacts directly, i.e., customers and counterparties. Such a failure could also affect market participants’ ability to sell and convert crypto-assets into national currency”, the report said. 

The failure of a number of crypto-asset platforms have led to insolvency challenges for investors. “In addition, platforms’ practice of placing customers’ crypto-assets into omnibus holding accounts, in which those assets are commingled with those of the platform, raises the risk that the bankruptcy of a platform could leave its customers as general creditors and vulnerable to losses or delays on their asset holdings”, the report further said.

The report noted that the general lack of interoperability between crypto-asset platforms also exposes investors to further risks. “In particular, because there is no direct mechanism for customers to trade across different crypto-asset platforms, customers may be significantly locked into individual crypto-asset platforms during times of distress, unless they wish to withdraw their assets directly into private wallets and as long as withdrawals are permitted and subject to transaction fees”, the report explained.  

Crypto-asset platforms may also expose investors to significant losses in their portfolios. “Customers may have significant holdings at crypto-asset platforms based on the belief that the funds belong to them, not the crypto-asset platform, potentially leading to losses in excess of what customers can easily withstand”, the report stated.  

As per the FSOC report, the inter-relatedness of crypto-asset platforms poses further risk to investors. “Finally, the failure of a large platform might also disrupt another platform through operational relationships or through other connections such as debt or equity investments”, the report said.

In her remarks during the presentation of the FSOC report, US Secretary of the Treasury, Janet L. Yellen said: “In all, these reports provide a strong foundation for policymakers as we work to mitigate the risks of digital assets while realizing the potential benefits. They also provide a valuable addition to the public’s understanding of digital assets”.