FSOC report on digital asset financial stability risks and regulation – Key takeaways

Background

The report recently issued by the Financial Stability Oversight Council (FSOC) is quite different from the other reports published so far by the U.S. financial regulators in response to Executive Order 14067 on digital assets (FSOC Report).[1] Helpfully, this report included a series of specific policy recommendations about what Congress and the regulators ought to do next. But the FSOC Report reveals a continuing lack of consensus and turf wars among the U.S. financial regulators, making its calls for coordination and cooperation ring hollow and introducing incoherence into some of the recommendations.

Following an exhaustive 60-page discussion of the potential financial stability risks of crypto-asset activities,[2] the FSOC Report identifies three principal gaps in the regulation of those activities – (1) limited direct federal oversight of the spot market for crypto-assets that are not securities, (2) opportunities for regulatory arbitrage and (3) the vertical integration of crypto-asset services[3] – and includes ten not very detailed recommendations for closing those gaps and addressing other identified regulatory considerations.[4]

Below are six key takeaways from the FSOC Report. We also compare the FSOC Report to other recent statements and reports by members of the FSOC. Appendix 1 is a chart with more details on the three identified regulatory gaps and the recommendations aimed at closing them.

Appendix 2 compares FSOC’s framework for assessing the financial stability risks of the crypto-asset ecosystem with the Federal Reserve’s framework for assessing the financial stability risks and resilience of the traditional banking system, which was introduced in the Federal Reserve’s inaugural Financial Stability Report in 2018.[5] In applying this framework to vulnerabilities in the form of interconnections between the crypto-asset ecosystem and the traditional financial system, the FSOC Report exaggerates the risks of many of those interconnections. Most of the other vulnerabilities in the crypto-asset ecosystem identified in the FSOC Report are identical to the vulnerabilities in the traditional financial system identified in the Federal Reserve’s Financial Stability Reports and can be addressed the same way they are addressed in the traditional financial system.[6]

Key takeaways

1. FSOC is more skeptical than supportive of crypto-asset activities.

• The FSOC Report focuses almost exclusively on the financial stability risks of crypto-asset activities,[7] but does not try to address the potential financial stability benefits of those activities.
  • The skeptical tone of the FSOC Report mirrors recent statements by various members of FSOC.[8]
  • The Financial Stability Board similarly focused almost exclusively on risks in a report on crypto-asset activities and markets released just a few days after the FSOC Report was published.
  • In contrast, in his first speech after the FSOC Report was released, Federal Reserve Vice Chair for Supervision Michael Barr described the promise of financial innovation, including crypto-asset activities, as making “financial products and services better, faster, cheaper, and more available … [and] disrupt traditional providers by spurring competition, creating products that better meet customer needs, and extending the reach of financial services and products to those typically unserved.”
• Among other things, the FSOC Report does not consider the risks of continued Congressional and regulatory inaction nor the public benefits of clarifying:
  • Which crypto-asset activities are permissible for the existing nonbank crypto-asset ecosystem; or
  • Which crypto-asset activities are permissible for banking organizations as an incident of the business of banking, closely related to banking, financial in nature, incidental to a financial activity or complementary to a financial activity.
• The FSOC Report similarly expresses skepticism on whether there are persuasive use cases and thus benefits for most crypto-assets, especially non-fungible tokens (NFTs), viewing their value as primarily driven by speculation rather than “fundamental economic use.”[9]
• Finally, the FSOC Report contains several threats of more enforcement of current laws, calling out noncompliance with existing laws.[10]

• The FSOC Report recommends that Congress provide new federal regulatory authority over spot markets in crypto-assets and, at the same time, says that “[c]ertain crypto-assets are securities” and thus are subject to regulation under the existing U.S. federal securities laws.
• The FSOC Report does not acknowledge the challenges in deciding whether a particular crypto-asset is a security or the significant gap between blanket statements from SEC leadership asserting that, Bitcoin aside, “almost all digital assets are securities” and more nuanced positions taken by market participants and other regulators – including the CFTC and some state regulators – recognizing that although some crypto-assets may be used in investment capital-raising transactions, it is inappropriate to treat the asset class as a whole as falling under the securities regulatory regime.
• Accordingly, the FSOC Report fails to recommend that Congress enact a definition for crypto-assets that would clarify the jurisdictional line between crypto-assets that are securities and those that are not—something that the current bills being considered in Congress also fail to do. See Davis Polk’s client update on this issue.
• The FSOC Report fails even to call for the SEC and CFTC to resolve this issue. Instead, the FSOC Report would allow the highly indeterminate Howey and Reves tests to remain in place, even though these judge-made tests are deliberately broad and subjective catch-alls and therefore unsuited for a new trillion-dollar asset class that can be objectively defined.
• As a result, its recommendations for a comprehensive federal market, consumer, investor and prudential framework cover only those crypto-assets without addressing which assets might fall within the framework. Because the SEC can be counted on to continue issuing broad statements about the crypto-assets that fall under its remit, this means that many of FSOC’s recommendations are unnecessarily limited in their scope.

