I would like to thank the Brookings Center on Regulation and Markets for hosting today’s program and giving me the opportunity to share some thoughts on the prudential regulation of crypto–assets. I would particularly like to thank my friend, Aaron Klein, for the invitation.
Let me begin with a comment on banking and innovation, since that is so much at the center of the discussion around crypto–assets.
Banking, Innovation, and Crypto–Assets
There is no doubt that innovation has played a central role in the evolution of banking and finance as we know it today.
Credit cards, mobile payments, remote check deposit, online bill pay, direct deposit, and automated teller machines have transformed the financial landscape. They have generally been a benefit to both banks and consumers.
Each of these innovations share an important element: each began with a social, financial, or economic need to be addressed. Technology was then developed for the express purpose of addressing the specific need. These innovations have served to foster accessibility to the banking system, increase the convenience of consumer engagement in banking transactions, and enhance the operational efficiencies of banks and the banking industry.
At the same time, these innovations were designed to operate in a manner that is safe and sound for banks and that provides important consumer protections. These five elements—accessibility, convenience, efficiency, safety and soundness, and consumer protection—among others, have made these innovations so transformative for the banking system. It is these five elements that banks and other stakeholders should consider when assessing new innovations.
It is worth keeping this in mind because, as we know, innovation can be a double–edged sword. Subprime mortgages, subprime mortgage–backed securities, collateralized debt obligations, and credit default swaps were all considered financial innovations that would serve the interests of both consumers and banks in the early 2000s. Yet they ended up being at the center of the Global Financial Crisis of 2008.
One of the main reasons that these innovations resulted in such a catastrophic failure was that their risks were too often poorly understood by consumers and industry participants, frequently downplayed, and even intentionally ignored, in the market’s eagerness to participate in these products. The risks associated with these products are clear today, and would have been clearer then, had we stepped back and taken the time to thoroughly analyze them. Indeed, history and hindsight show that the better approach is often caution when confronted with conditions such as these.
This brings me to the subject of today’s program – crypto–assets. For purposes of this discussion, I will rely on the definition used in the recently published digital asset report by the Financial Stability Oversight Council (FSOC). Crypto–assets are private sector digital assets that depend primarily on the use of cryptography and distributed ledger or similar technologies.1
Advocates of crypto–assets, and the distributed ledger technology on which they rely, have represented that these assets and technologies will increase financial accessibility and convenience for consumers, and operational efficiencies for banks. At the same time, they bring with them novel and complex risks that, like the risks associated with the innovative products in the early 2000s, are difficult to fully assess, especially with the market’s eagerness to move quickly into these products.
The recent Treasury Department report on crypto–assets should give us pause as it articulates the risks and implications for consumers, investors and businesses. The report states that for crypto–assets “both the existing use cases, and potential opportunities, come with risks, including conduct and market integrity risks, operational risks, and intermediation risks (i.e., traditional financial risks that have the potential to manifest in particular ways in the crypto–asset markets). Some risks are unique to the crypto–asset ecosystem, while others are versions of those experienced in traditional financial markets that may be heightened when experienced in the crypto–asset ecosystem.”2
Part of the difficulty in assessing these risks arises from the dynamic nature of crypto–assets, the crypto marketplace, and the rapid pace of innovation. As soon as the risks of some crypto–assets come into sharper focus, either the underlying technology shifts or the use case or business model of the crypto–asset changes. New crypto–assets are regularly coming on the market with differentiated risk profiles such that superficially similar crypto–assets may pose significantly different risks. For example, one popular price–tracking website for crypto–assets reports 21,398 unique crypto–assets, trading across 526 crypto–exchanges.3 Understanding the risks of such a large number of unique crypto–assets and the integrity of so many crypto–exchanges is a challenging task.
Similarly, consumers are often finding that they have no party to turn to when a problem arises, particularly in decentralized blockchain ledgers.4 And finally, many crypto–assets operate on open, permissionless networks that allow anyone, anywhere to trade on the network, which – by design – makes it difficult to track individual actors. This design feature also makes it nearly impossible to ensure compliance with anti–money laundering and counter terrorism financing requirements.
With that context, my remarks today will focus on two topics. First, I’ll provide a brief overview of the FDIC’s approach to engaging with banks as they consider crypto–asset related activities. Second, I’ll discuss the potential benefits, risks, and policy questions related to the possibility that a stablecoin could be developed that would allow for reliable, real–time consumer and business payments.
