The Bank for International Settlements (BIS) has released a document on the recent turmoil in the crypto markets and the potential risks to the financial system. It is important to foster sound innovation through regulation and programmable central bank digital currencies (CBDCs).
The Central Bank of Central Bank’s report discusses various policy options to address these risks, including banning certain crypto activities, isolating cryptocurrencies from traditional finance (TradFi) and the real economy, and regulating the sector in the same way as traditional investments. BIS also proposes an alternative CBDC approach that encourages robust innovation in traditional finance to improve the existing monetary system and harness the potential benefits of crypto-technology.
Ultimately, the report concludes that the crypto market does not yet pose a significant threat to financial stability. Nevertheless, it is important that authorities consider these policy options and take proactive measures to protect consumers and investors, ensure market integrity and ensure financial stability.
Crypto bankruptcies spark the debate
The recent bankruptcies of FTX and other crypto companies have revived the debate about the appropriate policy response to the crypto industry’s risks. The crypto ecosystem and “shadow banking systems” run by centralized crypto firms (CeFi) and decentralized finance protocols (DeFi) share many of the vulnerabilities seen in traditional finance (TradFi), according to the BIS.
But several factors exacerbate default risks. These relate to high leverage, liquidity and maturity mismatches and significant information asymmetries. Given the borderless nature of cryptocurrencies, policy measures should examine how these sources of risk can be appropriately addressed.
BIS is considering full crypto ban
The most extreme variant for BIS is a general ban on crypto activities. The pros and cons of this option could easily be assessed on an abstract level. In terms of the benefits, if a ban is effective, any potential damage to the financial system will be removed and investors will not suffer losses due to misconduct by crypto providers. The biggest downside would be that all useful innovations in the crypto space would be lost or delayed. Pursuing this option would raise the issue of enforcement. However, in the case of decentralized crypto activities (DeFi), enforcement is difficult due to their borderless nature. So not an ideal solution for BIS either.
The second option would mean isolating and limiting crypto activities so that they are more niche. This could be done primarily by limiting the flow of money in and out of the crypto industry and limiting other connections to traditional finance. At the same time, containment will aim to cut off any connection with the real economy (e.g. as a means of payment for goods and services or in response to tokenization of real assets). There are several possible justifications for this approach. As with bans, if cryptocurrencies are not seen as a solution to a practical real-world problem, that is a reasonable response. It would also make sense, according to the BIS, to assume that crypto activities would disappear with a curb.
Hybrid regulation as the most sensible approach?
The third option is to regulate the sector in the same way as traditional finance (TradFi). By identifying the key economic functions of crypto activities and assessing how regulation might affect them, authorities could apply well-known principles and tools to crypto markets. This approach will ensure coherence in the regulation of financial activities, promote the policy objectives at the heart of existing regulatory frameworks and enable responsible actors to innovate within the framework of regulatory compliance and monitoring.
The main challenge with this approach, according to the BIS, is enforcement, as crypto-companies can be difficult to identify and their operations less easily aligned with standard regulatory and supervisory tools. In addition, it can be difficult to match crypto activities and facilities to their traditional counterparts and create the appropriate legal basis. Ultimately, depending on the specific characteristics of the crypto world and the relative effectiveness of each measure, authorities could combine specific bans, containment and regulation to address the risks to the industry identified by BIS.
CBDCs: their own alternative
Central banks also have a role to play in managing these risks by fostering robust innovation in traditional finance. BIS proposes to develop an alternative. These could contribute to a more efficient monetary system. Central banks are in a unique position to do this because they are at the heart of the monetary and financial system. Your job is to create the trust that supports this system. An important part of such a strategy could be to improve the quality and reduce the cost of payments. One possibility is the introduction of fast mass payment systems such as the Unified Payment Interface (UPI) in India, Pix in Brazil, the upcoming FedNow system in the United States or initiatives such as the Single Euro Payments Area (SEPA).
Another option is the issuance of central bank digital currencies (CBDCs) that meet real-world needs. If designed and implemented correctly, CBDCs can support robust innovation in the private sector. According to BIS, they will help reduce the cost of payment transactions, improve financial inclusion, strengthen system integrity and promote user control over data and privacy. The innovation found in certain areas of the crypto industry can be leveraged to improve the way services are delivered in traditional finance. Thereby, these CBDC initiatives could support new technical possibilities, especially programmability, composability and tokenization, thus increasing the efficiency of the traditional systems.