According to the BIS, the approach to crypto risks is to prohibit, contain or regulate them – Ledger Insights

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The Bank for International Settlements (BIS) has published a brief article exploring options for dealing with the risk of cryptocurrencies, or as it likes to call them, crypto-assets.

He argues that cryptocurrencies present many of TradFi’s risks, but while similar, the risks tend to be exaggerated. These include the extensive use of leverage, liquidity and maturity mismatches, and significant information asymmetries.

We would like to add a comment on maturity mismatches. For example, crypto lenders have deposits that can be withdrawn instantly but lend to borrowers for months or years. TradFi may have similar lags. However, since cryptocurrency is networked, including on a social/Twitter level, “bank runs” and herd movements are much more common, exaggerating the problematic nature of maturity mismatches.

The BIS report highlights that DeFi is often not decentralized because founders have large token holdings or others can gain major influence. It also highlights the critical roles of centralized cryptocurrency exchanges as crypto-onramps. Another observation we have is that decentralized wallets increasingly allow direct access using credit cards, which over time may partially erode the access role of exchanges.

Four Ways to Manage Crypto Risk

While the BIS report highlights three pathways that directly address crypto risk, the report also mentions a fourth. This is to make TradeFi more attractive by reducing the cost of payments or via central bank digital currency (CBDC). However, we would argue that payments is just one application, although it is understandably the most on the central banking community’s radar.

The three direct paths to controlling crypto risk are to prohibit, contain, or regulate it.

The BIS recognizes that banning it may not be acceptable to free societies. Moreover, prohibitions can be circumvented and this could inhibit innovation.

By containing the crypto, the BIS signifies the limitation of the crypto, so the minimal overlap with TradFi is maintained. As an example of containment, the BIS cites the Basel Committee Crypto Rules for Banks – the final version was announced in December. Another example is the SEC’s refusal to authorize a spot Bitcoin ETF. However, even if TradFi is confined, there remains the problem of investor protection. And the BIS notes the risk that the credibility of regulators will be undermined if no action is taken to protect crypto investors.

And that action is likely to be regulation. A common approach is to map crypto activities to conventional activities to apply the same risks and rules. But mapping is not always straightforward. For example, some jurisdictions will regulate stablecoin issuers as banks, some as payment systems, and some as banks. A second challenge is to identify the entity in a decentralized world. However, he considers the starting point to be the entity that controls the protocol.

With the crypto crash, especially the collapse of FTX, the crypto community is preparing for extensive regulation. However, politicians are not always as conservative as central bankers. For example, in the UK this week the Treasury stressed that it wanted to strike a balance between innovation and investor protection and avoid “grasping the future”.

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