Disruptive Technologies

Regulators Stress Risk Management in Consultations on Crypto

New York's DFS launches review of four-year-old BitLicense; BCBS opens discussion on a "global prudential standard" for crypto-asset exposures; Bank of England on "payment chains"

Friday, December 20, 2019

By Jeffrey Kutler


The New York State Department of Financial Services (DFS) and Basel Committee on Banking Supervision (BCBS) separately announced initiatives that underscore financial regulators' determination to be proactive in oversight of fast-moving virtual currency and other crypto-asset developments.

Both efforts - DFS's Proposed Guidance Regarding Adoption or Listing of Virtual Currencies and a BCBS discussion paper on designing a prudential treatment for crypto-assets - place heavy emphasis on risk management principles and fundamentals. The former outlines governance, risk and monitoring responsibilities of New York's virtual currency licensees. The latter states: “Certain crypto-assets have exhibited a high degree of volatility and present risks for banks, including liquidity risk; credit risk; market risk; operational risk (including fraud and cyber risks); money laundering and terrorist financing risk; and legal and reputation risks.”

The announcements came on successive days, December 11 and 12, and were the latest in a series of statements by authorities who have been considering the macroprudential and systemic implications of digital assets, along with potential policy responses. In a recent lecture at Princeton University, for example, Bank for International Settlements general manager AgustÍn Carstens discussed the history and nature of money; how Bitcoin, stablecoins and other new developments fit into the narrative; and the concept of central bank digital currencies.

Carstens said that the “debate over the future of money and the payment systems has only just started. And the message has certainly been received by authorities in general, and central banks in particular, that they need to address the issues related to technological innovation and its impact on money and payments in a far more proactive way.”

Central Banks and Innovation

Now part of the BIS structure - as is the Basel Committee on Banking Supervision - is the BIS Innovation Hub, which is “to foster international collaboration on innovative financial technology within the central banking community, and also to contribute to the dialogue between the public and the private sectors,” Carstens said. The hub's head, effective January 15, 2020, is BenoÎt CoeurÉ, formerly of the European Central Bank executive board, who has spoken on such subjects as the retail payments of tomorrow and digital challenges to the international monetary and financial system.

Agustin Carstens Headshot
Central banks need to be “far more proactive” in addressing technological innovation, says BIS's Agust�n Carstens.

In a similar vein, the BIS-hosted Financial Stability Board on December 9 published reports on the stability implications of BigTech in finance and third-party dependencies in cloud services.

Both enumerated pluses and minuses of the technologies and competitive dynamics. The paper on the entries of companies such as Apple, Amazon, Facebook and Google into financial services raised the question of “whether additional regulation and/or financial oversight may be warranted. Regulators and supervisors might also be mindful of the degree to which the resilience of incumbent financial institutions and the viability of their business models might be affected by their interlinkages with and competition from BigTech firms.”

Listing Options and Policy Guidelines

DFS, which despite being a state agency has raised its profile internationally with its BitLicense program (see New York's DFS: A State Regulator on the World - and Crypto - Stage), on December 11 invited comments to be submitted by January 27 on its “proposed coin listing policy framework.” It is characterized as an initial step in reviewing the pioneering BitLicense in view of marketplace changes since its 2015 introduction. As of early December, the agency had granted 24 such virtual currency licenses or trust charters, the most recent to Social Finance subsidiary SoFi Digital Assets.

“New York is the center of both innovation and consumer protection, and the department must strive to deliver speed to market and continually adapt to keep pace as the financial services industry continues to rapidly evolve,” Superintendent of Financial Services Linda Lacewell said in a statement. “This is an important first step in our review of our virtual currency regime and is designed to make it easier for those who have obtained a New York license to periodically add new coins to their existing products.”

The proposed guidance allows for two coin adoption or listing options. In one, DFS would list on its website coins that are available to virtual currency licensees without having to get prior approval, “as long as such listed coins have not been subject to any modification, division, or change” after being listed. Those “currently contemplated” include Bitcoin, Bitcoin Cash, Ether, Ether Classic, Litecoin, Ripple, Paxos Standard and Gemini Dollar.

The second option is “a proposed model framework for a coin-listing or adoption policy that can be tailored to a VC [virtual currency] licensee's specific business model and risk profile.” The firm-specific policy, “if approved by DFS, will enable the licensee to self-certify the listing or adoption of new coins in addition to those” specified in the first option, without DFS's prior approval.

The proposal balances the streamlined self-certification with reporting requirements, such as written notices of intended new coin offerings with usage details, and to “keep DFS informed, no later than at the time of their next quarterly filing, of all coins to be used or offered in connection with their Virtual Currency Business Activities.”

The agency's “Proposed Model Framework for the Creation of Company Coin-Listing Policies” includes board oversight, meeting-minutes and stakeholder-review requirements.