FDIC’s Approach to Engaging with Banks on Crypto–Asset Related Activities
It is important to recognize that almost all crypto–asset activity today involves investing and trading in crypto–assets. That activity, and the platforms through which the activity occurs, fall in the first instance under the authority of the U.S. market regulators – the Securities Exchange Commission and the Commodity Futures Trading Commission.
However, the recent growth in the crypto–asset industry has triggered increasing interest on the part of some banks to engage in crypto–asset activities.5
From the perspective of a banking regulator, before banks engage in crypto–asset related activities, it is important to ensure that: (a) the specific activity is permissible under applicable law and regulation; (b) the activity can be engaged in a safe and sound manner; (c) the bank has put in place appropriate measures and controls to identify and manage the novel risks associated with those activities; and (d) the bank can ensure compliance with all relevant laws, including those related to anti–money laundering/countering the financing of terrorism, and consumer protection.
The FDIC had been generally aware of the interest in crypto–asset related activities through its normal supervision process, but as interest has accelerated, we recognized that we lacked sufficient information on the risks associated with these activities as well as on which banks have been engaging in, or are interested in engaging in, crypto–asset related activities.
To address that gap, in April of this year, the FDIC issued a financial institution letter,6 asking the banks the FDIC supervises to notify us if they are engaging in, or planning to engage in, crypto–asset related activities. If so, we asked banks to provide us enough details to allow us to work with them to assess the risks associated with the activities and the appropriateness of their proposed governance and risk management processes associated with the activity. The other federal banking agencies have issued similar requests to their supervised institutions.7
Once the FDIC develops a better understanding of activities planned or already active, we provide the institution with case–specific supervisory feedback.8 As the FDIC and the other Federal banking agencies develop a better collective understanding of the risks associated with these activities, we expect to provide broader industry guidance on an interagency basis.
This clearly reflects a cautious and deliberate approach by the agencies to bank participation in crypto–asset related activity. We are doing this for several reasons: (a) the risk of these activities to safety and soundness, consumer protection, and financial stability; (b) the lack of history and familiarity with these assets both in the marketplace and within regulated financial institutions; and (c) the dynamic nature of these assets.
You need only read the news to know that these risks are very real. After the bankruptcies of crypto–asset platforms earlier this year, there have been numerous stories of consumers who have been unable to access their funds or savings.9
In addition, false and misleading statements, either direct or implied, by crypto–asset entities concerning the availability of federal deposit insurance for a given crypto–asset product violate the law.10 We have seen several instances where crypto–asset companies have given customers the impression that they are protected by the government safety net when, in fact, they are not. Further, misrepresentations by crypto–asset firms about how they are regulated have also confused consumers and investors regarding whether a given crypto–asset product is regulated to the same extent as other financial products.
In other cases, customers may have fundamentally misunderstood the risks associated with investment in various types of crypto–assets, calling into question whether consumer disclosures and other important consumer safeguards are appropriately implemented within the crypto–asset marketplace.
Insured institutions need to be aware of how FDIC insurance operates and need to assess, manage, and control risks arising from third–party relationships, including those with crypto companies. In addition to potential consumer harm, customer confusion can lead to risks for banks if a third party with whom they are dealing, makes misrepresentations about the nature and scope of deposit insurance. The FDIC issued an Advisory in July reminding insured banks of the risks that could arise related to misrepresentations of deposit insurance by crypto–asset companies.11
Crypto–Assets and the Current Role of Stablecoins
Bitcoin was the first widely known crypto–asset. It was designed to operate on a public distributed ledger system employing blockchain technology.12
The purported purpose of Bitcoin was the development of an alternative currency system free of central control and free of the need for banks and governments. The validation transactions on the blockchain system operated by a decentralized public consensus process. Since the advent of Bitcoin, many other purported crypto–assets have come online, for example, Ether.
Neither Bitcoin nor Ether are backed by physical assets, but rather they purport to establish value by their scarcity or utility. As such, the value of these crypto–assets at any point is driven in large part by market sentiment. This has resulted in a highly volatile marketplace where fortunes have been made – and lost – overnight.13
As investors traded in and out of various crypto–assets, a desire arose for a crypto–asset with a stable value that would allow investors to transfer value from one crypto–asset into another without the need for converting into and out of fiat currencies. This gave rise to the development of various so–called stablecoins.
