Financial Stability Group Warns of Stablecoin, DeFi Risks in Annual Report

The Financial Stability Oversight Council is still waiting for the U.S. Congress to take action on cryptocurrencies, in particular stablecoins, before deciding if it needs to take action.

While FSOC punted on whether the group would take any specific crypto-related actions, the annual report published Friday highlights concerns regulators have involving stablecoins and the broader cryptocurrency market. The possibility that some stablecoins might not be fully backed, or are unable to maintain a peg to the dollar or other currency, were two key issues mentioned in the report.

“The reserves of these stablecoins, however, may not be subject to rigorous audits and the quality and quantity of collateral may not, in some cases, correspond to the issuer’s claims. Likewise, stablecoins that maintain their value through algorithmic mechanisms are potentially subject to failure due to market pressures, operational failures and other risks,” the report said.

The interagency group composed of key financial regulators met Friday to discuss financial stability issues, such as climate change, proposed rulemaking, LIBOR and digital assets. FSOC was formed after 2010 to monitor potential risks to the U.S. financial system in the wake of the 2008 market crash.

According to a press release, Treasury Secretary Janet Yellen, Securities and Exchange Commission Chair Gary Gensler, Acting CFTC Chair Rostin Behnam and over half a dozen other regulators were in attendance.

“The Council will also be prepared to consider steps available to it to address risks outlined in the [President’s Working Group on Financial Markets] report on stablecoins in the event comprehensive legislation is not enacted,” the FSOC report said.

Beyond stablecoins, Friday’s report highlighted the development and potential risks from decentralized finance (DeFi) and other crypto-related activities, such as lending and trading.

The report highlighted just how far FSOC, which formed a working group on cryptocurrencies in 2018, has come, at one point arguing that crypto risk is dependent on “the structure of the assets’s consensus mechanism.”

Trading

Despite this year’s watershed developments for crypto on Wall Street, FSOC appeared unconvinced that the highly volatile asset class has become a serious “investment instrument” for traditional types. Instead, speculators appear to drive the “majority” of trades, the report said.

Indeed, the crypto market has seen its usual expected volatility, as well as a number of hacks. Rug pulls and other scams saw cumulative losses exceed $7.7 billion over the past 12 months, according to Chainalysis.

Risks from market manipulation to criminal enterprise to operational failures could shatter crypto’s veneer “and, in an extreme case, undermine confidence in the system as a whole.”

Decentralized finance (DeFi) leverage only adds fuel to the potential for a “fire sale” that could tank one coin before spiraling cross-market. The more “traditional financial institutions” plug into these crypto markets, the greater a risk this contagion could “spread to the broader financial system.”

The report also suggested that DeFi users could face losses for any number of reasons, including price volatility, “operational issues” with the platforms they use or cybersecurity issues.

The $127 billion stablecoin market carries its own “operational, settlement and liquidity” risks that may be amplified as “network effects” drive ever more users in.

The SEC or the Commodity Futures Trading Commission (CFTC) might have jurisdiction over this segment of the crypto market, as well as other agencies, the report suggested.

Traders’ “confidence” in the stablecoin’s store-of-value usefulness is critical, FSOC wrote. And there’s any number of ways to undermine that confidence; “the mere prospect” of an issue might be enough to spark a self-perpetuating run.

How broadly the real-world economy might feel this fallout is dependent on the stablecoin’s prominence. Single-issuer dominance carries its own host of problems.

FSOC advised state and federal regulators to “continue” their scrutiny of the crypto market with an eye toward understanding its systemic risks.

Potential benefits

The report did discuss the potential benefits of stablecoins and other digital assets – at least, in the eyes of these technologies’ proponents. While at the moment stablecoins are “predominantly” used in trading, lending and borrowing, they could one day become a payment tool.

“Well-designed and appropriately regulated” stablecoins could allow for faster and better payments than current channels support, the report said.

“The transition to broader use of stablecoins as a means of payment could occur rapidly due to network effects or relationships between stablecoins and existing user bases or platforms,” the report said.

The way stablecoins are transferred might also boost the efficiency of payment tools, the report said.

Still, this section also noted the potential regulatory concerns around stablecoins, including the need for user confidence in the tool as a means of payment.

“Financial innovation can offer considerable benefits to consumers and providers of financial services by reducing the cost of certain financial services, increasing the convenience of payments, and potentially increasing the availability of credit. But innovation can also create new risks that need to be understood,” according to the report.

The comments on stablecoins echoed a broader theme within the report on digital assets and other risks.

“The development of digital assets and the use of associated distributed ledger technology may present the opportunity to promote innovation and further modernization of financial infrastructure … [but proper regulation is] critically important,” the report said.