On October 3, the Financial Stability Oversight Council (FSOC) released its “Report on Digital Asset Financial Stability Risks and Regulation” (Report), concluding, among other things, that unregulated cryptocurrencies could pose a risk to the stability of the U.S. financial system. FSOC further recommended legislation empowering financial regulators to more vigorously oversee the industry and to expand bank exams to require federal and state agencies to inspect services provided by crypto-asset service companies. Issued in response to Executive Order 14067, the Report called on federal regulators to come up with plans for overseeing cryptocurrencies. A fact sheet summarizing FSOC’s findings can be found here.

In a press release issued that same day, Treasury Secretary Janet Yellen said: “This report provides a strong foundation for policymakers as we work to mitigate the financial stability risks of digital assets while realizing the potential benefits of innovation. 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. It is vital that government stakeholders collectively work to make progress on these recommendations.”

Established under the Dodd-Frank Act, FSOC is chaired by Treasury Secretary Yellen, and its members include the heads of financial agencies, such as the Federal Reserve Board, the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission. FSOC is tasked with identifying emerging threats to the country’s financial security and organizing a coordinated response across U.S. financial regulators. FSOC is authorized to supervise and regulate nonbank financial companies, financial market utilities, and payment, clearing, or settlement activities to address possible vulnerabilities to financial stability.

Although the Report acknowledges that the existing regulatory system covers large parts of the crypto-asset system, it identifies three gaps:

  1. Spot markets — or financial markets where commodities are traded for immediate delivery as opposed to the futures market — for crypto assets that are not securities are subject to limited regulation. These markets may not be subject to the rules and regulations designed to ensure transparent trading, prevent conflicts of interest and market manipulation, and protect investors.
  2. Crypto-asset businesses do not have a comprehensive regulatory framework and can engage in regulatory arbitrage, i.e., financial transactions designed specifically to capture profit opportunities created by different regulations or laws.
    • Some businesses may have affiliates or subsidiaries operating under different regulatory frameworks, and no single regulator may have visibility into the risks across the entire business.
    • As Acting Comptroller of the Currency Michael Hsu said in his statement supporting the Report: “We know from the 2008 financial crisis what happens when regulatory agencies fail to coordinate effectively on risks that cut across jurisdictional lines: an unlevel playing field emerges and financial stability risks grow in the shadows.”
  3. A number of crypto-asset trading platforms have proposed offering retail customers direct access to markets by vertical integration of the services provided by intermediary broker-dealers.
    • This vertical integration may have negative implications for financial stability and investor protection.

To address these gaps, the Report makes the following recommendations:

  • Passing legislation providing rulemaking authority for financial regulators over the spot market for crypto assets that are not securities;
  • Passing legislation giving regulators authority to have visibility into and supervision over the activities of all affiliates and subsidiaries of crypto-asset entities;
  • Studying potential vertical integration proposed by crypto-asset firms.

The Report also recommended bolstering its members’ capacities related to data and to the analysis, monitoring, supervision, and regulation of crypto-asset activities.

SEC Chair Gary Gensler highlighted the need for oversight in his statement on the Report, noting his belief that “crypto cannot exist outside of our public policy frameworks, regardless of what the crypto industry initially expected or what certain market participants might say today. The policy frameworks include protecting investors and consumers, guarding against illicit activity, and supporting financial stability. Whether you call something a crypto token, stablecoin, or decentralized finance platform (DeFi), those public policy goals remain the same.”

Consumer Financial Protection Bureau Director Rohit Chopra also issued statement supporting the Report , which highlighted the risks of stablecoins, while Texas Banking Commissioner and FSOC state banking representative Charles Cooper supported the Report in a statement, focusing on the need for federal and state coordination.