The crypto winter: Regulators must step in before digital assets become a systemic risk

Momentum is growing as regulators recognise the urgent need to bring crypto within the fold, with the Bank of England’s deputy governor for financial stability urging that "new technology does not change old risks”.

Cryptocurrency has had a rough year. Since November, Bitcoin has lost 70% of its value while the high-profile, catastrophic collapse of stablecoins like Terra have resulted in a loss of faith in the settlement process. Yet Sir John Cunliffe, deputy governor for financial stability at the Bank of England, warns that “the lesson we should NOT take from this episode is that crypto is somehow ‘over’ and we do not need to be concerned about it anymore”.

Instead, he urged in a speech to the British High Commission in Singapore last week, regulators need to get on with the work of bringing digital assets within the regulatory perimeter – a task made all the more urgent by the growing integration of crypto assets and blockchain technology within the mainstream financial markets.

Although crypto does not yet pose a systemic risk, and the recent collapse (while it may have burned some players badly) did not seriously impact the wider financial infrastructure, Cunliffe pointed out that “given the speed of growth and the growing connections with conventional finance, it could pose such a risk relatively quickly”.

This growing institutional risk has been illustrated in recent weeks with the high-profile collapse of several firms – including Singapore-based hedge fund Three Arrows Capital, one of the biggest crypto hedge funds in the world, which went bankrupt recently in a drama-filled story that has seen its founders go missing and connected players (including Canadian crypto trading platform Voyager Digital) go under as a result. People are calling it the Archegos Capital of crypto.

Sir John Cunliffe noted that “finance carries inherent risks. Technology can change the way these risks are managed and distributed, but it cannot eliminate them. Most obviously, financial assets with no intrinsic value… are only worth what the next buyer will pay. They are therefore inherently volatile, very vulnerable to sentiment and prone to collapse.”

The problem is that crypto is becoming increasingly interconnected with institutional finance, and the ripple effect with each setback is getting bigger. Notably, the development of exchanges and other mechanisms such as DeFi platforms has given investors (both retail and wholesale) the ability to take very highly leveraged positions. In the most recent collapse, falling crypto prices led to large margin calls and automatic liquidation mechanisms – which amplified the impact, resulting in the consequent collapses of giants like Three Arrows Capital.

As a result, calls are growing for stronger regulation of the market – a subject that has long been cause for controversy, with incumbents arguing that regulation would stifle innovation. But it looks as if 2022 could be the year that crypto finally comes under the regulatory thumb.

“The interesting question for regulators is not what will happen next to the value of crypto assets, but what do we need to do to ensure that these developments can happen without giving rise to increasing and potentially systemic risks,” commented Cunliffe. “The starting point for regulators should be to apply the same regulation to the risks inherent in the provision of a financial service no matter how it is provided.”

And momentum would seem to be building. The European Parliament last week announced new rules to regulate crypto trading within the EU, while on 11 July the Financial Stability Board (FSB) also released a statement on the international regulation and supervision of crypto assets, stressing that: “crypto assets and markets must be subject to effective regulation and oversight commensurate to the risks they pose, both at the domestic and international level.”

The Committee on Payments and Market Infrastructures (CPMI) at the Bank for International Settlements (of which Cunliffe is chair), together with the International Organization of Securities Commissions (IOSCO), has also spent the past two years working through the details and risks of stablecoin arrangements, adding further guidance to the decade-old industry payment standard,  the Principles for Financial Market Infrastructures (PFMI), in relation to digital assets.

“The objective of such further guidance is to ensure we achieve for stablecoins the level of risk mitigation we expect of payment systems that are, or are likely quickly to become, of systemic scale,” explained Cunliffe.

For example, if a stablecoin is being used as a ‘settlement asset’, in transactions – in other words, as the means of settlement or the ‘money’ – it must be as safe as the other forms of money – central bank money or commercial bank deposits – that is currently used as the settlement asset in payments systems. To meet the new international standard, stablecoin issuers will have to demonstrate they can meet this requirement – something they are very far from doing at the moment.

But stablecoins are just one aspect of the crypto world, and regulators are spreading their gaze ever wider. The Basel Committee on Banking Supervision is in the process of issuing guidance on the prudential treatment of crypto assets held by banks, while IOSCO is also looking at the application of the standards for investor protection and market integrity across crypto assets, exchanges and platforms for lending and trading. The FSB, following its July statement, plans to publish a consultation report later this year with recommendations to promote international consistency in the regulation of non-stablecoin crypto assets, markets and exchanges.

On a domestic level, the UK Government recently announced its intention to update the powers of both the Bank of England and the Financial Conduct Authority (FCA) to regulate and supervise cryptocurrency. “We hope to issue a consultation document on the regulatory policy framework later this year,” said Cunliffe. The UK is also planning to launch a regulatory sandbox this year to explore the potential for smart contracts to expedite and improve efficiency in the fields of equity and fixed income trading, and how these risks could be managed – an area Cunliffe identifies as a “separate but rapidly developing field”.

The moves are being broadly welcomed by industry players, with the general view seeming to be that without effective regulation, institutional involvement will remain limited.

“The recent activity in crypto highlights just how unregulated this world is. Engaging regulators to define a market that allows for open competition, transparency, and risk reduction must be the way forward,” said Anoushka Rayner, head of growth commodities at Paxos, a regulated blockchain infrastructure platform, speaking to The TRADE.

“Certain providers will list every cryptocurrency available, but they are not really looking at the underlying asset and whether the end client should be exposed to that. What market participants need is a guarantee that any token acquired, that is linked to an asset, genuinely represents the asset itself.”