IMF Publication: Regulating the Crypto Ecosystem – The Case of Unbacked Crypto Assets

The ongoing evolution in the crypto ecosystem is revealing both opportunities and pitfalls. Crypto assets were originally developed to democratize payments but are mostly used for speculation and, in the case
of certain types of dollar-denominated stablecoins, also as a hedge against inflation and currency depreciation. Unbacked crypto assets are the oldest and most popular type of crypto assets, relying not on any backing asset for value but instead on supply and demand. These crypto assets offer limited or no rights for the token holder and are usually issued in a decentralized manner. Users treat unbacked crypto assets as speculative instruments rather than as a medium of exchange.

Nevertheless, innovations that have given rise to the crypto ecosystem, including their underlying technologies, could create potential benefits through greater competition and efficiency in some financial services, such as remittance, trade financing, and cross-border payments. Applying decentralized technologies to real use cases, coupled with appropriate regulation, can offer consumers compelling alternatives to traditional finance.

Crypto asset growth has been volatile, and associated financial stability risks in some emerging markets and developing economies are rising. The total valuation of crypto assets reached almost $3 trillion in November 2021 before falling to less than $1 trillion in July 2022, demonstrating relatively high volatility. Although the size of the market itself is not necessarily a financial stability risk, growing interlinkages with regulated financial services and the lack of regulation might be. The October 2021 Global Financial Stability Report revealed that crypto asset exchanges operating in some emerging markets and developing economies have reached trading volumes comparable to those of local stock exchanges and interbank foreign exchange markets. Despite these large retail holdings, many regulatory authorities do not have conduct or prudential regulation, or payments oversight.

Developing a robust and comprehensive regulatory framework for this quickly evolving industry will involve intense monitoring, a flexible approach, and domestic and global collaboration. The global regulatory framework should provide a level playing field along the activity and risk spectrum. Regulators need to continuously monitor the crypto asset landscape to understand the direction of industry developments. In this sense, ongoing efforts to address data gaps to monitor markets and potential contagion effects to the existing financial sector are welcome. Regulation should not be seen as stifling innovation but rather as building trust. As with the wider financial sector, regulation can instill trust in the business and foster a safer development of the sector by providing clear guidelines that remove uncertainty and foster confidence. Defining a clear scope is important, and the immediate focus should be on key entities that carry out core functions such as exchanges, wallet providers, and other centralized entities.

For crypto assets, it is important that key centralized entities that carry out core functions be licensed and authorized.
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Regulatory approaches should focus on key components and their functions to ensure those entities are licensed and authorized. Authorities might want to consider any unique risks—from the underlying technology to volatility, market awareness, product knowledge and understanding, and how the crypto assets are used. Although a technology-neutral approach to regulation might be appropriate, supervisory approaches should consider the unique risks of different methods of delivery and operation, and authorities should be confident in identifying where particular types of technologies might challenge (or support) their objectives. Regulators may also want to consider cross-sectoral issues that may need bespoke responses. Where entities are carrying out multiple activities, appropriate prudential
requirements coupled with entity-based regulation and supervision will be needed to manage these additional risks. Where these entities are considered systemic, drawing guidance from the PFMI could be
appropriate.

In jurisdictions where crypto assets are systemic, immediate action may need to be taken, including strengthening macroeconomic policies, but broad-based restrictions are unlikely to be a long-term solution. In the short term, in certain emerging markets and developing economies where crypto assets might already generate risks to financial stability, authorities should use existing regulatory powers to best manage any risks while a more comprehensive standards are developed at the global level. At the same
time, in jurisdictions where residents use crypto assets (in particular, dollar-denominated stablecoins) as a way of hedging against inflation or currency devaluation risk, implementing stronger domestic
macroeconomic policies—such as strengthening monetary policy credibility, ensuring central banks have independence from political and industry influence, ensuring traditional financial institutions are held
accountable for their failings, and maintaining a sound fiscal position—may help dampen incentives. Restricting the use of crypto assets for certain activities—such as restricting derivatives linked to, or payments in, crypto assets—could also be a short-term solution to dampen crypto asset growth. Broader prohibitions on the creation and use of crypto assets, however, are likely to inhibit innovation and be ineffective given the ability to access them easily across borders. Prohibitions could also trigger even stronger incentives for regulatory arbitrage and circumvention—rendering the enforcement of such broad bans extremely difficult.

The cross-sector and cross-border dimensions of crypto assets make domestic and international coordination and cooperation key. Activities related to crypto assets already are, and will continue to be, more cross-border and cross-sectoral than many traditional financial activities. This requires close international cooperation 63 to address regulatory gaps and prevent regulatory arbitrage. Consistent regulatory approaches can prevent the potential risk of a race to the bottom by regulators and
policymakers and can address regulatory arbitrage by financial entities.

To ensure effective and efficient cross-sectoral and cross-border cooperation, robust international standards are indispensable. Relevant SSBs are making significant efforts to develop their own standards
according to their mandates. Although these are important steps, the economic functions of crypto assets are likely to change over time, changing the suitability of sector-specific regulations. Against this background, it will be important for the FSB to take a leading role in coordinating efforts by the sectoral SSBs. Home authorities where crypto asset service providers are domiciled need to coordinate with other relevant authorities where the users of the crypto assets are located. IMF staff are actively contributing to
the SSBs’ activities to facilitate the development and implementation of robust international standards to ensure consumer protection, market integrity, and financial stability.

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