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The Fed is putting together a special team of experts to help craft its crypto policy

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(Kitco News) - Michael Barr, vice chair for supervision at the Federal Reserve, revealed on Thursday that the central bank is putting together a “specialized team of experts” to help it supervise the rapidly growing crypto sector, which continues to struggle in the wake of the events of 2022.

Barr made the comments during a speech at the Peterson Institute for International Economics in Washington, D.C., which was focused on outlining the Federal Reserve’s approach to supervision and regulation of banks’ crypto-related activities.

“Despite recent events, we have not lost sight of the potential transformative effect that these technologies could have on our financial system,” Barr said. “And we need to be careful lest regulation lock in the power of incumbents or stifle innovation. But the benefits of innovation can only be realized if appropriate guardrails are in place.”

According to Barr, a fifth of Americans say that they have owned some form of crypto, but the events of the past year have shown a light on the problems that the industry faces, which have affected a large segment of the public.

The Fed is now focused on creating a regulatory framework that “can serve both to encourage innovation and to support the safety and soundness of financial institutions and broader financial stability,” Barr said, adding, “Just as important is the need to protect the public from fraud and other abusive behavior.”

Barr noted that the speed at which innovation takes place can make it a challenge for market participants to understand the risks involved, but establishing regulation involves a deliberative process that takes time to unfold. This is as it should be, he said, “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.”

The vice chair of supervision went on to note the importance of the payments system in America, saying that it is “highly resilient but also can be slow and expensive,” especially when it comes to cross-border payments. “The technology underlying crypto assets—including that which enables programmability—could bring new functionality or efficiencies to payments systems,” he said.

He went on to highlight that distributed ledger technology holds the possibility of helping to facilitate faster reconciliation, clearing and settlement, and reduce the cost for a variety of traditional asset transactions, including new ways to link securities and cash markets that are not currently possible.

While the technology has many positive applications, the industry itself has caused financial pain for many inexperienced investors who didn’t understand the risks.

“Experience has shown that crypto-assets can face the same fundamental liquidity and credit risks as traditional assets, and can be highly correlated with other traditional risks, rather than being hedges against such risks,” said Barr. “When it comes to certain crypto-assets, some of which have no intrinsic value beyond the faith of their owners, the law of gravity will eventually apply, as it did with the tulip frenzy in Holland more than 400 years ago.”

The lack of clear regulation and confusion on the part of investors has led many to become victims of classic cases of fraud and abuse, Barr said, with many crypto projects in existence effectively operating 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,” he said.

The fact that many of these entities operate in jurisdictions with lax financial regulations only complicates matters further, “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.”

Barr highlighted the events that transpired with FTX to drive home this point, noting that the exchange “has reportedly wiped out the holdings of a million people, costing them billions of dollars.” And it wasn’t just FTX, as numerous crypto companies filed for bankruptcy in 2022, and 2023 has seen a similar trend, with crypto-focused Silvergate Bank announcing that it will be winding down its operations.

“As these cases are working their way through the bankruptcy courts, we are seeing indications of misuse of client funds, misrepresentations, obfuscation about availability of deposit insurance, and potential fraud,” Barr said.

He went on to explain that while the devastation that has been seen across the crypto ecosystem has had a limited effect on Federal Reserve-supervised banks, it's possible that crypto could pose risks to those banks in the future.

“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,” he said. “And we've set out our supervisory expectations for banks engaging with new product types and activities. We are also working with our international counterparts to minimize the possibility of regulatory arbitrage across jurisdictions.”

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Recently, the central bank focused its efforts on releasing public statements informing banks and the general population about the risks associated with crypto investments and encouraging greater care and due diligence. It is the stance of the Federal Reserve that banks should adopt a careful and cautious approach to engaging in crypto-related activities, Barr said.

“In addition to sharing what we learn with the public on an ongoing basis, we are also enhancing our supervision of these activities,” he added. “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.”

And on the topic of stablecoins, Barr said that “Any entity issuing money denominated in the U.S. dollar and drawing on the trust of the Federal Reserve needs to be subject to federal prudential regulation and supervision.”

“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,” he warned. “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.”

In closing, Barr said that the Fed’s goal is to “create guardrails while making room for innovation that can benefit consumers and the financial system more broadly.” The central bank is now working with 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,” Barr said. “As we continue our efforts, we will work to support innovation by establishing the guardrails essential for sustainable, safe, and transparent markets.”

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