BIS Highlights Crypto Data Gaps

A new paper published by the Bank for International Settlements (BIS) finds “significant data gaps” in the crypto financial system and calls for a proactive, holistic and forward-looking approach from regulators to improve oversight.

Although the paper, Banking in the shadow of Bitcoin? The institutional adoption of cryptocurrencies, finds banks’ exposures remain limited to the emerging asset class, it also observes that Increasing investor demand for cryptocurrencies has raised the question of how the resulting rise in demand for intermediary services will be met by financial institutions?

It further examines the footprint of cryptocurrencies in the financial system and documents the institutional adoption of cryptocurrencies drawing on a wide range of data sources. “Our stocktake reveals that the adoption of cryptocurrencies varies across market participants and differs notably from that of other major asset classes,” the paper states. “We find that banks’ direct exposures to cryptocurrencies have remained limited thus far, notwithstanding that some banks are considering a more active role in providing cryptocurrency-related services in the future.”

Based on the most recently available (end-2020) global supervisory data, the paper finds that only a handful of internationally active banks reported having any cryptocurrency exposures, with the average exposure amounting to less than 0.02% of their risk-weighted assets (RWAs) and no bank reporting exposures greater than 0.05% of RWAs. It also finds that such exposures are primarily in response to growing client interest – the bulk of banks’ exposures relate to trading on client accounts, followed by those due to the clearing of futures.

The flipside of limited adoption by banks is a dominant role for what the paper terms “novel crypto exchanges”, that provide platforms on which participants can trade and store cryptocurrencies. These remain largely unregulated to date, the paper observes, adding they essentially form a “shadow crypto financial system”.

Compared to existing regulated exchanges for “traditional” financial assets, the regulatory and supervisory oversight of crypto exchanges – encompassing consumer protection, market integrity, trading, disclosure, prudential and addressing anti-money laundering (AML), combatting the financing of terrorism (CFT) – remains “patchy” at best, the paper argues, adding the new crypto exchanges offer very different products from existing regulated exchanges and have mushroomed over the past years, supported by strong customer demand.

The business of crypto exchanges has been shifting towards institutional customers, as asset managers have also started to embrace cryptocurrencies,” the paper finds. A rising number of crypto investment funds has begun to provide institutional investors and retail investors a gateway to obtain exposure to cryptocurrencies. Assets under management have thus grown “significantly” since 2020, it adds, albeit starting from low levels.

The paper evaluates a broad range of potential drivers based on a formal regression setup and finds that banks domiciled in economies characterised by higher innovation capacity and more advanced financial development have been more likely to engage in cryptocurrency-related customer business than their peers. “Unsurprisingly, these factors have also contributed to supporting the activity of crypto exchanges, indicative of a self- reinforcing adoption of cryptocurrencies across different types of institutional investors.

Area,” it states, adding, “These findings can shed light on the evolving role of cryptocurrencies and their interactions with the mainstream financial system.”

Observing that a number of central bank officials have argued that the rise of cryptocurrencies and decentralised finance raises fundamental questions about the nature of trust and money in the digital area, the authors say their findings suggest that the footprint of the current generation of cryptocurrencies does not mark a sharp departure from the existing financial ecosystem. “Instead of relying on a trust-free – ie on-chain – environment, a new set of agents has come to the fore that is offering convenience, market access, transaction scale and liquidity to these markets in much the same manner as in commercial banking and securities trading, albeit without the same degree of regulatory and supervisory oversight,” it states. “This underscores the “decentralisation illusion” argument of Aramonte et al (2021) – the basic economic forces underlying blockchain-based financial applications make some centralisation of power inevitable. It also tallies with the survey results of Auer and Tercero-Lucas (2021), who document that cryptocurrency retail investors do not distrust fiat money or commercial banks.

Data gaps risk undermining the ability of authorities to oversee and regulate cryptocurrencies holistically

“Instead, investors increasingly add cryptocurrencies to their portfolio to diversify risks and boost performance,” it adds.

The authors say their analysis has three policy implications. First, a new set of market participants, consisting of crypto exchanges and ancillary entities (wallet providers) has arisen that deserves closer regulatory and supervisory scrutiny. “These new intermediaries not only serve retail clients, but also other institutions, such as hedge funds and investment funds,” the paper says. “The exponential growth of this industry requires a proactive, cross- sectoral and forward-looking approach to regulating and overseeing an emerging crypto financial system.

“Cryptocurrency intermediaries, including crypto exchanges, should be subject to the same types of regulation and oversight as intermediaries in economically equivalent asset classes, including with regards to financial stability, consumer and investor protection, and standards to AML, including know-your- customer requirements, and CFT,” it continues. “The purportedly decentralised nature of cryptocurrencies does not negate the need for these critical public policy functions.”

 A related question, the paper says, is how regulation could leverage on cryptocurrency technology, including novel approaches to enforce AML/CFT and consumer protection standards without imposing large overhead costs. One option for such a framework is “embedded supervision”, which harnesses information in distributed ledgers and decentralised finance to increase the quality of data available to supervisors and to reduce administrative costs for firms.

Second, and most pressing, the paper says, is the need to address growing data gaps in the industry. While market activity has started from a relatively low base, the growth and trends over the past years underline the potential for cryptocurrencies and other forms of digital money (such as stablecoins) to scale up quickly and become widely used. “Yet data gaps risk undermining the ability of authorities to oversee and regulate cryptocurrencies holistically,” the authors argue. “While some of these blind spots reflect the global nature of cryptocurrencies, there is scope to enhance the systematic collection and publication of cryptocurrency data in a more rigorous and robust manner.”

The third policy factor is the potential for many interlinkages between novel cryptocurrency intermediaries and the mainstream financial system to require a comprehensive approach to assessing and mitigating risks. Growing demand for cryptocurrencies could increasingly see traditional nodes of the financial system – such as banks and institutional investors – relying directly and indirectly on new nodes of the cryptocurrency ecosystem, such as crypto exchanges. “A recurring lesson from the history of financial crisis is that risks in the “shadow” corners of the financial system can quickly find their way to established and regulated institutions,” the paper suggests. “Left unaddressed, this evolving landscape would see conventional and regulated intermediaries relying on a crypto “shadow” financial system.

“While cryptocurrencies have originated from outside the traditional financial system, risks from cryptocurrencies could easily transfer to banks and other established financial institutions,” it continues. “Indeed, banks and asset managers could potentially be exposed to cryptocurrencies through a number of direct and indirect channels over the coming years.”

As such, the authors argue the fundamental policy choice is to either focus on a framework that allows such interlinkages but adamantly enforces a more level playing field with regard to the regulation and supervision of financial services. Alternatively, policy could treat cryptocurrencies as a self-contained system that can develop in parallel with the mainstream financial system but does not interlink with it. “Developments to date, including the gradual, but increasing, prevalence of established financial institutions in cryptocurrency activity, suggests that separating both systems could prove challenging at a global level, making the former solution inevitable,” the paper argues. “Initiatives to promote regulatory clarity on the treatment of these potential exposures, such as ongoing efforts by the BCBS (BCBS (2021)), could help to ensure a more level playing field and ensure the prudent management of risks from a microprudential and macroprudential perspective. In practice, this would mean applying more stringent regulatory and supervisory oversight of crypto exchanges with regard to the provision of financial services (for example intraday credit, margin financing, provision of custody services), while applying a conservative bank prudential regulatory treatment for cryptocurrency exposures.”