Remarks as Prepared for Delivery on October 26, 2022
Thank you ISDA for the opportunity to speak to your members about cryptocurrency. I taught law students about cryptocurrency in my advanced securities regulation course at Georgetown Law School, and then a cryptocurrency regulation course at the University of Virginia Law School. Cryptocurrency was of natural interest given my decade as the Special Inspector General over TARP.
You see, Bitcoin, the first cryptocurrency, was borne of, or at least heavily influenced by, the 2008 financial crisis and bank bailouts. On Halloween October 31, 2008, the same month that Congress authorized TARP, Satoshi Nakamoto, the inventor of Bitcoin, published a whitepaper stating, “I’ve been working on a new electronic cash system that’s fully peer-to-peer, with no trusted third party.” Later, the first 50 coins had the following embedded message, “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”
My experiences and that unique crypto origin confirm for me that one word should guide the federal government’s approach to crypto. That word is “risk.” I advocate for a “same risk, same regulatory outcome” approach, starting first with an assessment of risk, and in particular, financial stability risk.
With reportedly one in five Americans owning cryptocurrency, and growing interest by more traditional finance “Trad-Fi,” it is important for the United States to have a regulatory framework with effective guardrails to address crypto’s financial stability risks. The market’s ability to harness crypto’s promise to deliver more inclusive, cheaper, faster, and competitive financial services, should not come at the expense of financial stability.
Today, I will talk first about how crypto presents many similar financial stability risks as the traditional financial system, with parallel themes to 2008, and the potential for that risk to become systemic.
Second, novel risks can apply to these novel assets, increasing financial stability risks.
Finally, to bolster financial stability, we can look to post-crisis reforms that worked before to keep U.S. markets the strongest and safest in the world.
Crypto Markets Face Similar Financial Stability Risks as the Traditional Financial System, with Parallel Themes to 2008
Today, we are confronted by emerging financial stability risks in a market that did not exist in 2008 – the rapidly developing crypto market. Cryptocurrency was supposed to break from the traditional financial system, and all of its fragility and vulnerabilities. However, this spring, unregulated crypto markets revealed their vulnerabilities to similar financial stability risks as traditional finance, with parallel themes from the 2008 financial crisis.
In 2008, the financial crisis spiraled out of control due to unchecked risk-taking by financial institutions that were highly interconnected with each other. Innovative derivatives that were largely unregulated, complex and opaque connected one financial institution to another. Underlying assets that were not the high quality represented resulted in hidden exposures and vulnerabilities.
Significant interconnections caused contagion risk. The market lost confidence in any counterparty who looked to be on weak footing, leading to runs and withdrawals of financial support. Defaults led to cascading losses and deleveraging. Short-term liquidity dried up.
Redemption requests and fire sales resulted from a loss of market confidence. It is seared in my mind the day when I was counsel to the U.S. Securities and Exchange Commission Chairman when the presumably “stable” Reserve Primary Fund broke the buck due to fears of Lehman exposure.
In the 2008 crisis, regulators were caught unaware of the fragility of the financial system to unregulated and under-regulated financial institutions and products. The consequences fell hardest on American families. High unemployment. The loss of trillions in wealth. A housing crisis. A deep recession – the human toll of which is too often overlooked. Public trust in the financial system eroded.
Congress and financial regulators undertook reforms to promote financial stability. They limited vulnerabilities to contagion risk and run risk. They expanded regulatory authorities and increased transparency. By making the U.S. financial system more resilient to times of stress, the U.S. increased financial stability.
We are again confronted by emerging financial stability risks with an innovative asset class. Digital assets operate differently from the products in 2008, and with far more hype, celebrity endorsements, and novel technologies. However, there has not been a full assessment of the risks that they pose. Let me discuss some risks that I have observed based on my experiences. However, given the unregulated state of the market, I caution that the full risks are not known.
Digital assets have recently shown to have financial stability risks with similar themes as in 2008. In May, there was the collapse of TerraUSD, an algorithmic stablecoin, and related crypto-asset Luna which was critical to Terra’s peg. TerraUSD, the then-third largest stablecoin with an $18 billion market capitalization, broke the buck, triggering redemptions across the Terra ecosystem. Those controlling a Luna-related foundation may have liquidated as much as $3.5 billion of Bitcoin, placing downward pressure on Bitcoin, affecting all with exposure. Tether, the largest dollar-based stablecoin, also broke the buck, reducing its total market capitalization by almost $9 billion. This is what can happen with a lack of confidence, run risk, and contagion risk.
Contagion risk continued as the drop in Luna triggered a broad sell off in crypto and spread losses to institutions, including Three Arrows Capital (“3AC”). 3AC then defaulted on loans to Voyager Digital, who filed bankruptcy. 3AC also instigated financial distress for lenders Genesis, BlockFi and Blockchain.com, who liquidated positions and abruptly cut off lending, including for Celsius, which subsequently failed.
