The Bank of England, U.K.’s central bank has in its March issue of the Financial Stability in Focus report set out the Financial Policy Committee’s (FPC) views on crypto assets and decentralized finance. The FPC, is of the view that enhanced regulatory and law enforcement frameworks, both domestically and at a global level, would be needed to encourage sustainable innovation as well as to maintain broader trust and integrity in the financial system.
The document dwells at length on the role of crypto assets and decentralized finance in the financial system, the financial stability implications, the FPC’s approach to monitoring risks including financial stability risks arising therefrom, as well as the status of regulatory initiatives.
The FPC report acknowledges that the technology underpinning crypto assets has the potential to reshape activity in the traditional financial sector and lead to several benefits including reducing cost, enhancing the speed of cross-border payments by allowing peer-to-peer transactions, reducing the need for centralized intermediaries, increasing competition and further lowering costs to end-users. The Distributed Ledger Technology, could potentially be used to make financial market infrastructure (FMI) processes (in particular settlement) more efficient, transparent and resilient, it says.
As a crystallization of the vulnerabilities in the crypto assets and DeFi space could affect financial stability, FPC deems it essential to mitigate the financial stability risks so as to ensure sustainable benefits from new technologies.
FPC recognizes that the potential risks related to crypto assets and DeFi could be operational risks arising from the use of crypto technology, regulatory and stability challenges or the financial risks on account of direct exposures or spill overs between markets. These could arise from interlinkages between crypto assets and the traditional financial sector and also from growth in activity outside of the existing regulatory perimeter.
Risks to systemic financial institutions like banks and insurers, risks to core financial markets, risks to the ability to make payments, and the impact on real economy balance sheets are seen as the main channels through which the risks to financial stability could arise.
The report said the growth of stablecoins for payments could increase the role of non-banks in the financial system, and opportunities for regulatory arbitrage could arise. The composition of stablecoin backing assets may in some cases not be sufficient to cope with mass redemptions, which could create risks for the wider financial system. A fire sale of stablecoins’ backing assets could disrupt the functioning of certain markets if they were to grow materially, the report stated.
Public confidence in money and payments could be undermined if a systemic stablecoin used for payments fails to meet its obligations. In this backdrop, the FPC had previously set out expectations that systemic stablecoins would need to meet before widespread adoption as a means of payment.
The FPC is also apprehensive that the increased institutional investments, could cause spill overs to core financial markets. It also believes believes that when the traditional financial sector and crypto sector performs an equivalent economic function, it should take place within existing regulatory arrangements. The Committee opines that in such cases the regulatory perimeter should be adapted so as to ensure an equivalent regulatory outcome.
The Committee, whose primary responsibility is to contribute to the Bank of England’s financial stability objectives believes that direct risks to the stability of the UK financial system from crypto assets and DeFi are currently limited.
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