America’s top banking regulators waited three days after New Year’s Eve to launch fireworks, and their Press release it could usher in an exciting new phase in the evolution of the digital asset market.
The big three banking regulators are the Board of Governors of the Federal Reserve System (Federal Reserve), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC). According to his statement, “it is important that risks related to the crypto-asset sector that cannot be mitigated or controlled do not migrate to the banking system.”
This launch is an important milestone in the sense that banking regulators have accepted digital assets as worthy of recognition and that the industry is still immature. Recognizing and listing the risks of digital assets is the first important step in preparing for an effective regulatory environment.
The key risks highlighted in the report could have been pulled from the headlines of any major publication at any time in the last few months and represent a good summary of current deficiencies within the industry. From another perspective, the list also provides a roadmap on how to overcome current issues to realize the benefits and promise of digital assets.
Approximately half of the risks are related to the conduct of current industry participants. Concern about suspicious and non-standard practices is certainly justified, and if judged solely by the bad actors in the space, perhaps the list can be taken at face value as an indictment of the industry.
However, such a simple analysis ignores reputable operators. Within the digital asset industry there are participants who are looking to do the right thing and want to operate in accordance with financial industry standards. The headlines are full of lewd details of those doing bad things, but what about those who believe in the future and are building strong businesses?
The regulator’s statement should bring hope to trade show operators and industry participants. Clearly the authorities are now aware of the problems and are working their way through analysis towards solutions.
Banking regulators warned that “issuing or holding primary crypto assets…is highly likely to be inconsistent with safe and sound banking practices.” This seemingly simple sentence carries considerable weight, much more than it appears at first glance.
Banks must operate in a “safe and sound” manner and therefore, through this release, issuing or holding crypto assets is essentially a prohibited activity. Banks must not own Bitcoin or other forms of digital assets.
While this in itself is consistent with existing regulations restricting bank ownership of volatile investments like common stocks, it means that not all commodities are created equal. Bitcoin and the euro are accepted as commodities, and both are the currency of sovereign nations. Banks can hold euros, but banks cannot hold Bitcoin, the legal tender of El Salvador. So perhaps as their analysis evolves, bank regulators will view ownership of designated commodities as having different risk characteristics than other digital assets and adjust the rules.
Another area for further development is stablecoins. In November 2021, the President’s Task Force on Financial Markets, the FDIC, and the OCC issued a report on stablecoins, recommending that depository-insured institutions, also known as banks, issue stablecoins. What has changed so that the issuance recommendation by banks has changed to a ban?
It is clear that stablecoins that are not backed 1:1 are not stablecoins. Clearly, US market participants and regulators should not trust entities other than well-managed issuers with audited balance sheets, and certainly not coins issued through unregulated foreign entities. So what is the recommended path to stablecoins? Perhaps in their next publication the regulatory agencies will address the issue.
If the existing digital asset industry is a disaster, and banking regulators certainly believe this to be the case, then perhaps an optimal solution is to migrate some activity within the perimeter of well-regulated financial institutions. For commodity digital assets, how about adopting an arrangement similar to that seen with forex products where banks and the Commodity Futures Trading Commission (CFTC) work together?
Who better to take the lead in digital asset commodities than banks that know how to comply with financial rules and regulations? Also, banks in the US are well supervised by various regulatory agencies and the US has a well-deserved reputation for security. Investors and industry participants would benefit from bank regulators taking a strong lead in the space.
Digital assets are not going away, and the sector remains robust despite the scandals and failures of the past year. Longer-term planning is clearly appropriate. Banking regulators are scrutinizing the industry, and participants should be grateful for their attention.
The US financial system is the envy of the world because it benefits from a strong regulatory framework. Perhaps the joint statement by banking regulators was their signal that they are preparing to introduce a robust regulatory regime for the digital asset class. It is exciting to see if banking regulators have more fireworks in store for the digital asset community.