The vulnerabilities seen during this beginning of what some call the “Crypto Winter” warn of growing intra-market risks, with parallel themes seen in 2008. Opaque, complex, leveraged, and unregulated products. Underappreciated risk. A lack of confidence that underlying assets were stable or of high quality. Lots of connections between market participants. A market vulnerable to contagion risk, run risk, risk of defaults, cascading losses and a liquidity crisis. Customers, including many retail investors, saw redemptions halted, and a significant loss of wealth as their assets were frozen, tied up or lost. A reported $2 trillion in market capitalization was lost.
Just as regulators could not see the true exposures or risk in 2008 due to unregulated companies and products, we cannot see that today with unregulated crypto markets. The Financial Stability Oversight Council recently found that to the extent that the digital asset industry scales to a significant size, it could present systemic risk. Therefore, it is important to monitor intra-market risk and for regulators to understand possible spillover effects on the financial system or economy during times of stress. However, without additional authority, the CFTC is hampered in its ability to monitor these risks.
Growing interest in digital assets by the traditional financial system and the potential for systemic risk
The digital asset market remains relatively small, and contained from the level of systemic risk that would come with greater scale or interconnections with the traditional financial system. But this may not be the case in the near future, particularly given growing interest by traditional finance. It is not lost on me that last week I spoke to managed funds and this week to international swap dealers, all with an interest of potentially expanding into cryptocurrency markets.
Financial stability risk will increase, and could rise to the level of systemic risk if in the future there are greater interconnections between the crypto industry and traditional finance players performing critical market functions. I caution that a full assessment of the risks has not been completed, and presents challenges without additional regulatory authority.
Stablecoins: Stablecoins, which are used to trade or lend crypto assets, are an area of growing interest by traditional finance. Financial stability risks are based on the stablecoin’s ability to remain stable. Algorithmic stablecoins present run risk, as seen with TerraUSD. There is also run risk with asset-backed stablecoins with fear that the underlying assets may not be as represented or of high quality. The CFTC brought an enforcement action against Tether, the largest dollar-backed stablecoin, for fraudulent misrepresentations related to its stability. A lack of creditworthiness of an affiliate could impede market confidence. A maturity mismatch caused by underlying assets with maturities that do not allow for immediate redemption could also increase run risk. In the case of significant redemptions, stablecoins may liquidate positions, which could bring contagion to U.S. Treasuries or other markets.
The credibility of stablecoins could be significantly bolstered by regular independent audits of the stabilization mechanism or quality of underlying assets. However, such audits are not the norm. Nor are comprehensive disclosures.
Pension funds, custody, and other indirect connections: I have significant concerns about the possibility of pensions and retirements funds investing in cryptocurrencies. Cryptocurrencies have not served as a hedge or to diversify traditional investment exposures, but instead have broadly correlated with equity markets. Crypto exposures thought to hedge against risk may unexpectedly amplify risk, heightening financial stability concerns.
There are indirect connections between crypto and traditional finance. The Bank of New York Mellon announced that it would begin to custody crypto. A small number of public companies hold significant crypto assets, indirectly exposing creditors and shareholders. Venture capital and hedge funds have raised billions of dollars for crypto-related trading and investments, in some cases with global financial institutions.
Monitoring and mitigating inter-market risk that could pose systemic risk will require a whole-of-government approach. This will remain a challenge for the CFTC without a regulatory window into the spot market, leaving much of the task of monitoring inter-market risk on prudential regulators within their supervisory authority. Financial institutions should keep their prudential regulators informed about their activities in this space. A financial institution’s assessment of risk should take into account traditional risks as well as novel risks that apply to crypto assets.
Novel Risks for Crypto Assets that Could Increase Financial Stability Risk
Novel technology brings novel risk. The anonymity that can be associated with crypto assets has led to the use of cryptocurrency for terrorist financing, money laundering, and dark-net illegal transactions. Fraudulent scams abound. Cyber hacks and thefts pose significant risk. Legitimate crypto-related exchanges and other companies well aware of this dark history say they want to be regulated. However, their business may be structured in a way that is different to what financial institutions are used to seeing, particularly if customer assets are not segregated, and there are unresolved conflicts of interest. Any financial institution interested in crypto should undertake substantial due diligence to determine vulnerabilities in the following areas, and even then, may find these novel risks difficult to assess.
Cyber Theft, Money Laundering, and Sanctions Evasion
Vulnerabilities to cyber hacks and theft are significant. This year alone saw an extraordinary number of hacks. Senator Debbie Stabenow said in a September hearing, “$1.9 billion of cryptocurrency was stolen in hacks in the first seven months of this year alone.” A few weeks later, on October 7, 2022, Binance announced a $570 million hack that took place over a cross-chain bridge, which is a bridge that sits between two blockchains. That day, the CEO of Binance said on television that cross-chain bridges are used every day by people. He said that the industry has to learn from these mistakes and make their code more secure. He said, “in the blockchain world, whenever there is a bug, it can result in large losses.”
