The Office of Financial Research Identifies Three Ways “DeFi” Growth (But Actually, Custodial Stablecoin Reliance) Could Threaten Financial Stability
On Tuesday, the Office of Financial Research (OFR) released a blog post spotlighting the ways in which “DeFi” purportedly could impact broader U.S. financial stability and urging the continued monitoring of decentralized technologies.
First, the post describes the impact of digital asset price declines on broader financial markets, citing, for instance, the 30-day rolling correlation between the returns on Bitcoin and the S&P 500 has increased noticeably since the beginning of 2021.
Second, the post focuses particularly on the risk of rapid withdrawals of stablecoins backed by commercial paper on traditional financial institutions, as well as the reliance of traditional borrowers on stablecoin or crypto-asset lenders.
Finally, the post argues the “substantial efficiencies” stablecoins could bring to commercial uses such as global supply chains could create a source of “immediate economic consequences” should the stablecoin markets be disrupted or fail.
What does this mean?
The Spotlight's identification of potential financial stability risks and the rationale underlying them is not far off, but they are not DeFi-specific risks.
While the effects from price declines in digital assets could spill over into traditional financial markets, that is not a DeFi specific risk or one caused by the use of DeFi protocols. For example, before DeFi existed in 2016, the decline of digital asset prices would have likewise posed a potential risk to financial stability.
Similarly, the risk that could be caused by runs on custodial stablecoin arrangements is not a risk caused by DeFi. DeFi protocols could not exist and runs on custodial stablecoin reserves would still be a pressing issue.
Furthermore, a failure of a global payments system would pose financial stability risks, but that is a risk created by the potential mass adoption of stablecoins, not a risk created by DeFi protocols.
Precise characterization is important here to appropriately identify risks and avoid demonizing DeFi.
SEC Announces Emerging Technologies and Crypto-Assets as a Priority for Examination
The SEC Division of Examinations announced its 2023 priorities this week, which broadly defined which areas targeted investigations will focus on, selected through a risk-based approach.
Unsurprisingly, the Division cited “market volatility, cyber-events, and market disruptions caused by recent bankruptcies and financial distress among crypto asset market participants” as motivation to continue its focus on broker-dealers and registered investment advisers (RIAs).
The Division will focus on advisers using ““emerging financial technologies or employing new practices, including technological and on-line solutions to meet the demands of compliance marketing to service investor accounts,” and are in the business of “the offer, sale, or recommendation of, advice regarding and trading in crypto or crypto-related assets.
Procedurally, the Division is concerned as to whether broker-dealers or advisers in crypto-asset trading “met and followed their respective standards of care” and “routinely reviewed, updated and enhanced their compliance, disclosure and risk management practices” when providing investment advice or recommendations for trading in crypto-related assets.
RIAs that private funds that hold “certain hard-to-value investments, such as crypto assets” and transfer agents (i.e. those who keep records of ownership) that service crypto asset issuers are also specifically earmarked as examination priorities.
These examinations will zero in most on firms that employ novel marketing tools, such as “digital engagement practices” (think: robo-advisors, gamification, and social media), to assess whether advice or recommendations are being provided; whether advice is in the best interest of investors; whether representations being made are fair and accurate; whether operations and controls are consistent with investment disclosures; and whether these practices take into account associated risks to vulnerable parties.
What does this mean?
Though its focus on crypto assets is a trend that continues from the Division’s 2022 priorities, the 2023 edition placed a new emphasis on adherence to the new Marketing Rule, which broadly requires investment advisors to be truthful and have a reasonable justification for the statements they make that investors could be expected to rely on.
These priorities indicated the SEC’s increased focus on investigation and enforcement of crypto since 2022. The rise of retail investors on highly-accessible digital platforms and investing apps, paired with the infamous marketing tactics used in crypto recently (see class-action lawsuits and state-led investigation against influencers promoting FTX without sufficient disclosures) have led the Division to increasingly prioritize adherence to marketing and disclosure rules.
St.Louis Fed Publishes a Paper on Tornado Cash
On February 3, the Federal Reserve Bank of St. Louis published a paper on Tornado Cash and blockchain privacy. The authors Matthias Nadler and Fabian Schär explain the core concepts behind privacy-enhancing protocols, including smart contracts, hash functions, Merkle trees, and zkSNARKs. The article also offers a detailed description of how Tornado Cash functions and provides an empirical analysis of the usage and scale of the protocol.
Importantly, instead of banning any interactions with the protocol, the paper suggests that honest participants be allowed to use Tornado Cash. According to the authors, this can be achieved through the concept of “partial privacy."
The paper explained that because of the transparency of public blockchains, anyone can see whether an address has interacted with Tornado Cash smart contracts. However, the technology behind public blockchains also allows showing that the interaction was not illegal. It can be done by sharing cryptographic proof linking deposit and withdrawal addresses. Honest users, upon demand, can share the proof and allow a counterparty to verify that the funds received from the protocol came from a legal source.
This solution is not fully anonymous, as users will have to voluntarily share information with third parties. However, as the authors claim, “this process creates a situation where honest actors can remain partially anonymous, while dis-honest actors will face severe search and matching cost to find a counterparty that is willing to take the risk and accept the funds without the proof of origin.”
What does this mean?
We’re happy to see a Federal Reserve bank publish a just-the-facts explainer on Tornado Cash.
Fed Issues Statement On Banks & Digital Assets
The Board of Governors of the Federal Reserve issued an interpretation of Section 9(13) of the Federal Reserve Act to govern the use and custody of digital assets by its member banks.
In its interpretation, the Board of Governors found that the holding of most digital assets are “presumptively prohibited,” and that member banks that wish to hold or use stablecoins, or “dollar tokens,” will first need to prove the security measures in place are sufficient and receive formal approval prior to holding and transacting in these assets.
The board reasoned that “significant risks” associated with the cryptocurrency sector as justification for the directives, including fraud, legal ambiguity, and volatility.
“The Board believes this presumption is bolstered by safety and soundness concerns,” it noted. “The Financial Stability Oversight Council has observed that, in the absence of a fundamental economic use case, the value of most crypto-assets is driven largely by sentiment and future expectations, and not by cash flows from providing goods or services outside the crypto-asset ecosystem.”
Further, the Board found that “issuing tokens on open, public and/or decentralized networks or similar systems is highly likely to be inconsistent with safe and sound banking practices.”
What does this mean?
At least for the time being, this decision damages the hopes of the digital asset ecosystem becoming more incorporated into the regulated banking sphere and economy at large; however, the decision is consistent with the most recent guidance and actions from federal banking regulators.
In January, the Federal Reserve, FDIC, and OCC, the three primary bank regulators in the US, issued a joint statement warning depository institutions of the significant risks associated with banking firms with exposure to the cryptocurrency ecosystem
Even more recently, the Fed denied the membership application of digital asset-focused bank Custodia, citing similar concerns with the cryptocurrency ecosystem at large as its justification.