Sir John Cunliffe, Bank of England Deputy Governor, Financial Stability, has now given three speeches this year on crypto covering the crypto winter (our previous article on this can be found here), financial stability risk, and DeFi, digital currencies and regulation.  We consider the key messages and what this means for upcoming regulation.

Why regulation is important – potential for crypto to impact financial stability

• Crypto technologies offer a prospect of radical improvements in financial services
• Bulk of cryptoassets have no intrinsic value and are vulnerable to major price corrections
• The crypto world is beginning to connect to the traditional financial system and we are seeing the emergence of leveraged players

Although cryptoassets currently pose limited financial stability risk, they could grow very rapidly.  Sir John Cunliffe observed that that you don’t have to account for a large proportion of the financial sector to trigger financial stability problems.  He notes that regulators internationally and in many jurisdictions have begun work, but it needs to be pursued as a matter of urgency.  Bringing the crypto world effectively within the regulatory perimeter will help ensure that the potentially very large benefits of the application of this technology to finance can flourish in a sustainable way.

Recent failure of crypto platform illustrates the need for regulation

The crypto ecosystem is not a stable one.  Sir John Cunliffe’s view is that this is not just due to the volatility of unbacked instruments that constitute the majority of cryptoassets, but also because the crypto institutions at the centre of the much of the system exist in largely unregulated space and are very prone to the risks that regulation in the conventional financial sector is designed to avoid.  He considers that technology in and of itself does not change the need for such regulation.  He further notes that whilst it will take some time to establish exactly what caused the collapse of centralised crypto trading platform FTX and most of its associated businesses, there are key themes arising that are addressed by regulation in the traditional financial sector.

Organisation and governance

Corporate structure, governance, internal controls and record keeping.  Such regulatory and supervisory requirements in the traditional financial sector aim to protect users, other financial firms, and the financial system more broadly.

Conflicts of interest.  Requirements and constraints include transparency concerning a financial firm’s affiliates, and requiring a firm’s controllers to be fit and proper.

Internal segregation of different activities.  Lending, brokering, providing an exchange platform, clearing and settlement perform different economic functions that carry different risks and require separate, independent governance.  A number of centralised trading platforms operate as conglomerates, bundling (at an organisational rather than technological level) products and functions and thereby operating without structural separation or ring-fencing.

Credit, liquidity and market risk.  Restricted according to function.

Financial instruments

Collateral.  Subject to conditions including credit quality and volatility.  (Unbacked cryptoassets are highly volatile, given that they have no intrinsic value. They are subject to runs and their value can change very quickly).  A firm accepting its own unbacked crypto asset as collateral for loans and margin payments, as there are indications may have happened with FTX, creates extreme risk where the exposure to a counterparty increases together with the risk of the counterparty’s default.

Protection of client funds.  To achieve assurance through custody of assets/claim on balance sheet.  It is not clear that platforms taking possession of cryptographic keys and managing transactions on a ledger provides a sufficient level of assurance.

Is regulation the answer?

Rather than regulation of the risks in centralised crypto platforms, some would argue the better alternative is the development of decentralised finance in which functions like lending, trading, clearing etc. take place through software protocols built on the permission-less blockchain where the ‘code’ manages the risks rather than intermediaries.  Sir John Cunliffe is sceptical that the risks inherent in finance can be managed in this way, and considers regulation is needed for three reasons:

• It would afford better protection to consumers and investors.
• Financial stability would be better protected by regulation before the crypto ecosystem is sufficiently large and connected to have a destabilising impact.
• To foster innovation: technology will only be developed and adopted at scale within a framework that manages risks to existing standards.

What next?

The guiding regulatory principle remains “same risk, same regulatory outcome”, and therefore the application of existing regulatory frameworks. 

• In this vein, the current Financial Services and Markets Bill seeks to extend the Bank of England and FCA regulatory regimes for e-money and payment systems to cover the use of ‘stablecoins’ for payments.  The Bank of England is planning to consult in early 2023 in detail on the regulatory framework that will apply to such systemic payment systems and the services, like wallets, that accompany them.  The expectation of the Financial Policy Committee is that stablecoins used as money to make payments in systemic payment chains should meet standards equivalent to those expected of commercial bank money – including stability of value, robustness of legal claim and the ability to redeem at par in fiat.
• HM Treasury intends to consult in the near future on extending the investor protection, market integrity and other regulatory frameworks that cover the promotion and trading of financial products to activities and entities involving crypto assets
• Central Bank Digital Currency (issuance by Bank of England of digitally-native pound Sterling): at present, all forms of commercial bank money in the UK have to be redeemable in cash - Bank of England money - on demand and without loss of value. Given the trends away from physical cash, and, potentially, towards new forms of tokenised money, a digital pound may be needed in future to fulfil the same function.  The Bank of England and HM Treasury intend to issue a report on next steps shortly.