Update 564 — Emerging Fin. Systemic Risks:
Assessing Asymmetrics: Crypto and Climate
Feverish negotiations on BIF and BBB continue on the Hill. Elsewhere in Washington, broader issues will get more attention once the big-ticket items are disposed of this fall. The Financial Stability Oversight Council (FSOC), created by the Dodd-Frank Act after the 2008 financial crisis, will face new, growing risks to financial stability represented by digital asset markets and global climate change — of asymmetrical scale and notoriously hard to define, assess, and regulate.
Policy analysts and regulators are just coming to grips with digital assets, their functions, and risks. Climate change itself is more easily grasped and frequently encountered but what does it mean for FSOC and the markets? Today, we survey financial policy considerations related to digital assets and climate change and evaluate options that regulators are considering.
Best,
Dana
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On Thursday, FSOC will meet for the fifth time this year. Composed of the heads of the financial regulatory agencies, FSOC is tasked with identifying and mitigating risks to the financial sector. The Council’s agenda on Thursday will include discussions of forthcoming reports on two critical topics related to financial stability: stablecoins and climate-related financial risk. The recommendations in these reports will signal the Biden administration’s willingness to create new policies to address these emerging threats.
Digital Assets
Digital assets are quickly becoming a significant feature of the global financial system. Global market cap for digital assets — broadly defined as anything existing in a digital format that comes with a right to use, such as cryptocurrencies — is approaching $2.5 trillion, with much of the growth occurring in just the past few years. While the SEC has denied applications for Bitcoin ETFs for years, a new ETF dedicated to bitcoin futures launched this week, as the reach and complexity of digital assets in the economy grows.
The federal government lacks a unified approach for regulating the industry, causing most digital assets to be assessed under existing financial regulations. Under the Trump administration, financial regulators did not seek to generally apply their existing authorities to many digital assets, leading to poor compliance with the rules.
Market Capitalization of Digital Assets
Source: Capital.com
Stablecoins, a class of digital assets that are designed to be backed by reserves in another asset, such as a fiat currency, has drawn the most immediate attention by federal regulators in this space. The market cap of stablecoins recently exploded to more than $100 billion. Notably, the actual holdings of stablecoins are not generally transparent nor low-risk. Last week, the CFTC settled an action against the largest stablecoin, Tether. The agency found, among other problems, that Tether was not backed 1:1 with assets, was generally not audited, and was backed with volatile, illiquid assets.
Although primarily used by investors to trade between different types of digital assets, stablecoins pose a threat to the dollar as a reserve currency and to the financial sector if there is a sudden run on redemptions, or if reserves are insufficient. At the FSOC meeting this week, members are expected to discuss in closed session a long-awaited report on stablecoins by the President’s Working Group on Financial Markets, which will signal the willingness of the Biden administration to step up regulation.
In addition to stablecoins, digital assets pose several potential problems, including:
- Unchecked speculation on assets that can fluctuate wildly in price
- The possibility of massive market manipulation and outright fraud
- Use of cryptocurrencies for money laundering and tax evasion
- Growing crypto exposure for banks, hedge funds, and other investors
- The risk of significant breakdowns due to technological problems and cyber attacks
With all of these problems on the table, regulators will have their hands full as the growth of digital assets in the financial system only continues to accelerate. Potential reforms include:
- The SEC could apply existing securities laws to assert jurisdiction over digital assets meeting the definition of “securities” and those who trade them to lessen the risk of fraud, manipulation, tax evasion, and money laundering
- Other regulators could assert existing authorities to promote the integrity and stability of stablecoins. This could involve regulating stablecoins as money market funds, or regulating stablecoins as deposits under authority from the Glass-Steagall Act, or FSOC using its statutory authority under Dodd-Frank to designate certain activities as “systemically important” to potentially subject stablecoins to heightened regulation
- The Fed could accelerate efforts to modernize the payments system and create a Central Bank Digital Currency, decreasing demand for stablecoins and bolstering the US dollar as a reserve currency
Climate Risk
Human-caused climate change is increasingly linked to catastrophic severe weather events and other physical risks to life and property. As climate change worsens, these physical risks can threaten the financial sector due to sudden changes in asset prices, supply chain disruptions, and more. These risks are why Treasury Secretary Janet Yellen has described climate change as an “existential threat” to the financial system. In its meeting this week, FSOC is expected to review a major report on climate risk, which may signal how far the Biden administration is willing to make new policy in this area.
Policy considerations for climate-related risks to the financial system include:
- Systemic Risk: Current regulatory oversight of banks and other financial institutions does not adequately address the exposure these institutions face from potential climate-related events. For example, widespread coastal flooding and wildfires causing significant property damage pose a threat to insurance companies and banks holding large quantities of asset-backed securities. Also, new investments in renewable energies can cause old investments to become obsolete. Financial institutions and their government supervisors would benefit from greater awareness of climate risks and be better prepared for financial stress that may occur as climate events worsen.
- Economic Growth: Investors increasingly want companies and funds to disclose the extent to which they are exposed to climate-related risks and invested in industries like oil and gas. Without adequately assessing the risks and opportunities associated with climate change, market participants will make suboptimal business decisions. Information through disclosure of climate-related risks is key to ensuring transparent and well-functioning markets.
The Biden administration has a range of possible policy reforms at its disposal to mitigate the financial risks caused by climate change. These include, but are not limited to, the following:
- Requiring bank supervisors to take climate-related risks into account when evaluating an institution’s safety and soundness
- Factoring in climate risk for stress tests of large financial institutions
- Implementing SEC rules to require companies (both public and private), products, and funds to identify, assess, and disclose climate-related information
- Requiring rating agencies and index providers to incorporate climate risk into their assessments of companies and investment products
What FSOC Can Do
The Biden administration can take some positive steps forward toward policy reform. In particular, FSOC can take a leading role in examining risks and establishing a regulatory path forward. Likewise, the Office of Financial Research (OFR) can actively build a body of research identifying where risks may lie in the financial system. The raison d’être of FSOC and OFR is to identify and respond to emerging risks to the financial sector and proactively prevent future financial crises. Given the risks posed by digital assets and climate change, there is no reason for delay in doing so.
Opposition to policy reform will be difficult to overcome. The fossil fuel industry has long-established power in Washington, and the crypto lobby is rapidly building influence as well. Crypto markets today are exhibiting behaviors and activities that are eerily similar to the risky behaviors and activities in the mortgage and derivatives markets that preceded the 2008 financial crisis. Times might be good in the present, but the potential risks justify taking prudent actions now to prevent an avoidable financial crisis in the future.