Unlike Bitcoin, Ether, and similar crypto–assets, most stablecoins are represented as backed by a pool of assets or utilize other methods to help maintain a stable value. Currently, the most prominent stablecoins are purported to be backed by financial assets such as currencies, U.S. Treasury securities, or commercial paper. Like the concept of money market mutual funds, many types of stablecoins seek to maintain a stable value of one dollar (or other unit of fiat currency) per coin either through the backing by a pool of assets, which could include other digital assets, or through the use of an algorithmic mechanism as a value stabilization mechanism. Of course, what is represented and what is true may be two different things.14
Thus far, as I previously stated, stablecoins have predominantly been used as a vehicle to buy and sell crypto–assets for investment and trading purposes– there has been no demonstration so far of their value in terms of the broader payments system.15
Even if crypto–assets and stablecoins have not yet proven to be a meaningful or reliable source of payments in the real economy, the distributed ledger technology upon which they are built may prove to have meaningful applications and public utility within the payments system.
We are at a pivotal policy point with this new technology and asset class, much as we were during the free banking era of the late 1800s and early 1900s, as the financial system we know today came into being. As pointed out in the FSOC digital asset report, “currency during the free banking era consisted of bank notes, that is, liabilities of individual banks payable in gold or silver if presented at the issuing bank. As many as 1,500 currencies circulated at any one time.”16
This decentralized form of monetary exchange led to numerous bank runs and cycles of bank failures.17 While our financial system has advanced significantly over the past century, we would do well to keep our history in mind. It offers a valuable lesson about the risks of private money, both digital and physical, for the U.S. financial system when we consider the more–than 21,000 crypto–assets currently in existence.
There has been considerable discussion and public debate regarding the benefits and risks associated with the development of a payment stablecoin for both domestic and international cross–border payment purposes that is subject to prudential regulation.
The main benefit given for the development of a payment stablecoin is the ability to offer cost–effective, real–time, around–the–clock retail and business payments. On the domestic level, this is similar to the benefits proposed by the Federal Reserve’s FedNow system that is scheduled to come online in the coming year.18 The extent to which a payment stablecoin would provide additive or complementary benefits to the FedNow system remains to be seen.
Nonetheless, there may be merit in continuing to examine the potential benefits associated with payment stablecoins. To be clear, I see the notion of payment stablecoins as conceptually distinct and separate from the existing broader universe of stablecoins and designed specifically as an instrument to satisfy the consumer and business need for safe, efficient, cost–effective, real–time payments.
Policy Considerations for Payment Stablecoins
There are three important features that could make payment stablecoins significantly safer than the stablecoins currently in the marketplace.
First, payment stablecoins would be safer if they were subject to prudential regulation. One vehicle for ensuring prudential regulation and separation from deposit taking would be the issuance of a payment stablecoin through a bank subsidiary.
Second, payment stablecoins would be safer if they were required to be backed dollar–for–dollar by high–quality, short–dated U.S. Treasury assets. Backing with such high–quality assets would help ensure that payment stablecoins could be quickly and efficiently redeemed for fiat currency on a dollar–for–dollar basis limiting the potential for risks associated with these instruments to spillover to the traditional financial system.
Third, payment stablecoins would be safer if they were transacted on permissioned ledger systems with a robust governance and compliance mechanisms. The ability to know all the parties – including nodes and validators – that are engaging in payment stablecoin activities is critical to ensuring compliance with anti–money laundering and countering the financing of terrorism regulations, and deterring sanction evasion.19 The U.S. Department of the Treasury action plan to address illicit financing risks of digital assets is a helpful step in addressing those risks.20
While these three features would make payment stablecoins safer, there remain several important policy considerations that should be taken into account when examining the benefits and risks associated with payment stablecoins.
The development of a payment stablecoin could fundamentally alter the landscape of banking. Economies of scale associated with payment stablecoins could lead to further consolidation in the banking system or disintermediation of traditional banks. And the network effects associated with payment stablecoins could alter the manner in which credit is extended within the banking system – for example by facilitating greater use of FinTech and non–bank lending – and possibly leading to forms of credit disintermediation that could harm the viability of many U.S. banks and potentially create a foundation for a new type of shadow banking.
This raises very important policy questions. For example, should nonbanks be allowed to offer stablecoins, or should the issuance of payment stablecoins be limited to banks and prudentially–regulated bank subsidiaries? It is important to have this debate, not only in the context of regulating crypto–related risks, but in the context of the future of banking—especially community banking.
