FSOC calls for legislation on crypto spot markets

WASHINGTON — The Financial Stability Oversight Council published its report on crypto regulation Monday, calling for the most significant and specific action from Congress yet out of the batch of reports written at the behest of President Biden

The wide-ranging report asks Congress to pass laws that would help regulators oversee crypto assets that aren’t securities, that regulators take steps to prevent regulatory arbitrage and that regulators study digital asset firms that offer direct access to markets by retail customers. It’s part of a series of reports in response to Biden’s March 9 executive order that called on the FSOC, the Treasury Department and other regulators to study the growing impact of digital assets. 

The report warns of dangerous regulatory holes in spot markets, an area that other reports on digital assets haven’t discussed in detail. Those markets, according to the report, don’t have the same kinds of regulations that securities markets do, and regulators have found “possible sources of fraud and manipulation in the spot Bitcoin market.” 

Michael Hsu, acting director of the Office of the Comptroller of the Currency, said regulatory arbitrage in the crypto market is a potential source of financial stability risk.

Bloomberg News

The legislation should give the regulator responsible for these markets enforcement and examination authority, the report said. 

Acting Comptroller of the Currency Michael Hsu highlighted issues around regulatory arbitrage at the FSOC meeting where the regulators released their report. 

“We know from the 2008 financial crisis what happens when regulatory agencies fail to coordinate effectively on risks that cut across jurisdictional lines,” he said. “An unlevel playing field emerges and financial stability risks grow in the shadows.” 

Some crypto firms, according to the report, prefer to operate in different states and countries, based on the varying regulatory burden in each place. They can also choose different regulatory regimes they want to operate under for different affiliates and subsidiaries. 

“In such cases, the regulatory system for crypto-assets may not provide any single regulator with a comprehensive view of a firm as a whole or its relationships with third-party service providers,” the report said. 

To that end, the FSOC recommends that federal and local regulators coordinate their efforts. To address the problem specifically in the stablecoin market, council called on Congress to pass a prudential framework for stablecoin issuers.

The council said that the Federal Deposit Insurance Corp., the Federal Reserve Board, Office of the Comptroller of the Currency and state banking regulators should use their existing powers to review partnerships between banks and crypto firms, and that they ” gain experience in examining crypto-asset services.” Bank regulators should also “continue to evaluate whether their existing authorities are sufficient,” it said. 

The report also asks agencies to consider whether “vertical integration,” or business models where retail customers can directly access markets instead of going through a broker-dealer, “can or should be accommodated.” 

These kinds of arrangements can lead to financial stability issues if, for example, a trading platform liquidates a consumer’s under-margined position based on a new place rather than making margin calls through an intermediary.  In times of financial stress, that could set off a cascade of liquidations that regulators would have little power to stop. And if this happens outside of traditional business hours, there could be no one monitoring or preventing fraud and manipulation, exacerbating the problem. 

Integrated models could also run into consumer protection issues, notably around disclosures that are typically the responsibility of intermediaries. If trading platforms continued to take on that role, it could present “conflicts of interest that could result in incentives to liquidate customer positions,” the report said. 

The report repeated the line held by bank regulators throughout crypto market turmoil: that the traditional banking system has been well insulated from any extreme shocks. There is still risk in the traditional financial sector, however. 

“If banks were to scale up their participation in the crypto-asset ecosystem, such activity could potentially entail much greater access to the crypto-asset market by a broad range of institutional investors, corporations, and retail customers than currently exists,” according to the report. 

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