The Fed and web3: Understanding the U.S. central banking system’s approach to all things crypto

Despite some concerns within the web3 community about the Federal Reserve’s understanding of the evolving digital landscape, recent evidence suggests that these fears may be unfounded. The Fed has been diligently studying the intricacies of the web3 ecosystem and the technology underpinning it.

As the central bank formulates its perspectives on stablecoins, central bank digital currencies, and financial privacy, its findings, priorities, and ultimate conclusions on all web3 matters are of critical concern and worth understanding in detail.

With that in mind, the following is a primer on how the U.S. central banking system thinks about crypto. It is important to not that in most crypto matters, the Fed has no formal policy position and makes no recommendations beyond adherence to its dual mandate of ensuring maximum employment and price stability at moderate long-term interest rates. The following ‘positions’ simply refer the questions and concerns at the forefront of its research and assessment.

Fed position on Stablecoins

Stablecoins serve as the critical intermediary between the frenetic world of decentralized finance (DeFi) and the more structured realm of traditional finance. The Federal Reserve, in its research, points out that stablecoins, rather than becoming a popular medium for everyday transactions, have found their primary utility in the DeFi sector. As the Federal Reserve report states, “S.C.s are essential to transacting across crypto-assets in DeFi,” and they “are not widely used as a means of payment at present.”

Given this niche yet significant role, stablecoins must maintain their pegged stability. Any misperception that they’re as secure as conventional currency can prove risky. The report highlights, “Stablecoins have grown tremendously over the past year as digital assets gain broader adoption and the use cases of programmable digital currencies are clarified.” However, with this growth comes the necessity for vigilance. The paper further notes, “This rapid ascension has raised concerns that there might be negative impacts on banking activities and the traditional financial system.”

A case that underscores these concerns is Tether’s (USDT) substantial position in the commercial paper market. Commercial papers are unsecured, short-term debt instruments corporations use for immediate financing needs. Tether has historically held a significant stake in this market. Any sudden move to liquidate its holdings could result in a cascading effect. Such an event could lead to higher corporate borrowing costs and instigate a liquidity crisis in a worst-case scenario. This example accentuates the intricate balance that stablecoins, despite their primary role in DeFi, must strike within the broader financial ecosystem to ensure stability and trust. However, Tether has reportedly reduced its commercial paper exposure significantly over the past 12 months, instead choosing to increase its U.S. Treasuries holdings.

Fed position on CBDCs

The digital finance landscape is changing swiftly, leading the Federal Reserve to explore Central Bank Digital Currencies (CBDCs) deeply. In a 2022 report, the Federal Reserve depicted CBDCs as a digital version of a central bank’s obligation, similar to an electronic variant of conventional banknotes. While not endorsing a U.S. CBDC, the report encourages a transparent dialogue about its potential advantages and challenges.

The current U.S. monetary system is diverse, encompassing central bank money, consisting of the Federal Reserve’s physical currency and digital balances at commercial banks; commercial bank money, digital funds in retail bank accounts; and nonbank money, digital funds at nonbank financial institutions. Central bank money is perceived as the most secure, while nonbank money often carries more risks than its commercial counterpart.

Despite its overall efficiency, the U.S. payment system grapples with challenges. Few Americans remain without access to digital banking, and international transactions can be costly and sluggish. Efforts from both the public and private sectors are underway to enhance financial inclusivity and revamp the payment framework.

On a related note, the Biden Administration has articulated policy objectives for a potential U.S. CBDC, emphasizing its ability to safeguard consumers, bolster economic growth, and further financial inclusion. These aims also underscore the importance of national security, human rights, and alignment with the country’s environmental priorities. The National Objectives for Digital Assets Research and Development further stresses the importance of research and development in comprehending CBDCs, pinpointing secure architecture, interoperability, and system resilience and adaptability.

Michelle W. Bowman from the Federal Reserve Board posed an essential question in a speech in April 2023: What is the problem that a CBDC is intended to solve? She acknowledges that while CBDCs have the potential to streamline payment systems, their actual necessity and the likelihood of public acceptance remain uncertain. Since many U.S. households engage with banking services and many unbanked exhibit skepticism towards banks, there might be hesitancy towards a digital currency backed by the government.

