The Bank of England’s Sir Jon Cunliffe provides some reflections on crypto-currencies and regulation in light of the FTX debacle
Reflections on DeFi, digital currencies and regulation - speech by Jon Cunliffe | Bank of England
Key take-aways from the BOE Deputy Governor in response to recent shocks
1. Unbacked cryptoassets are highly volatile because they have no intrinsic value. A firm accepting its own unbacked crypto asset as collateral for loans and margin payments (as may have happened with FTX) creates extreme ‘wrong way’ risk.
2. Protection of client funds is crucial. In many of these platforms the platform takes possession of the cryptographic keys and manages transactions on the ledger for a pool of assets. It is far from clear whether these practices deliver the assurance of either custody of assets in the conventional finance world or of a claim on the balance sheet in the way that occurs with accounts at a bank.
3. ‘Crypto’ was born in unregulated space: part of the objectives of its early developers was to create a financial system outside regulation. While not yet of systemic scale, the crypto ecosystem has grown very rapidly in recent years and broadened to encompass a range of financial services.
4. Crypto is not a stable ecosystem. Part of this is because, its foundation is completely unbacked instruments of extreme volatility that can swing wildly in value. But part is 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.
5. Decentralised Finance is not the answer because robustness and resilience of DeFi has not been demonstrated at scale and over time.
6. Not clear the extent to which DeFi platforms are truly decentralised. Behind these protocols typically sit firms and stakeholders who derive revenue from their operations. Often unclear who, in practice, controls the governance of the protocols.
7. FTX, along with a number of other centralised crypto trading platforms, appear to operate as conglomerates, bundling products and functions within one firm. In conventional finance these functions are either separated into different entities or managed with tight controls and ring-fences.
Three reasons for crypto regulation
1. Consumer and investor protection
Whether or not one thinks it is sensible to invest or trade in the highly speculative assets that make up most of the activity in the crypto world, investors should be able to do so in transparent, fair and robust marketplaces, with the protections that they would get in conventional finance.
2. Financial Stability
While the crypto world is not at present large enough or interconnected enough with mainstream finance to threaten the stability of the financial system, its links with mainstream finance have been developing rapidly.
We should not wait until it is large and connected to develop the regulatory frameworks necessary to prevent a crypto shock that could have a much greater destabilising impact.
The experience in other areas of digitalisation has demonstrated the difficulty of retrofitting regulation on new technologies and new business models after they have reached systemic scale.
3. To Foster Innovation
Bringing the activities of the crypto world within the relevant regulatory frameworks will foster innovation. This may appear counter intuitive to those who see regulation as opposed to innovation.
‘People do not fly in unsafe aeroplanes’.
Innovation may start in unregulated spaces. But it will only be developed and adopted at scale within a framework that manages risks to existing standards.
The technologies that have been pioneered and refined in the crypto world, such as tokenisation, encryption, distribution, atomic settlement and smart contracts, not only seem unlikely to go away as our everyday lives become more ‘digital’, but may well have the potential to improve efficiency, functionality and reduce risk in the financial system.
And by holding innovative approaches, using technological advance, to the same standards as existing approaches we can ensure that the benefits of new technology and new business models actually flow form innovation rather than from regulatory arbitrage.
How to regulate?
The guiding principle should be ‘same risk, same regulatory outcome’. The starting point should be our existing regulatory frameworks – for investment products, for exchanges, for payments systems and other financial functions – and the level of assurance we require that the relevant risks have been managed.
The Financial Services and Markets Bill
The Financial Services and Markets Bill, currently in Parliament will extend the UK regulatory framework to the use of crypto technologies.
The Bill addresses the regulation of payment systems using “digital settlement assets” defined as “digital representations of value” – in other words digital tokens representing money.
The objective is to extend the current Bank of England and FCA regulatory regimes for e-money and payment systems to cover the use ‘stablecoins’ for payments.
The powers in the Bill will extend not only to the systems for transferring such coins between parties to make payments, but to the issuance and storing of the coins. The Bank will have responsibility for such payment systems which are systemic or likely to become systemic. This will apply whether such systems exist to make payments for real things or for crypto assets should the latter activity become systemic in scale.
Consultation Next Year
The BOE intends early next year to consult in detail on the regulatory framework that will apply to such systemic payment systems and the services, like wallets, that accompany them.
In doing so, they will be guided by the principle of ‘same risk, same regulatory outcome’.
In the case of stablecoins used as money to make payments, the expectation is that stablecoins used in systemic payment chains should meet standards equivalent to those expected of commercial bank money. And that is in terms of stability of value, robustness of legal claim and the ability to redeem at par in fiat.
Some of the likely foundational features of the regulatory regime on which we will consult are already clear. The FPC made clear last year that to deliver that regulatory outcome “regulatory safeguards will be needed for a systemic stablecoin to ensure that the coin issuance is fully backed with high quality and liquid assets, alongside loss absorbing capital as necessary, to compensate coinholders in the event that the stablecoin fails”.
The 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.
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