As different countries take different approaches to how they police cryptoassets, there have been calls for more international coordination on crypto regulation. The Financial Stability Board – a global financial markets standard-setter – has now proposed a framework aimed at greater consistency between emerging crypto regimes. The FSB is inviting feedback on its proposals by 15 December 2022.

Concerns around cryptoassets and financial stability

In the overview to its proposals, the FSB observes that the turmoil experienced in the cryptoasset markets earlier this year has highlighted a number of structural vulnerabilities, exposing:

• inappropriate business models,
• significant liquidity and maturity mismatches, 
• extensive use of leverage, and
• a high degree of interconnectedness within crypto markets.

It considers that all of these vulnerabilities were amplified by: 

• a lack of transparency,
• poor governance,
• inadequate consumer and investor protection, and
• weaknesses in risk management.

The FSB concludes that – for now – there has been limited spillover into established financial markets due to relatively low interconnectedness with the wider financial system but warns that this could “change rapidly” as cryptoasset markets recover. In essence, given the speed with which crypto markets are evolving, there is a real possibility that crypto markets could reach a point where they influence global financial stability.

Issues with the current regulatory landscape

The FSB considers that cryptoassets are “predominantly used for speculative purposes” and that many remain non-compliant with or outside the scope of existing regulation. Whether existing financial regulation applies depends on a case-by-case assessment of whether the relevant assets and activities are regulated under each jurisdiction’s laws. The result for cross-border cryptoasset activities is a global patchwork of regulatory frameworks which is becoming more complex as crypto-specific regimes are being developed.

A design for crypto regulation – key takeaways

To help guide consistency between those emerging regimes, the FSB has issued a framework for the regulation of cryptoasset activities for public consultation. Once finalised, this will be delivered to the G20 Finance Ministers and Central Bank Governors and is intended as guidance for national regulators to follow.

In summary, the FSB recommends that national regimes should:

1. Empower regulators to oversee cryptoasset activities and markets, including crypto issuers and service providers
2. Regulate crypto issuers and service providers in a way which is proportionate to the (potential) financial stability risk they pose
3. Facilitate information-sharing between regulators
4. Expect crypto issuers and service providers to have comprehensive governance frameworks in place with clear lines of responsibility
5. Require crypto service providers to have effective risk management frameworks and require issuers to address financial stability risks in their relevant markets
6. Allow for regulatory reporting of relevant data
7. Impose disclosure requirements on crypto issuers and service providers
8. Monitor risks arising from interconnections both within the cryptoasset ecosystem and between the crypto ecosystem and the wider financial system
9. Address risks associated with the combination of functions in a single entity, including requirements to separate certain functions and activities

Some points to note are:

• The FSB does not prescribe how these recommendations should be implemented. In some cases the aims may be achieved through the extension of existing regulation to cryptoassets; in others crypto-specific guidance or regulation may be required.
• The proposals are based on the principle of “same activity, same risk, same regulation”. In other words, (unregulated) cryptoassets performing an equivalent economic function to (regulated) financial instruments should be subject to equivalent rules.
• The recommendations apply very broadly to all cryptoasset activities, issuers and service providers that may pose risks to financial stability. This could present a challenge for countries which have so far chosen not to follow the EU’s approach in pursuing a comprehensive regulatory structure for a wide range of cryptoassets.
• The aim is for regulators to provide effective guardrails around cryptoassets and markets, providing for adequate transparency, accountability, market integrity, investor and consumer protections and AML/CFT defences across the cryptoasset ecosystem.
• The recommendations support rules being imposed on crypto issuers and service providers to, for example, require them to act honestly and fairly with stakeholders, comply with prudential and market conduct standards, and establish effective contingency arrangements and business continuity plans. The recommendations also envisage segregation requirements to make sure that customer assets are safeguarded.
• Many providers offer a wider range of crypto services – such as trading, custody, settlement and lending – from a single entity. The combination of multiple functions in a single provider complicates the provider’s risk profile and introduces conflicts of interest. The FSB suggests regulation could require certain functions and activities to be kept separate.
• The FSB considers that more rigorous regulatory standards should apply to cryptoassets, such as stablecoins, that could be widely used as a means of payments and/or store of value because they could pose significant risks to financial stability.

An update on global stablecoin arrangements

As well as presenting a general framework for regulating crypto, the FSB is also consulting on changes to its recommendations for supervising global stablecoin arrangements. The revisions are a response to recent market and policy developments. The recommendations represent a higher level of regulatory standard for this category of cryptoasset.

Among the changes, the FSB proposes extending the scope of its recommendations to include stablecoins with the potential to become global stablecoins. The revised recommendations also suggest regulators require global stablecoin arrangements to prepare for run scenarios by having comprehensive liquidity risk management practices and contingency funding plans in place.

The most significant changes relate to stabilisation mechanisms. Many stablecoins in today’s market rely on algorithmic protocols and/or arbitrage activities to maintain a stable value. In the wake of the Terra/Luna collapse, the FSB has concluded that relying on algorithms or arbitrage is not an effective stabilisation mechanism. Its revised recommendations call on national regulators to impose robust requirements for the composition of reserve assets, “consisting only of conservative, high quality and highly liquid assets”. Few existing stablecoins would meet this standard.

As well as changes to stabilisation mechanisms, the FSB also calls for improvements to governance, risk management, redemption rights and disclosures relating to global stablecoin arrangements.

Next steps

Feedback on the consultations is requested by 15 December 2022. The FSB then expects to finalise its recommendations by mid-2023. Given that the FSB reports to the G20 nations, any suggestions it makes can be expected to influence the approach being taken by national policymakers and so could have a real impact on crypto market participants. The FSB plans to review progress made on implementing its final recommendations before the end of 2025.

One area which is not covered in detail in these papers is the role of decentralised finance. An annex on DeFi suggests that DeFi protocols purport to rely on decentralised governance but that in practice governance is often concentrated in the hands of the protocol development team and/or a small group of related stakeholders. The FSB says that it will consider in 2023 whether additional policy work focusing on DeFi is needed.