Bowman also expressed concerns about the potential misuse of CBDCs that mirror those shared by crypto enthusiasts, suggesting they could limit individual spending or even jeopardize the Federal Reserve’s independence by turning the monetary system into a political weapon. She also emphasized that trust in physical currency endures despite its many inconveniences—a fact certainly not lost on the Board of Governors.

Fed position on DeFi

Decentralized Finance (DeFi) represents a transformative innovation in the digital finance sector, primarily operating on open-access blockchains through open-source code. It endeavors to provide financial services, typically facilitated by traditional financial intermediaries, in a decentralized manner. By leveraging smart contracts, DeFi automates economic activities, offering products like lending and borrowing without conventional intermediaries. However, this decentralized ecosystem comes with its set of vulnerabilities and challenges.

DeFi lending protocols allow users to pool assets, enabling depositors to earn interest from loaned-out assets. Depositors receive a utility token representing their share and the interest accrued. Loans in this ecosystem are often overcollateralized, with crypto-assets serving as collateral.

Like traditional banks, DeFi lending protocols engage in maturity transformation, which creates potential liquidity risks. These risks are further exacerbated by the ease of obtaining leverage on DeFi platforms. Users can leverage their crypto assets, like Ether, to acquire loans in stablecoins (S.C.s). This borrowed capital can be reinvested in crypto-assets, amplifying their exposure.

Moreover, many platforms rehypothecate the collateral, meaning it’s used elsewhere before the initial loan is repaid, introducing more complexity and risk into the system. Additionally, crypto-assets value can be highly volatile, influenced by factors like liquidation mechanisms on lending platforms and blockchain congestion. Sophisticated actors might exploit this volatility, leading to further destabilization. Another concern is the dependency on oracles for price information, which, if manipulated, can result in cascading liquidations.

Novel risks in the DeFi space include the inflexibility of smart contracts. Once deployed, these contracts execute transactions automatically without the possibility of intervention or amendment. The lack of circuit breakers can lead to rapid market crashes. Governance in DeFi, often touted as decentralized, can vary widely across platforms, potentially hampering swift decision-making during crises.

Moreover, DeFi lending platforms operate without the stringent capital or risk-management requirements traditional financial institutions adhere to. This absence of oversight means platforms might lack sufficient loss-absorbing capacity. Some, like Celsius, have faced stress and insolvency due to these vulnerabilities.

Engaging in such high-risk activities without adequate safeguards can potentially trigger a domino effect, with one platform’s failure affecting others in the ecosystem. As DeFi grows, understanding its potential and risks becomes imperative for participants and regulators.

Security and Privacy Concerns

The White House’s National Objectives for Digital Assets Research and Development highlights the need for research and development to focus on protecting sensitive financial data. This includes ensuring cybersecurity privacy and aligning with broader goals such as combating money laundering and terrorism financing, safeguarding human rights, and promoting market integrity. The challenge lies in creating systems that offer secure transactions while protecting users from fraud and breaches without compromising efficiency or cost-effectiveness.

A common misconception among users is the level of privacy these systems offer. While many hope for complete anonymity similar to cash transactions, the reality often differs. The paper delves into the nuances of data privacy, advocating for a hybrid approach that combines the best of both worlds: privacy-by-design and privacy-by-policy. The former ensures systems are designed from the ground up to collect minimal user data. At the same time, the latter emphasizes obtaining user consent and establishing transparent data handling practices, often through user agreements or internal policies.

Several frameworks are currently in place that reflect this hybrid approach to privacy. For instance, the Generally Accepted Privacy Principles (GAPP) offers guidelines on protecting personal information. Though created by accountants and primarily focusing on privacy-by-policy, GAPP also touches on privacy-by-design by suggesting certain privacy-enhancing technologies.