When we consider where payment stablecoins should fit into the regulatory landscape, we must also consider the manner and extent to which states should charter stablecoin issuers or license them as money transmitters. Many states have invested considerable time and effort into understanding the risks associated with crypto–assets and stablecoins. All payment stablecoin issuers should – just like banks, whether Federal or state chartered, be subject to prudential regulation and oversight. As I mentioned, the potential for non–bank stablecoins to disintermediate community banks from their local communities is an issue that should also be carefully explored and considered.
Payment stablecoins by their very design could exhibit many of the features, and potential vulnerabilities, associated with money market mutual funds. As we have seen previously, in stressed market conditions, large investors could quickly exit their holdings, leading to the fire–sale pricing of underlying securities and panic selling by other investors. This could result in contagion across other payment stablecoins and similar pooled asset holdings, resulting in a systemic event.
Careful attention should also be paid to disclosure and consumer protection issues. While the fundamental premise of payment stablecoins is that they may be safer and easier to understand than more complex crypto–assets, the interface with retail businesses will pose new questions and challenges, as both consumers and businesses adjust to a new form of payments and its associated rights and obligations. Unfortunately some fraud–related experiences with certain peer–to–peer payment systems have highlighted risks associated with novel retail payment systems.21
The disclosure and consumer protection issues will also need to be carefully considered, especially if custodial wallets are allowed outside of the banking system as a means for holding and conducting transactions with payment stablecoins. It is uncertain whether and to what extent such wallets would or should be subject to prudential supervision.
Consideration must be given to the ability of a payment stablecoin to foster a more inclusive and accessible banking system. A payment stablecoin and any associated hosted or custodial wallets should be designed in a manner that eliminates – not creates – barriers for low– and moderate–income households to benefit from a real–time payment system. Further, additional studies should be undertaken to see if there are design features that could provide incentives for greater participation by unbanked and under–banked households. At the same time, it also raises the questions about those lacking appropriate technological resources, including internet connectivity, and risks of financial exclusion if the financial system moves primarily to a digital format.
As I previously indicated, another important policy consideration should be how a payment system that is based on the use of payment stablecoins would appropriately interact with the Federal Reserve’s upcoming FedNow service, as well as the potential development of a U.S. central bank digital currency.
Finally, we are left with one of the most pressing policy questions: Is legislation needed, and, if so, for what issues are legislation most needed?
The Federal banking agencies have a significant breadth of authority when it comes to addressing the safety and soundness and financial stability risks associated with crypto–asset–related activities, including perhaps payment stablecoin issuance, by our regulated entities. However, there are clear limits to our authority, especially in certain areas of consumer protection as well as the provision of wallets and other related services by non–bank entities. We must consider the extent to which legislation would be necessary to provide a cohesive framework to prudentially regulate a payment stablecoin system from “end–to–end” and to ensure that consumers are appropriately protected in the process.
While I have sounded several notes of caution, it is important for the FDIC and the other Federal banking agencies to approach crypto–assets and crypto–asset–related activities thoughtfully.
We must understand and assess the risks associated with these activities the same way that we would assess the risks related to any other new activity. However, the risks associated with crypto–assets are novel and complex, so the assessment of these risks will take time and a significant amount of dialogue with multiple stakeholders.
We will continue to work with our supervised banks to ensure that any crypto–asset–related activities that they engage in are permissible banking activities that can be conducted in a safe and sound manner and in compliance with existing laws and regulations. If so, we will work with banks to ensure that they have put in place appropriate measures and controls to identify and manage risks and can ensure compliance with all relevant laws, including those related to anti–money laundering and consumer protection. And we will do this in collaboration with our fellow banking agencies.
There may be benefits associated with a payment stablecoin, especially to the extent that it fosters an inclusive, real–time payment system. However, there are important risks and policy concerns that will need to be taken into consideration before a payment stablecoin system is developed. To the extent that a payment stablecoin system is developed, it should be designed in a manner that complements the Federal Reserve’s FedNow system and the potential future development of a U.S. central bank digital currency.
Those are my thoughts for today. I very much appreciate your attention.
1 Financial Stability Oversight Council Report on Digital Asset Financial Stability Risks and Regulation 2022, available at https://home.treasury.gov/system/files/261/FSOC-Digital-Assets-Report-2022.pdf
2 U.S. Department of the Treasury report Crypto–Assets: Implications for Consumers, Investors, and Businesses, available at https://home.treasury.gov/system/files/136/CryptoAsset_EO5.pdf.
