Speech by Vice Chair for Supervision Barr on crypto

It isn’t hard to find evidence for the need to discuss crypto, but let me start with a recent personal experience. Last month, I visited the Mississippi Delta to talk about financial inclusion and community development, and I spent a morning talking with a group of college students. When I asked, it turned out that most of the students I met owned some crypto-assets. This surprised me because in my experience as a professor, most college students are usually strapped for cash. What didn’t surprise me is that many of those who said they owned crypto-assets also said they had lost money, and they weren’t very happy about that.

When I think about how to approach crypto-assets, the technology behind them, and the interaction between the crypto sector and traditional financial system, I find it helpful to place recent innovation in historical context. Innovation in financial markets has long raised questions about the appropriate role of regulation. Of particular concern is how the regulatory framework can serve both to encourage innovation and to support the safety and soundness of financial institutions and broader financial stability. Just as important is the need to protect the public from fraud and other abusive behavior.

The challenge here begins with a mismatch in timing. Innovation often comes quickly, but it takes time for consumers to become aware that they could both gain and lose money on new financial products. It may take time for market participants to understand attendant risks and come up with tools to manage them. Likewise, regulation involves a deliberative process—as it should because it needs to balance the risk that over-regulation will stifle innovation with the risk that under-regulation will allow for substantial harm to households and the financial system.

Back then, I was talking about some of the causes and consequences of the financial crisis. At that time, new types of financial products had become so intertwined with the banking and broader financial system that the turn in the innovation cycle resulted in devastating consequences for homeowners, workers, businesses, and our economy. Today, while the crypto-asset sector is more nascent and less pervasive, the questions about how new financial products will affect the public, the economy, and financial stability are similar. Innovation surges ahead, and regulation follows, trying to balance benefits and risks.

The Potential Benefits of Innovative Technologies

Before I get into how we are responding to developments in the crypto sector in our approach to supervision and regulation, I want to recognize the potential public benefits of the technologies underlying crypto-assets. It is often argued that these technologies will have extensive beneficial application beyond crypto-assets themselves.

The payments system is critical to everyday Americans. It is highly resilient but also can be slow and expensive. This is particularly true with respect to cross-border payments. The technology underlying crypto assets—including that which enables programmability—could bring new functionality or efficiencies to payments systems.

While purveyors of crypto-assets have represented to customers that they are protected through the decentralized nature of the underlying technology, customers are often at a greater risk because those purveyors often find ways to function outside a robust supervisory and regulatory system. In the absence of regulatory compliance, customers don’t have the information they need to assess and mitigate their risks. Investors do not have the structural protections they have relied on for many decades. As a result, many have been victims of classic cases of fraud and abuse—some appropriately classified as “Ponzi schemes” under a high-tech veneer. Moreover, while crypto-assets are hyped as “decentralized,” there has been an emergence of new, quite centralized intermediaries that are either not subject to or not compliant with appropriate regulation and supervision, which has perpetuated harm to consumers. Complicating matters further, these entities often seek out jurisdictions with loose or less developed legal and regulatory frameworks for financial activities. And the lack of consolidated home country supervision and coordination with host country supervisors rekindles the kind of abuses that bank regulators long ago quashed. While such cross jurisdictional regulatory arbitrage is not new, the digital nature of these activities provides for greater opportunity to expand the reach of such entities to customers around the world.

This kind of behavior can cause substantial harm to investors and consumers as well as to our financial system. The federal bank regulatory agencies, including the Federal Reserve Board, have a statutory responsibility to ensure that the activity of the entities we supervise is conducted in a safe and sound manner, and in compliance with all applicable laws. While the effects of the events in the crypto sector on Federal Reserve-supervised banks have been limited in the aggregate thus far, recent experience has made it clear that crypto could pose risks to those banks. In response, we have worked with the other federal bank regulatory agencies to provide clarity and guidance on what is permissible, safe and sound, and compliant with anti-money-laundering and anti-terrorist financing laws as well as consumer and investor protections. And we’ve set out our supervisory expectations for banks engaging with new product types and activities. As noted above, this is not just a domestic issue. We are also working with our international counterparts to minimize the possibility of regulatory arbitrage across jurisdictions.

The Federal Reserve’s Approach to Supervising Banks’ Engagement with Crypto

One overarching principle of the Federal Reserve’s financial oversight is that activities that are fundamentally the same should be regulated the same, regardless of where or how the activity occurs or the terms used to describe the activity. We have a somewhat complicated financial services regulatory framework in the United States, and there are several regulatory authorities with oversight of financial services activities. But we know how important it is for entities interested in providing financial services with new technologies to engage on a level playing field. That is why we have worked closely with the other bank regulatory agencies to develop a consistent approach. Our overall stance is that, at this stage of the development, banks should take a careful and cautious approach to engaging in crypto-asset related activities and the crypto sector.

The letter said, in effect, “Don’t jump in and plan to figure out risk management later.” It stated that “Federal Reserve-supervised banking organizations should have adequate systems and controls in place to conduct crypto-asset-related activities in a safe and sound manner prior to commencing such activities.”

Again, we took these steps to make clear that we have the same expectations for all the institutions that we supervise and which seek to engage in novel activities. These expectations are not new. We expect supervised entities to ensure that they conduct their activities in a safe and sound manner and in compliance with all relevant laws, including anti-money-laundering laws. These public statements are transparent and provide the same information for everyone, including for small banks that may not have large teams of analysts assessing industry developments, large banks with more resources, and, of course, the public. We plan to continue to publish guidance of this kind as we continue to examine activity in the sector.

In addition to sharing what we learn with the public on an ongoing basis, we are also enhancing our supervision of these activities. We are creating a specialized team of experts that can help us learn from new developments and make sure we’re up to date on innovation in this sector.

Stablecoin issuers seek to have—but don’t—some of the same characteristics as federally insured bank deposits. Stablecoin issuers represent that their liabilities can be redeemed on demand at par, a dollar for a dollar. In fact, however, the assets backing the liability can fluctuate in value. Even if the assets backing the claim are high quality, they cannot necessarily be immediately monetized, and operational risks are quite high. As we have seen all too often, depositors sometimes want or need their money immediately, especially in times of stress. This mismatch in value and liquidity is the recipe for a classic bank run. Issuers are not supervised by the Fed and lack capital and liquidity as a backstop. The banks we regulate, in contrast, are well protected from bank runs through a robust array of supervisory requirements.

Consider the consequences if a stablecoin not subject to appropriate supervision and regulation were to be adopted as a widespread means of payment, which some stablecoin developers state as a goal. Stablecoins have the potential to scale quickly because of network effects. An unregulated, unsupervised, deposit-like asset could create tremendous disruptions, not just for financial institutions but for people who might rely on the coin if it were to get wide adoption. We must learn from the past to ensure that we do not allow for new forms of unregulated private money subject to classic forms of run risk, and with the associated spillovers and systemic implications for households, businesses, and the broader economy.

Conclusion

That gets me back to the central point of my remarks, which is the need to balance innovation with safeguards. Our goal is to create guardrails, while making room for innovation that can benefit consumers and the financial system more broadly. We are working with the other bank regulatory agencies to consider whether and how certain crypto-asset activity can be conducted in a manner that is consistent with safe and sound banking. We are also working toward providing additional clarity on our views of risks and effective risk management practices across a range of crypto-related activity. We will continue to be transparent with the banking sector and the public about our expectations. We will also work with the other agencies to align our approach to ensure that the same risks receive the same treatment. As we continue our efforts, we will work to support innovation by establishing the guardrails essential for sustainable, safe, and transparent markets. Thank you.