On December 16, 2022, the Financial Stability Oversight Council (Council) published its 2022 annual report. The report highlights a number of key policy recommendations for federal financial regulators, including four recommendations for further legislation or regulation in the digital asset space.

The Council is a committee of federal financial regulators established under the Dodd-Frank Act. The Council generally has no enforcement or rulemaking powers of its own, but instead is designed to serve as a kind of clearinghouse to stimulate interagency dialogue and ensure consistent financial policy across the federal government. One of the principal tools the Council uses to advance new policy goals is the publication of white papers and other thought leadership pieces that provide concrete recommendations for future action, such as its recent report on digital assets. Recommendations found in these publications then filter through the various financial agencies to inform future rulemaking or influence policy positions on trending issues. We have found, for example, that the Federal Reserve’s recent views on stablecoins have been heavily influenced by ideas filtered through the Council.

The Council’s annual report discusses a broad range of emerging issues and risks potentially impacting the financial system, and, as to digital assets, focuses in particular on recent volatility in the prices of cryptocurrencies, as well as the bankruptcies of several prominent crypto intermediaries. The report discusses the recent crypto downturn and reported instances of fraud in the crypto markets. The report notes, however, that the recent downturn did not have notable effects on the traditional financial system, and that the current regulatory framework, together with the limited overall scale of the crypto market, have helped insulate traditional financial institutions. Citing potential regulatory gaps and anticipating future interconnectedness between crypto and traditional financial markets, the annual report provides four policy recommendations:

First, the spot markets for crypto-assets that are not securities are subject to limited direct federal regulation. As a result, those markets may not be subject to a regulatory framework designed to ensure orderly and transparent trading, prevent conflicts of interest and market manipulation and protect investors and the financial system more broadly. To address this regulatory gap, the Council recommends that Congress pass legislation that provides for explicit rulemaking authority for federal financial regulators over the spot market for crypto-assets that are not securities. The Council recommends that this rulemaking authority should not interfere with or weaken market regulators’ current jurisdictional remits. Legislation should provide for enforcement and examination authority to ensure compliance with these rules.

Second, crypto-asset market businesses do not have a consistent or comprehensive regulatory framework and can engage in regulatory arbitrage. Some crypto-asset businesses may have affiliates or subsidiaries operating under different regulatory frameworks, with no single regulator having visibility into the risks across the entire business. To address the risk of regulatory arbitrage, the Council recommends continued coordination, legislation addressing the risks posed by stablecoins, legislation relating to regulators’ authorities to have visibility into and supervise the activities of all of the affiliates and subsidiaries of crypto-asset entities, and appropriate service provider regulation.

Third, a number of crypto-asset trading platforms have proposed offering retail customers direct access to markets by vertically integrating the services provided by intermediaries such as broker-dealers or futures commission merchants. Financial stability and investor protection risks may arise from retail investors’ exposure to some practices often proposed by vertically integrated trading platforms, such as automatically and rapidly closing out customer positions. Therefore, the Council recommends that member agencies assess the impact of potential vertical integration by crypto-asset firms.

Finally, the Council recommends that Council members continue to build capacities related to data and the analysis, monitoring, supervision and regulation of crypto-asset activities. The Council’s report on digital assets describes these recommendations in greater detail.