Among the risks said to need attention are operational and technology; market, concentration and price manipulation; cybersecurity and theft; money-laundering; and risks related to compliance with applicable rules and guidances such as those of the U.S. Securities and Exchange Commission, Commodity Futures Trading Commission and the Treasury Department's Financial Crimes Enforcement Network.

Designing Prudential Treatment

The BCBS discussion paper - which may be followed by a consultation process seeking further input on a prudential policy - takes off from the previously stated view that cryptocurrencies, or crypto-assets, “do not reliably provide the standard functions of money and can be unsafe to rely on as a medium of exchange or store of value. These types of crypto-assets are not legal tender and are not backed by any government or public authority. Therefore, if banks are authorized, and decide, to acquire crypto-assets or provide related services, the committee is of the view that banks should apply a conservative prudential treatment to such exposures, especially for high-risk crypto-assets.”

Linda Lacewell Headshot
New York's financial services regulator must “continually adapt to keep pace,” says Superintendent Linda Lacewell.

The 14-page paper asks for feedback by March 13, 2020, relating to “the features and risk characteristics of crypto-assets that should inform the design of a prudential treatment for banks' crypto-asset exposures; and general principles and considerations to guide the design of a prudential treatment of banks' exposures to crypto-assets, including an illustrative example of potential capital and liquidity requirements for exposures to high-risk crypto-assets.”

One of 15 questions posed by the Basel Committee invites discussion of “general principles in guiding the design of a potential prudential treatment of crypto-assets.” The committee said it has been guided by three:

- Same risk, same activity, same treatment - “A crypto-asset and a traditional asset that are otherwise equivalent in their economic functions and the risks they pose should not be treated differently for prudential purposes.”

- Simplicity - Given the potential for certain types of crypto-assets to become systemically important, “the design of the prudential treatment of crypto-assets should therefore be simple and flexible in nature. For example, complex internally-modeled approaches should not be used to calculate regulatory requirements. And, where appropriate, the prudential treatment should build on the existing framework, especially for crypto-assets with equivalent economic functions and risks as other asset classes.”

- Minimum standards - While the BCBS might set a minimum standard, “jurisdictions would be free to apply additional and/or more conservative measures if warranted.” Jurisdictions that prohibit banks from having any crypto-asset exposures “would be deemed compliant with any potential global prudential standard.”

Regulation of Payment Chains

The Bank of England, in its December 2019 Financial Stability Report, includes a section on payments developments, pointing out that payment chains - “the activities necessary for a payment to be made” - are becoming more complex as a result of innovation and nonbank entrants into the market.

“It is possible that new entrants could ultimately become critical links in systemically important payment chains without being subject to commensurate financial stability regulatory standards,” says the report. This has led the central bank's Financial Policy Committee (FPC) to develop a new regulatory approach “reflect[ing] the financial stability risk, rather than the legal form, of payments activities.” Firms deemed systemically important “should be subject to standards of operational and financial resilience that reflect the risks they pose. This may include firms not currently regulated.”

The report describes Bitcoin as “too volatile to become widely accepted as a means of payment.” But stablecoins address that shortcoming, and one high-profile example, Facebook's proposed Libra, “would have the potential to become systemically important. The regulatory framework that would apply to Libra,” the BOE continued, “must be clear and in place in advance of any launch.”

Because of the way digital tokens are created in stablecoin systems, there are risks beyond those of traditional payment systems - “the risks of this money creation aspect” - that also have to be managed.

The FPC makes a case for equivalent regulatory treatment: “Where stablecoins are used in systemic payment chains as money-like instruments, they should meet standards equivalent to those expected of commercial bank money in relation to stability of value, robustness of legal claim and the ability to redeem at par in fiat.”

Lael Brainard Headshot
Various stablecoin risks “could trigger a loss of confidence and run-like behavior,” says the Fed's Lael Brainard.

Consumer Exposure

Another central bank voice on the case of stablecoins, Federal Reserve governor Lael Brainard says that Libra and others have potential to grow quickly and, at global scale, “may put consumers at risk.”

Speaking on December 18 at a European Central Bank event honoring the soon-to-depart BenoÎt CoeurÉ, Brainard mentioned “significant” concerns in such areas as anti-money-laundering, counter-terrorist financing and Know Your Customer compliance, as well as financial stability and monetary policy implications.

“If not managed effectively, liquidity, credit, market, or operational risks, alone or in combination, could trigger a loss of confidence and run-like behavior,” Brainard warned. “This could be exacerbated by the lack of clarity about the management of reserves and the rights and responsibilities of various market participants in the network. The risks and spillovers could be amplified by potential ambiguity surrounding the ability of official authorities to provide oversight, backstop liquidity, and collaborate across borders.”

On central bank digital currencies, she added, issuing them directly to consumer accounts “would raise profound legal, policy, and operational questions. That said, it is important to study whether we can do more to provide safer, less expensive, faster, or otherwise more efficient payments . . . At the Federal Reserve, we look forward to collaborating with other jurisdictions as we continue to analyze the potential benefits and costs of central bank digital currencies.”


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