BIS Assesses Crypto Risks – With One Key Message?
Posted by Colin Lambert. Last updated: January 17, 2023
The latest BIS Bulletin from the Bank for International Settlements carries a paper that addresses the risks in crypto, and lays out the options for authorities looking at how they can regulate or control the still relatively nascent asset class.
While the report stresses that authorities may consider different, but not mutually exclusive, approaches, it also highlights that central banks and public authorities “could also work to make TradeFi more attractive”. To this end, it pointedly observes that “sound innovation” with central bank digital currencies is “a key option”.
Although the report notes that we have seen crypto boom and bust cycles before, it says the scale and prominence of recent failures, not least FTX, “heighten the urgency of addressing these risks before crypto markets become systemic”.
It adds that DeFi and CeFi share many of the same vulnerabilities as TradFi markets, but “several factors exacerbate the standard risks’.
These relate to high leverage, liquidity and maturity mismatches and substantial information asymmetries. The paper says policy responses should consider how to address these sources of risk appropriately, given the borderless nature of crypto.
The paper asserts that recent developments, “underscore that the decentralisation in crypto and DeFi markets is illusory”, and that the vision of crypto proponents is “to do away with financial intermediaries”. In response, the paper says, however, if these markets are to function and achieve meaningful scale, they rely upon centralised entities, not least because the governance of DeFi protocols is often concentrated. It adds that stablecoins also play a crucial function in crypto market functioning and are largely a centralised gateway to the wider crypto markets.
Another vulnerability of crypto markets, the paper argues, is that crypto intermediaries face “severe deficiencies” in risk management, ring-fencing of business lines and handling of customer funds.” Several business models in crypto turned out to be outright Ponzi schemes,” it states. “These characteristics, coupled with the huge information deficit customers face, strongly undermine investor protection and market integrity.”
The paper identifies three broad responses from authorities and looks at the pros and cons of each avenue, the first, and most drastic , is to ban crypto activities outright. The obvious “pro” is that without crypto markets the contagion risks being discussed would disappear, while the “con” is that useful innovation from crypto would be lost or delayed.
A ban would also face the challenge of enforcement on a global scale, mainly due to the borderless nature of the product, the paper continues, adding that while it may work with centralised intermediaries, the likely outcome would be a shift by these players to jurisdictions that allow them to operate or have a softer regulatory regime.
The second option is to “isolate and contain” crypto so that it remains a relatively niche activity. This could be done by limiting the flow of funds into and out of crypto and by limiting other connections with TradFi, the paper suggests. At the same time, containment would seek to curb any linkages with the real economy.
“There are several possible justifications for this approach,” the paper states. “As with bans, it is a reasonable response if crypto is seen as not solving any practical real-world problem. It would also make sense if it is believed that crypto would fade away with containment. If this option is successfully pursued, problems stemming from and propagating within the crypto markets would not damage TradFi. Importantly, this option would avoid giving crypto a “seal of approval”, which might encourage its growth.”
On the other side of the ledger, the paper points out that a firewall may not be fully effective in practice and may introduce complexity. “It may be feasible to prevent banks becoming a conduit for crypto activity (in line with the approach pursued by the Basel Committee on Banking Supervision, as well as some asset managers (in line with the decision of the US SEC not to approve any exchange-traded funds based on spot Bitcoin markets),” it states. “However, entities with less constrained investment mandates could still be lured by high promised returns, take outsized bets and indirectly threaten their prime broker financiers.”
A second “con” is that if flows of new investor money were to be channelled into the system such that crypto growth resumes, then – even if financial stability risks for TradFi remained contained – concerns with investor protection and market integrity would still need to be addressed. Without doing so, the reputation of supervisory agencies could be tarnished by shocks.
The third approach is to regulate crypto in a similar fashion to TradFi, applying the same principles and tools. Crypto activities would have to be “mapped” the paper observes, before the use of an activity and entity approach. “This approach would ensure consistency in regulating financial activities – whether performed by crypto players or TradFi – and help to promote the policy goals at the core of existing regulatory frameworks,” the paper suggests. “Moreover, it would allow responsible actors to innovate with regulatory compliance and oversight.”
A familiar challenge with this approach, the paper continues, is the appropriate and effective “mapping” of the crypto industry, especially if there is crossover with TradFi activities. Another challenge is enforcement. “For the approach to work, it is necessary to identify the entities suited as entry points for regulation,” the paper states. “This is more difficult in crypto, as in some cases they lack clear reference points, whether these be firms or individuals. Indeed, some crypto proponents argue that the task is impossible.
“If properly designed and implemented, CBDCs could support sound private sector innovation and help reduce the cost of payments, enhance financial inclusion, bolster the integrity of the system and promote user control over data and privacy.
“That said, a useful starting point could be the entities (and persons) exerting de facto control of a DeFi protocol,” it continues. “In CeFi, of course, the problem is easier, given the more traditional nature of entities such as stablecoins and platforms. Yet even when entities can be identified, they may be less amenable to standard regulatory and supervisory tools, at least initially. As recent events have shown, some entities lack the basic accounting, corporate governance, compliance and control functions that are a prerequisite to participating in TradFi.”
Inevitably the paper also suggests that authorities could combine specific bans, containment and regulation. By way of illustration. It says individual jurisdictions could ban energy-intensive proof-of-work or the distribution of algorithmic stablecoins, while some intermediaries that bridge TradFi and crypto could be brought under regulation and other parts of crypto could be isolated as part of a containment strategy.
The Real Message?
There has been an increasing volume of statements from the central bank world in particular seeking to push CBDCs as an alternative for cryptocurrencies, and the sense is this paper is part of that effort. The final part of the paper looks at the prospects for an alternative to cryptocurrencies, namely CBDCs.
The paper observes that “central banks may want to do more”. It says that by encouraging sound innovation in TradFi, they could contribute to a more efficient monetary system and are uniquely placed to do this, as they sit at the core of the monetary and financial system. Their task is to provide the trust that underpins it.
One important component of such a strategy, the paper argues, could be improving the quality and reducing the costs of payments. One option is to introduce retail fast payment systems, such as the Unified Payment Interface (UPI) in India, Pix in Brazil, the upcoming FedNow system in the US or initiatives such as the Single Euro Payments Area (SEPA). “Another option is to issue CBDCs that meet real needs,” it states. “If properly designed and implemented, such initiatives could support sound private sector innovation. They could help reduce the cost of payments, enhance financial inclusion, bolster the integrity of the system and promote user control over data and privacy.
“The innovation that is present in certain areas of crypto could be harnessed to improve the way in which services are provided in TradFi,” it continues. “In the process, these initiatives could support and leverage new technical capabilities, notably programmability, composability and tokenisation, thereby increasing the efficiency of TradFi.”