U.S. officials have long been concerned about looming threats from the digital-asset industry much of which operates in regulatory gray areas. The issues have been underscored this year amid market turmoil, the bankruptcy of crypto lenders, and, most recently, the collapse of the exchange giant FTX.

“Crypto-asset activities could pose risks to the U.S. financial system if their interconnections with the traditional financial system or their overall scale were to grow without adherence to or being paired with appropriate regulation,” Treasury Secretary Janet Yellen said on Friday about the findings. “Recent crypto market developments have demonstrated the importance of Congress and regulators acting on the report’s recommendations.”

FSOC, which was formed after the financial crisis, is led by the Treasury secretary and includes the heads of key agencies such as the Federal Reserve, Securities and Exchange Commission and Commodity Futures Trading Commission. The group is tasked with identifying risks to financial stability and responding to emerging threats.

Recent volatility in digital-asset markets has hit many crypto investors hard, with some losing their entire life savings. Still, traditional financial institutions have been largely insulated from those problems due to the current regulatory framework and the limited overall scale of crypto activities, FSOC said in its annual report.

Yet there is some overlap, and ties could strengthen—for instance, through banks holding reserve assets backing so-called crypto stablecoins, they said. Those tokens serve as a key on and off ramp between crypto and mainstream finance.

Overall, FSOC identified several gaps in the current U.S. framework for regulating digital assets, such as a lack of federal oversight of tokens that aren’t considered legally to be securities under the SEC’s remit like Bitcoin. Fixing that blindspot would require Congress to write a new law.

How Washington regulates crypto—or doesn’t—has been thrust into the forefront after FTX and a web of related companies collapsed last month. The firm’s co-founder, Sam Bankman-Fried, is now in locked up in the Bahamas and facing extradition to the U.S. to face a range of criminal charges. He has also been sued by the CFTC and the SEC.

Before FTX’s collapse, the exchange had been pushing for U.S. approval to take the middleman out of crypto derivatives trading. The controversial proposal, which could have eventually encroached on a function managed by Wall Street brokers, was withdrawn after FTX and more than 100 related entities filed for bankruptcy last month.

On Friday, FSOC said in its report that regulators should assess the “impact of potential vertical integration by crypto-asset firms,” citing proposals to give retail customers direct access to markets by removing traditional intermediaries.

Other risks

The council’s report also identified several non-crypto issues as representing threats to financial markets and financial institutions.

FSOC said enhancing the resilience of the $24 trillion Treasury securities market, which has had several bouts with low liquidity, remained a priority. The group also said regulators should review market structure issues that may contribute to “liquidity challenges.”

The regulators said it supports initiatives from the SEC and other agencies to address possible risks from investment firms.

“The hedge fund industry has grown considerably over the last five years,” the report said. “Over the same period, qualifying hedge funds’ presence in the critically important short-term funding markets and the U.S. Treasury market has increased markedly.”

The report included a section on global risks, with one focus on China that mentioned difficulties in the real estate sector there and implications for that country’s financial institutions and markets. FSOC also reiterated a call for states and federal agencies to work together to gather data to assess the risks posed by climate change.

“Climate-related financial risks could contribute to financial instability through numerous channels, including financial intermediaries experiencing significant losses, impairment of financial market functioning, or the sudden and disruptive repricing of assets,” the council said.

(Photo by Leonid Sukala/iStockphoto/Getty Images North America/TNS)

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