(Kitco News) -
Jon Cunliffe, the Bank of England’s Deputy Governor for Financial Stability, delivered a speech on Monday that spelled out the impact of FTX on the BoE’s approach to crypto in a fair amount of detail.
Speaking at the Gilmore Centre Policy Forum Conference on DeFi & Digital Currencies, Cunliffe said the Bank appreciates the scale of what has happened in recent weeks.
“We have seen what is probably the largest – and certainly the most spectacular – failure to date in the crypto ecosystem,” he said of the collapse of FTX and its associated businesses.
While Cunliffe acknowledged that understanding exactly what happened at FTX will take time, “there do appear to be some general themes that are very familiar to those who regulate and supervise conventional financial firms and financial instruments.”
“The first are fundamental issues around how financial institutions should be organized,” he said. “Regardless of the financial service activity – be it banking, insurance, exchanges, clearing houses – regulation in the conventional financial sector imposes stringent/substantive requirements. Supervision aims to ensure that these are implemented.”
He said that these requirements reflect the inherent risks that financial services pose to users, other financial firms and the financial system. “Technology in and of itself does not change the need for transparency in corporate structures, governance, audit and systems and controls – for example to protect customers’ funds,” he said.
Cunliffe said that regulation imposes requirements and constraints on the connections between financial firms and their affiliates to ensure proper controllers and to prevent conflicts of interest. “In this respect, transparency in corporate structures and the relationships between them is the key foundation,” he said.
The connections between activities carried out within the firm also matter, he said, adding that “lending, brokering, providing an exchange platform, clearing and settlement perform different economic functions that carry different risks.” When they happen within one group, Cunliffe said regulation requires “separate, independent governance” to ensure the risks inherent in each activity are properly managed.
“FTX, along with a number of other centralised crypto trading platforms, appear to operate as conglomerates, bundling products and functions within one firm,” he said. “In conventional finance these functions are either separated into different entities or managed with tight controls and ring-fences.”
He said that in the case of FTX, he saw other familiar issues surrounding the financial instruments involved. “Collateral performs a variety of vital function in financial services,” he said. “It protects lending counterparties from credit risk. It can also serve as margin in clearing processes. The higher the credit quality and lower the volatility of assets used as collateral, the better suited it is to serving as assurance against risk.”
Cunliffe said that because of this, “there are stringent, material conditions on collateral that can accepted” in central counterparty clearing.
“Unbacked cryptoassets are highly volatile, given that they have no intrinsic value,” he said. “They are subject to runs and their value can change very quickly as we have seen in recent months.”
Moreover, a firm like FTX accepting their own coin as collateral for loans and margin payments “creates extreme ‘wrong way’ risk – i.e. when the exposure to a counterparty increases together with the risk of the counterparty’s default,” he said adding that “there are indications that it could have been a run on its crypto coin, FTT, which triggered the collapse.”
Cunliffe also said that protecting client funds is essential, and that many platforms take possession of the keys and manages transactions for a pool of assets. “It is far from clear whether these practices deliver the assurance of either custody of assets in the conventional finance world or of a claim on the balance sheet in the way that occurs with accounts at a bank,” he said.
“‘Crypto’ was born in unregulated space,” he said. “The experience of the past year has demonstrated that it is not a stable ecosystem.”
Cunliffe believes that this is because “its foundation is completely unbacked instruments of extreme volatility that can swing wildly in value,” but also due to the fact that “the crypto institutions at the center of much of the system exist in largely unregulated space and are very prone to the risks that regulation in the conventional financial sector is designed to avoid.”
He said that the FCA has been warning UK residents about FTX since September, telling them that “you are unlikely to get your money back if things go wrong.”
Cunliffe also expressed doubts about whether decentralized finance (DeFi) could effectively mitigate the risks created by centralized crypto platforms like FTX.
“From the standpoint of a financial stability authority and a financial regulator, I have yet to be convinced that the risks inherent in finance can be effectively managed in this way,” he said. “That skepticism is greater if the activity in question is the trading, lending, etc. of super volatile assets without intrinsic value.”