In addition to cybersecurity concerns, the pseudo-anonymity of crypto can result in trading side-by-side with or lending to those with nefarious and illegal intentions or sanctioned individuals or companies. While companies may say that they have Anti-Money Laundering and Know Your Customer controls, there is an open question as to whether they meet the standards required of federal-regulated companies. I remind financial institutions of their own regulatory responsibilities to comply with U.S. sanctions, and rules to combat money laundering and terrorist financing.
Fraud, Scams and Manipulation
Earlier this year, the U.S. Federal Trade Commission reported that since January 2021, “more than 46,000 people have reported losing over $1 billion in crypto to scams—that’s one out of every four dollars reported lost [to fraud].” The CFTC has experienced an uptick in crypto complaints – the main source for enforcement actions. Wash trades, rug pulls, pump and dump, and other fraudulent or manipulative schemes continue. I am proud of the CFTC’s Enforcement Division for its work protecting customers and markets from digital asset-related harm. In Fiscal Year 2022, the Commission brought 18 digital asset enforcement actions, which was more than 20% of our cases filed this year. Fraud, scams and manipulation will continue to serve as potential shocks to the market, and increase financial stability risk.
The Lack of Segregated Customer Assets
Segregation of customer assets from a company’s operating funds is a foundational customer protection in regulated entities that is not common for unregulated digital assets, nor is bankruptcy priority. There is not enough awareness or attention on this critical area where customer protections dovetail with financial stability risks. Customers may be left in a musical chairs’ dilemma. This increases run risk at the first sign of a company’s or counterparty’s weakness. In my conversations with Congressional members, their staff, and market participants, I remain focused on the need to segregate customer assets for purposes of financial stability and customer protection.
Conflicts of Interest
Crypto-related companies may serve multiple functions that are separated into different entities in traditional finance. An exchange may also be a market maker, clearinghouse, lender, and/or custodian. These conflicts present significant risk that in a regulated environment would be disclosed and resolved. In an unregulated environment, the full extent of these conflicts may not be disclosed or resolved, which could lead to cascading losses and contagion risk.
Addressing Financial Stability Risks Through a “Same Risk, Same Regulatory Outcome” Approach
The U.S. government should not wait until crypto assets or markets rise to the level of systemic risk before addressing financial stability risks. Similar to post-crisis reforms, Congress can address financial stability risks by providing additional authority to the CFTC. Additionally, the CFTC should continue to use its existing authority, following a “same risk, same regulatory outcome” approach. This starts with establishing the basic foundation of customer protections and guardrails that investors and customers are familiar with, and expect, from other regulated financial products and markets.
Crypto companies seeking to come within the CFTC-regulated derivatives markets should expect the application of our existing regulatory framework because it has a proven record of reducing financial stability risk. As companies seek bespoke treatment, I will be guided in my decisions by the twin pillars of financial stability and customer protection, in particular for retail investors. Crypto companies set up for an unregulated environment will need to change to look more like a regulated entity. On balance, regulators must be careful in allowing bespoke treatment that could increase financial stability risks – risks that are well in check with our existing framework.
The challenge faced by regulators is that cryptocurrency was designed to sit side-by-side with the traditional financial system – an alternative to, rather than a part of, Trad-Fi. This critical distinction is the reason why creating a regulatory framework for cryptocurrency, and digital assets more broadly, is complex and can take time.
We at the CFTC are continuing to assess risks to the best that we can without a window into the market that comes with regulatory authority. This includes risks that are both familiar from the 2008 financial crisis, and novel risks associated with novel technology. Strong and effective guardrails to limit financial stability risks and other risks are necessary to build resilience in times of stress. What is most important is that the U.S. does not rush, but instead develops a regulatory framework that is effective and can stand the test of time.
 Even at the November 2021 peak, digital asset markets comprised approximately one percent of global market capitalization across major asset classes. See, e.g., Exec. Order No. 14067, Ensuring Responsible Development of Digital Assets, 87 Fed. Reg. 14143 (Mar. 9, 2022). See, e.g., L. Brainard, Vice-Chair of the Board of Governors of the Federal Reserve System, Crypto-Assets and Decentralized Finance through a Financial Stability Lens (July 8, 2022).
 Opening Statement of Sen. Stabenow, Hearing to Review the Digital Commodities Consumer Protection Act, Before the U.S. Senate Committee on Agriculture, Nutrition, & Forestry (Sept. 15, 2022).
 CNBC, $570 million worth of Binance’s BNB token stolen in another major crypto hack, October 7, 2022 $570 million worth of Binance's BNB token stolen in another major crypto hack (cnbc.com).
 U.S. Federal Trade Commission, Consumer Protection: Data Spotlight, Reports show scammers cashing in on crypto craze (June 3, 2022).