The Financial Stability Oversight Council (FSOC), a group of U.S. regulators, warned that bitcoin and blockchain are threats to financial stability and noted they need to adapt to the changing market structure if cryptocurrency reduces the importance of traditional centralized intermediaries.
The FSOC includes the Federal Reserve, the Securities and Exchange Commission and the Treasury Department. The Council is charged with identifying risks to the financial stability of the United States, promoting market discipline, and responding to emerging risks to the stability of the financial system.
In its annual report [PDF] on the financial stability of the U.S. financial system, the group highlighted, for the first time, its concerns about digital currencies.
Bitcoin has gained favor as an alternative to currencies that central banks manage on behalf of governments since its functions as a decentralized database for transactions without governing institutions.
Report Addresses Distributed Ledger
In its annual report Tuesday, the FSOC said the distributed ledger systems, like most new technologies, pose uncertainties and risks that market participants and regulators must monitor.
The report reviewed the benefits of distributed ledger systems. It noted such systems can allow market participants to manage many types of transactions without the direct participation of trusted third parties.
Proponents of distributed ledger technology say it can help to significantly improve efficiency by replacing manually intensive reconciliation processes and limit risks associated with trading, settlement, clearing, and custody services. Such systems can mitigate risk and improve resilience in financial networks.
Since distributed ledgers can be designed to be broadly accessible and verifiable, they can provide a valuable mechanism to enhance market transparency, the report noted. By removing the need for some transactions to flow through trusted third parties, the ledgers can limit concentrated risk exposures to those firms and infrastructures.
In addition, by improving the accuracy and speed of settlement systems, the systems can reduce the counterparty and operational risks that arise when financial assets are exchanged. For instance, distributed ledger systems can facilitate the automation of complex, multi-party transactions like the payment of bonds and insurance coupons through smart contracts.
Market participants have limited experience working with distributed ledgers, FSOC noted, so it is possible operational vulnerabilities connected with such systems might not be apparent until deployed at scale.
Regulators Changing Course?
Some bitcoin advocates have noted that governments concerned about criminals and terrorists using bitcoin could undermine the digital currency.
Regulators demanded in bitcoin’s early days that processors install anti-money laundering checks. Other than that, regulators were willing to allow the bitcoin experiment to continue.
FSOC members noted they were laying down a marker about the growing technology and wanted to be vigilant about potential problems. They also acknowledged there was no certainty about such problems.
The FSOC noted that bitcoin has witnessed “dramatic” increases in transaction failures and trade delays in recent months. The delays occurred due to the speed by which new transactions has surpassed the speed by which they are added to the bitcoin blockchain.
Regulators Note Vulnerabilities
While cryptocurrency systems are designed to prevent fraud from a single party, the regulators stated that some such systems can be vulnerable to fraud that is performed through collusion among system participants.
The FSOC said regulators have to adapt to the changing market structure if cryptocurrency systems eventually limit the importance of traditional centralized intermediaries.
Because market participants that use a distributed ledger system can span national boundaries or regulatory jurisdictions, a “considerable degree” of coordination among regulators might be needed to successfully address and identify risks connected with such systems, the report said.
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