4 See Emma Fletcher, Reports show scammers cashing in on crypto craze, The Federal Trade Commission (June 3, 2022) available at https://www.ftc.gov/news-events/data-visualizations/data-spotlight/2022/06/reports-show-scammers-cashing-crypto-craze; Chainanalysis Team, The Biggest Threat to Trust in Cryptocurrency: Rug Pulls Put 2021 Cryptocurrency Scam Revenue Close to All-time Highs, Chainanalysis (December 16, 2021) available at https://blog.chainalysis.com/reports/2021-crypto-scam-revenues/;Khristopher J. Brooks, Cryptocurrency heists are getting more ambitious — and costlier to investors, CBS News (April 26, 2022) available at https://www.cbsnews.com/news/cryptocurrency-theft-hack-defi-beanstalk-blockchain/; E. Napoletano and Benjamin Curry, What Is DeFi? Understanding Decentralized Finance, Forbes (April 8, 2022) available at https://www.forbes.com/advisor/investing/cryptocurrency/defi-decentralized-finance/; Sam Becker, DeFi Is the Wild West of Banking and Investing. Here’s What Crypto Investors Should Know, NextAdvisor, in Partnership with Time (June 30, 2022) available at https://time.com/nextadvisor/investing/cryptocurrency/what-is-defi/; David Yaffe–Bellany, The Crypto World Is on Edge After a String of Hacks, The New York Times (September 28, 2022) available at https://www.nytimes.com/2022/09/28/technology/crypto-hacks-defi.html
5 The impact of COVID–19 on cryptocurrency markets: A network analysis based on mutual information, available at https://journals.plos.org/plosone/article?id=10.1371/journal.pone.0259869.
6 Federal Deposit Insurance Corporation, Financial Institution Letter 16–2022: Notification of Engaging in Crypto–Related Activities, FDIC (April 7, 2022) available at https://www.fdic.gov/news/financial-institution-letters/2022/fil22016.html
7 OCC, Interpretive Letter 1179 (November 18, 2021); Federal Reserve SR 22–6 / CA 22–6: Engagement in Crypto–Asset–Related Activities by Federal Reserve–Supervised Banking Organizations (August 16, 2022).
8 Notifications under the FIL and knowledge of engagement or potential engagement that we learn through the supervisory process is confidential supervisory information, but we are aware of approximately 80 FDIC–supervised institutions that are engaging in or are interested in engaging in crypto–asset activities, and approximately two dozen that appear to be actively engaged in activities described in the FIL. The FDIC is providing various types of supervisory feedback, depending upon the activity involved, the status of the activity (active or planned), and the institution’s risk management framework, among other things.
11 See Advisory to FDIC–Insured Institutions Regarding Deposit Insurance and Dealings with Crypto Companies, FIL–35–2022 (July 29, 2022) available at https://www.fdic.gov/news/financial-institution-letters/2022/fil22035.html
13 See Mackenzie Sigalos, Voyager customer lost $1 million saved over 24 years and is one of many now desperate to recoup funds, CNBC (August 15, 2022) available at https://www.cnbc.com/2022/08/15/voyager-customers-beg-new-york-judge-for-money-back-after-bankruptcy.html#:~:text=Investing%20Club-,Voyager%20customer%20lost%20%241%20million%20saved%20over%2024%20years%20and,now%20desperate%20to%20recoup%20funds&text=Many%20of%20Voyager%20Digital's%203.5,court%20judge%20overseeing%20the%20case
14 Financial Stability Oversight Council Report on Digital Asset Financial Stability Risks and Regulation 2022, available at https://home.treasury.gov/system/files/261/FSOC-Digital-Assets-Report-2022.pdf
15 President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency Repot on Stablecoins, available at https://home.treasury.gov/system/files/136/StableCoinReport_Nov1_508.pdf.
16 See footnote 14.
17 See Franklin D. Roosevelt, Transcript of Speech by President Franklin D. Roosevelt Regarding the Banking Crisis, FDIC (March 12, 1933) available at https://www.fdic.gov/about/history/3-12-33transcript.html
18 Brainard, Lael, “Progress on Fast Payments for All: An Update on FedNow,” August 29, 2022 at https://www.federalreserve.gov/newsevents/speech/brainard20220829a.htm
20 U.S. Department of the Treasury Action Plan to Address Illicit Financing Risks of Digital Assets, available at https://home.treasury.gov/system/files/136/Digital-Asset-Action-Plan.pdf
21 See Stacy Cowley and Lananh Nguyen, Fraud Is Flourishing on Zelle. The Banks Say It’s Not Their Problem, The New York Times (March 6, 2022) available at https://www.nytimes.com/2022/03/06/business/payments-fraud-zelle-banks.html