U.S. FSO Council Recommends Crypto Legislation To Address Regulatory Gaps: Report

Officials from the United States Financial Stability Oversight Council (FSOC) recommended that U.S. legislators address the regulatory gaps surrounding crypto in this year’s annual report published on December 16th.

The Council’s 2022 annual report evaluates key financial market developments, discusses potential new risks to American financial stability, identifies financial system weaknesses, and offers mitigation suggestions.

Digital Assets are one of five market and credit risk vulnerabilities identified by the Council. Digital assets were deemed a priority area by the Council in February 2022. 

In response to Executive Order 14067, Ensuring Responsible Development of Digital Assets, the Council published its Report on Digital Asset Financial Stability Risks and Regulation on October. 2

They warned that the U.S. financial system would be at risk from uncontrolled cryptocurrency in October. The Council recognized lending and borrowing on the trading platforms used by the sector as a major developing risk involving digital or “crypto” assets like stablecoins.

Treasury Secretary Janet Yellen said:

The report concludes that crypto-asset activities could pose risks to the stability of the U.S. financial system and emphasizes the importance of appropriate regulation, including enforcement of existing laws. 

Turmoil In Crypto-Assets Ecosystem

Recent years have seen the crypto industry increase in size, including the acceptance of cryptocurrencies by large corporations. Yet despite this growth, prices for cryptocurrencies dropped heavily across the board last year, with coins such as Bitcoin struggling to maintain its value. 

Major companies like Blockfi and Voyager Digital went bankrupt due to financial hardships, while Celsius Network experienced many setbacks before declaring bankruptcy. In November, another major exchange, FTX, and some related firms declared bankruptcy.

According to the annual report, although the issues at FTX caused price drops in cryptoassets, they have had little effect on the larger U.S. financial system so far. However, the traditional financial system was not significantly impacted by the turmoil in the digital-asset ecosystem.

The current regulatory framework, and the limited overall scale of crypto-asset activities, have helped largely insulate traditional financial institutions from the acute instability seen in the crypto-asset ecosystem.

Despite the fact that a significant portion of the ecosystem for digital assets is covered by the current regulatory framework, the report identifies three regulatory gaps in the U.S. for digital asset activities.

Firstly, digital-asset markets that are not securities fall under a sparse federal level of oversight. Secondly, since there is no uniform regulatory framework governing cryptocurrencies, these exchanges can easily evade regulations by engaging in what amounts to an act of regulatory arbitrage.

Third, some digital currency trading platforms have announced plans to give retail customers access to financial markets through vertical integration. 

Financial stability and investor protection risks may arise when retail investors are exposed to practices often adopted by vertically integrated trading platforms, such as automatically and rapidly closing out customer positions. 

For this reason, the Council recommends that member agencies assess the impact of potential vertical integration by digital-asset firms. Additionally, they suggest developing their data-related capabilities and ability to analyze, monitor, supervise, and regulate the actions involving digital-assets.

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