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Federal Reserve: Crypto and DeFi Insights from Recent Turbulence Through a Financial Stability Lens

Federal Reserve | Jul 8, 2022

Federal Reserve Vice Chair Lael Brainard - Federal Reserve:  Crypto and DeFi Insights from Recent Turbulence Through a Financial Stability LensSpeech:  Vice Chair Lael Brainard at Bank of England Conference, London, United Kingdom

Recent volatility has exposed serious vulnerabilities in the crypto financial system.  While touted as a fundamental break from traditional finance, the crypto financial system turns out to be susceptible to the same risks that are all too familiar from traditional finance, such as leverage, settlement, opacity, and maturity and liquidity transformation. As we work to future-proof our financial stability agenda, it is important to ensure the regulatory perimeter encompasses crypto finance.

Distinguishing Responsible Innovation from Regulatory Evasion

  • New technology often holds the promise of increasing competition in the financial system, reducing transaction costs and settlement times, and channeling investment to productive new uses. But early on, new products and platforms are often fraught with risks, including fraud and manipulation, and it is important and sometimes difficult to distinguish between hype and value.
  • If past innovation cycles are any guide, in order for distributed ledgers, smart contracts, programmability, and digital assets to fulfill their potential to bring competition, efficiency, and speed, it will be essential to address the basic risks that beset all forms of finance.

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  • These risks include runs, fire sales, deleveraging, interconnectedness, and contagion, along with fraud, manipulation, and evasion. In addition, it is important to be on the lookout for the possibility of new forms of risks, since many of the technological innovations underpinning the crypto ecosystem are relatively novel.

Insights from Recent Turbulence

  • Contrary to claims that crypto-assets are a hedge to inflation or an uncorrelated asset class, crypto-assets have plummeted in value and have proven to be highly correlated with riskier equities and with risk appetite more generally.
  • Second, the Terra crash reminds us how quickly an asset that purports to maintain a stable value relative to fiat currency can become subject to a run. New technology and financial engineering cannot by themselves convert risky assets into safe ones.
  • Third, crypto platforms are highly vulnerable to deleveraging, fire sales, and contagion—risks that are well known from traditional finance as illustrated by the freeze on withdrawals at some crypto lending platforms and exchanges and the bankruptcy of a prominent crypto hedge fund. Some retail investors have found their accounts frozen and suffered large losses.
  • Large crypto players that used leverage to boost returns are scrambling to monetize their holdings, missing margin calls, and facing possible insolvency. The crypto ecosystem is tightly interconnected, as many smaller traders, lenders, and DeFi (decentralized finance) protocols have concentrated exposures to these big players.

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  • Finally, we have seen how decentralized lending, which relies on overcollateralization to substitute for intermediation, can serve as a stress amplifier by creating waves of liquidations as prices fall.

Private Digital Currencies and Central Bank Digital Currencies

  • Stablecoins represent a second area with a heightened risk of spillovers. Currently, stablecoins are positioned as the digital native asset that bridges from the crypto financial system to fiat.
  • Well-regulated stablecoins might bring additional competition to payments, but they introduce other risks. There is a risk of fragmentation of stablecoin networks into walled gardens. Conversely, there is a risk that a single dominant stablecoin might emerge, given the winner-takes-all dynamics in such activities.

Building in Risk Management and Compliance

  • While innovation and competition can reduce costs in finance, some costs are necessary to keep the system safe.  Someone must bear the costs of evaluating risk, maintaining resources to support those risks through good times and bad, complying with laws that prevent crime and terrorism, and serving less sophisticated customers fairly and without exploitation.

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  • In the current crypto ecosystem, often no one is bearing these costs. So when a service appears cheaper or more efficient, it is important to understand whether this benefit is due to genuine innovation or regulatory noncompliance.

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NCFA Jan 2018 resize - Federal Reserve:  Crypto and DeFi Insights from Recent Turbulence Through a Financial Stability LensThe National Crowdfunding & Fintech Association (NCFA Canada) is a financial innovation ecosystem that provides education, market intelligence, industry stewardship, networking and funding opportunities and services to thousands of community members and works closely with industry, government, partners and affiliates to create a vibrant and innovative fintech and funding industry in Canada. Decentralized and distributed, NCFA is engaged with global stakeholders and helps incubate projects and investment in fintech, alternative finance, crowdfunding, peer-to-peer finance, payments, digital assets and tokens, blockchain, cryptocurrency, regtech, and insurtech sectors. Join Canada's Fintech & Funding Community today FREE! Or become a contributing member and get perks. For more information, please visit: www.ncfacanada.org

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