Similarly, while heavily leaning towards privacy-by-policy, the National Institute of Standards and Technology (NIST) Privacy Framework incorporates technical details to ensure robust data privacy designs.

Stability of the Overall Financial System

Based on reports from the Board of Governors of the Federal Reserve System and its allied financial institutions, there’s a growing wariness about the crypto-asset sector’s infiltration into the traditional banking sphere. While these institutions haven’t explicitly barred banks from venturing into crypto, there’s an ongoing rigorous assessment.

The primary objective is ensuring crypto-asset endeavors adhere to established safety standards, soundness, and legal compliance. Certain practices, notably holding or issuing cryptocurrencies on decentralized platforms, seem to be regarded with a degree of skepticism. Moreover, there are reservations about business models that heavily pivot around crypto-assets.

Recent studies show that intermediaries in the cryptocurrency world play indispensable roles. Their functions range from facilitating trading to offering an array of financial services. Yet, their operations remain somewhat shrouded from regulatory bodies. Initial glimpses into the regulatory data landscape underscore a pronounced market concentration.

The key players in the market seem to control a significant chunk of transaction volumes and hold vast volumes of customer-centric digital assets. This dominance, coupled with the meteoric rise of digital assets and the apparent lack of stringent regulatory measures, raises concerns about potential oversight gaps.

In the future: The Novel Activities Supervision Program

Amid an evolving financial landscape marked by innovations and emerging technologies, the Federal Reserve has unveiled the “Novel Activities Supervision Program.” Detailed in the S.R. 23-7 letter from August 8, 2023, this program is a response to the surge in unconventional activities by banking institutions, notably in areas like crypto-assets, distributed ledger technology (DLT), and collaborations with tech-driven non-banking entities.

The initiative’s primary objective is to navigate and potentially mitigate the uncertainties and risks associated with these new-age financial activities. Several specific areas are under the spotlight:

Tech-Driven Partnerships: Partnerships where nonbanks operate as banking service providers are drawing attention, especially those utilizing technologies such as application programming interfaces (APIs) to integrate with established banking systems seamlessly.

Crypto-Asset Engagements: With the crypto sector’s unpredictable trajectory, activities such as crypto-asset custody, crypto-backed lending, crypto trading facilitation, and involvement with stablecoins or dollar tokens are being closely examined.

DLT Explorations: Activities that delve into distributed ledger technology, especially those concerning issuing dollar tokens or tokenizing securities and other assets, are under scrutiny.

Banking for Crypto Entities: Traditional banking services, like deposits, payments, and lending, when offered primarily to crypto-focused entities and fintechs, are also being evaluated.

Contrary to what some might assume, this program isn’t a complete revamp of the existing oversight mechanisms. The Federal Reserve emphasizes that the Novel Activities Supervision Program will collaborate with the existing supervisory frameworks. Banking institutions dabbling in these innovative pursuits won’t be isolated into a new oversight category. The intent appears to be integrating this new program into the current supervisory system, utilizing established processes to maintain efficiency and avert unnecessary complexities.

Given the rapid transformations in the financial sector, it remains to be seen how practical the Federal Reserve’s new approach will be in navigating the complexities of this evolving landscape.

Conclusions

The Federal Reserve closely monitors and studies the evolving crypto-asset landscape, including innovations like stablecoins, CBDCs, DeFi, and tokenization. Through extensive research, it aims to comprehend the implications of these technologies for monetary policy, financial stability, inclusion, privacy, and security. While not outright forbidding crypto experimentation in banking, the Fed plans to ensure activities meet soundness, safety, and compliance standards.

An informed, impartial understanding of the Fed’s perspective facilitates the navigation of crypto-traditional finance intersections. Though uncertainties exist, ongoing dialogue between the ecosystems is essential. The crypto industry staying aware of the Fed’s stance allows collaborative advancement.

To its credit, the Fed is willing to learn rather than reflexively reject new paradigms while still warily assessing the digital asset landscape. Its research aims at measured policies attuned to an evolving landscape. Continued transparency and open communication will be essential for the Federal Reserve to adapt its policies for a digital future effectively.

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