• FSOC is skeptical of the sufficiency of state money services regulation, stating that state regulation focuses on consumer protection and AML/CFT[11] instead of prudential regulation and financial stability—while allowing crypto platforms to advertise that they are “regulated.”
• The FSOC Report is clearly designed to put pressure on Congress to create a comprehensive regulatory framework for crypto-assets.

• The FSOC Report does not recommend that stablecoin issuers be limited to insured depository institutions (IDIs). This represents a welcome shift from the November 2021 Report on Stablecoins by the President’s Working Group, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, which recommended such a limitation.
  • Instead, like various Senate bills or discussion drafts,[12] the FSOC Report is consistent with the view that stablecoin issuers could be stand-alone nonbank entities, separately incorporated subsidiaries of IDIs or IDIs.
• The FSOC Report recommends that such legislation reflect the principle of same activity, same risk, same regulatory outcome.
  • This principle implies that if the risk profile of stablecoin issuers is lower than that of traditional banks, the prudential standards, such as capital and liquidity calibrations, should be tailored to reflect this lower risk profile.
• The FSOC Report suggests that if Congress does not implement this recommendation, the FSOC might designate stablecoin issuers as systemically important financial companies or stablecoin activities as systemically important payment, clearing or settlement activities under Title I or VIII of the Dodd-Frank Act.[13]

• The FSOC Report recommends that Congress pass legislation that would create authority for regulators to regulate and supervise the activities of all of the affiliates and subsidiaries of crypto-asset entities, including by imposing activities and investment restrictions on such entities, their affiliates and subsidiaries.
• This recommendation on comprehensive supervision is not limited to crypto-assets that are not securities.
• While the FSOC Report does not mention the Bank Holding Company Act by name, the recommendation is virtually identical to the consolidated regulatory and supervisory regime in the Bank Holding Company Act, except that it contemplates a group of agencies exercising this authority instead of a single agency.
• A multi-agency structure for exercising consolidated supervision over a group of companies is unprecedented, and we believe, unworkable. It could be more or less stringent than the traditional single-agency consolidated supervision structure, but is likely to lead to a cumbersome supervisory environment for regulated firms.
• It is not clear whether the FSOC would tailor the consolidated supervisory regime to reflect differences between the scope and scale of a group’s activities or its risk profile.

• FSOC defines vertical integration as “offering retail customers direct access to markets by vertically integrating the services provided by intermediaries such as broker-dealers or futures commission merchants.”
• Since many crypto-asset businesses are structured like universal banks, with most of their activities and services being provided by a single legal entity, FSOC probably means that an assessment of this single-entity model is necessary when it refers to the crypto-asset ecosystem as being vertically integrated.
  • In contrast, traditional U.S. financial services groups are generally subsidiarized, with separate legal entities providing different types of products and services, such as deposit-taking, underwriting and dealing in securities, securities brokerage and derivatives trading.
• There are pros and cons to the universal banking model, which exists in many other parts of the world such as Asia, Canada and Europe.
  • Many customers consider the direct access to crypto-asset products and services through a single legal entity to be an advantage of the current crypto-asset ecosystem. It is also more capital and operationally efficient than the subsidiarized structure.
  • But the subsidiarized structure arguably insulates one affiliate from the risks of another affiliate, makes it easier to manage conflicts of interest and may make recovery and resolution easier.
  • The FSOC Report did not seem to seriously assess the specific pros and cons of this model, but instead, given its skeptical positioning, seems to suggest a move toward a subsidiarized model may be warranted.
• The FSOC also seems to have a separate concern about vertical integration when it states that vertically integrated arrangements “are also sometimes known as non-intermediated, in reference to retail customers placing orders directly to an exchange, rather than through an intermediary such as a broker-dealer or an FCM, that performs these functions.”[14]

Appendix 1: Overview of FSOC recommendations

Click to view Appendix 1