Cunliffe also said about DeFi that “it is not clear the extent to which these platforms are truly decentralized. Behind these protocols typically sit firms and stakeholders who derive revenue from their operations.”
He said it is also often unclear who actually controls the governance of the protocols. “As with driverless cars, they are only as good as the rules, programs and sensors which organize their operations,” he said. “We would certainly need a great deal of assurance before such systems could be deployed at scale in finance.”
Cunliffe said the key question is whether regulators like the Bank of England should bring the crypto world within the regulatory framework, and, if so, how should they do it?
Cunliffe believes it is important to regulate them, for three reasons.
“First, and most obviously, the need to protect consumers/investors,” he said. “Whether or not one thinks it is sensible to invest or trade in the highly speculative assets that make up most of the activity in the crypto world, investors should be able to do so in transparent, fair and robust marketplaces, with the protections that they would get in conventional finance.
His second reason is the need to protect financial stability. “While the crypto world […] is not at present large enough or interconnected enough with mainstream finance to threaten the stability of the financial system, its links with mainstream finance have been developing rapidly,” he said. “We should not wait until it is large and connected to develop the regulatory frameworks necessary to prevent a crypto shock that could have a much greater destabilizing impact.”
Cunliffe said some argue that “the very instability and riskiness of the world of unregulated crypto finance, most recently demonstrated by FTX, will in the end ensure that the sector cannot grow,” and that the Bank of England should keep crypto outside the regulatory framework to ensure that “users’ ‘caveat emptor’ concerns prevent both growth and connection with mainstream finance.”
He said arguments like this led him to his third reason. “The technologies that have been pioneered and refined in the crypto world […] may well have the potential to improve efficiency, functionality and reduce risk in the financial system […] so my third reason for bringing the activities of the crypto world within the relevant regulatory frameworks is to foster innovation,” he said.
“This may appear counterintuitive to those who see regulation as opposed to innovation. But, as I have said before, ‘people do not fly in unsafe aeroplanes’. Innovation may start in unregulated spaces. But it will only be developed and adopted at scale within a framework that manages risks to existing standards.
As to the question of how regulation should be applied, Cunliffe said proportionality is the key. “The guiding principle should be ‘same risk, same regulatory outcome’. The starting point should be our existing regulatory frameworks – for investment products, for exchanges, for payments systems and other financial functions – and the level of assurance we require that the relevant risks have been managed.”
Cunliffe said that the approach of regulators should be open, but that they should also be firm that where equivalent regulatory protections cannot be created or extended, they should be firm: “We are not prepared to see innovation at the cost of higher risk,” he said.
Addressing the Financial Services and Markets Bill currently being debated in Parliament, Cunliffe said the goal is “to extend the current Bank of England and FCA regulatory regimes for e-money and payment systems to cover the use of ‘stablecoins’ for payments.”
He said the Bill would extend “not only to the systems for transferring such coins between parties to make payments, but to the issuance and storing of the coins,” and that the BoE would be responsible for systems “which are systemic or likely to become systemic. This will apply whether such systems exist to make payments for real things or for crypto assets should the latter activity become systemic in scale.”
Regarding the Bank’s plans for a central bank digital currency (CBDC), or “a digitally native pound sterling,” Cunliffe said they will issue a consultative report around the end of year.
“Our work on a digitally native pound is driven by the trends we now see both specifically in payments, including the reducing role of cash, and more generally in the increasing digitalization of daily life,” he said. “It is motivated by two primary concerns. First, that […] we remain able to ensure that all forms of money that circulate in the UK are robust, interchangeable without loss of value and denominated our unit of account – the pound sterling. Second, to ensure that there can be competition and innovation in the development of new functionalities using tokenized money.”
The Financial Services and Markets Bill was introduced to the House of Commons on July 20, 2022. The Bill is currently at the Report stage in Parliament, and it is expected to finish making its way through the House of Commons by late 2022, after which it will be passed to the House of Lords.
