For release on delivery
10:00 a.m. EST
March 9, 2023
Supporting Innovation with Guardrails: The Federal Reserve's Approach to Supervision
and Regulation of Banks' Crypto-related Activities
Remarks by
Michael S. Barr
Vice Chair for Supervision
Board of Governors of the Federal Reserve System
at
The Peterson Institute for International Economics
Washington, D.C.
March 9, 2023
I'm here today to discuss what we have learned from the recent turmoil in the
crypto sector and what role supervision and regulation should play in helping banks
manage their engagement with the sector and the innovative technologies that support it.
Despite recent events, we have not lost sight of the potential transformative effect that
these technologies could have on our financial system. And we need to be careful lest
regulation lock in the power of incumbents or stifle innovation. But the benefits of
innovation can only be realized if appropriate guardrails are in place. I am going to talk
about how we are working to provide clarity to the banks we supervise about what we
have learned and about our supervisory expectations. I will wrap up by sharing some
thoughts on stablecoins.1
It isn't hard to find evidence for the need to discuss crypto, but let me start with a
recent personal experience. Last month, I visited the Mississippi Delta to talk about
financial inclusion and community development, and I spent a morning talking with a
group of college students. When I asked, it turned out that most of the students I met
owned some crypto-assets. This surprised me because in my experience as a professor,
most college students are usually strapped for cash. What didn't surprise me is that many
of those who said they owned crypto-assets also said they had lost money, and they
weren't very happy about that.
It was a reminder for me that crypto-assets aren't just held by people with ample
money for speculation. A fifth of Americans, many of them with limited savings, say
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they have owned some form of crypto.2 The problems that have come to light in the
crypto sector over the past year may have affected a large segment of the public.
When I think about how to approach crypto-assets, the technology behind them,
and the interaction between the crypto sector and traditional financial system, I find it
helpful to place recent innovation in historical context. Innovation in financial markets
has long raised questions about the appropriate role of regulation. Of particular concern
is how the regulatory framework can serve both to encourage innovation and to support
the safety and soundness of financial institutions and broader financial stability. Just as
important is the need to protect the public from fraud and other abusive behavior.
The challenge here begins with a mismatch in timing. Innovation often comes
quickly, but it takes time for consumers to become aware that they could both gain and
lose money on new financial products. It may take time for market participants to
understand attendant risks and come up with tools to manage them. Likewise, regulation
involves a deliberative process-as it should because it needs to balance the risk that
over-regulation will stifle innovation with the risk that under-regulation will allow for
substantial harm to households and the financial system.
Long before crypto became an issue for regulation and public policy, I was
grappling with how to think about the cycle of innovation in the context of the Global
Financial Crisis. New products often develop slowly at first while market participants are
unsure of their value or their risks, but excitement and enthusiasm can then lead to rapid
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growth and new products flood the market as a result.3 Participants assume too quickly
that they know how the new products work, and novel products can appear both safe and
lucrative, particularly if they have not been tested through bouts of market stress. The
innovation cycle turns when this mismatch-between perceived understanding of risk
and actual underlying risk-becomes apparent.
Back then, I was talking about some of the causes and consequences of the
financial crisis. At that time, new types of financial products had become so intertwined
with the banking and broader financial system that the turn in the innovation cycle
resulted in devastating consequences for homeowners, workers, businesses, and our
economy. Today, while the crypto-asset sector is more nascent and less pervasive, the
questions about how new financial products will affect the public, the economy, and
financial stability are similar. Innovation surges ahead, and regulation follows, trying to
balance benefits and risks.
The Potential Benefits of Innovative Technologies
Before I get into how we are responding to developments in the crypto sector in
our approach to supervision and regulation, I want to recognize the potential public
benefits of the technologies underlying crypto-assets. It is often argued that these
technologies will have extensive beneficial application beyond crypto-assets themselves.
The payments system is critical to everyday Americans. It is highly resilient but
also can be slow and expensive. This is particularly true with respect to cross-border
payments. The technology underlying crypto assets-including that which enables
programmability-could bring new functionality or efficiencies to payments systems.
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Proponents claim that distributed ledger technology, encryption, and new ways of
validating transactions could be used to facilitate faster reconciliation, clearing, and
settlement and reduce costs for a variety of traditional asset transactions-including, for
example, by linking securities and cash markets in ways that are more difficult to achieve
under our current financial infrastructure.4 Use of smart contracts could automate certain
actions, creating further efficiencies. Such use of the technology could lead to potential
operational efficiencies and reduced costs. The Federal Reserve has dedicated
considerable resources to exploring and understanding these technologies and their
potential benefits as well as the risks associated with these innovations.
A Few Lessons from the "Crypto Winter"
In contrast to the potential benefits of these technologies, there is the actual
experience of the many people whose hope and enthusiasm for crypto-assets have met
with disappointment and sometimes devastating loss. Robert Shiller describes how
Bitcoin is a prime example of what he calls a contagious economic narrative. The story
of Bitcoin's value proposition taps into the fears of government control with the promise
5
that, through superior technology, a new product can yield untold riches. But when it
comes to certain crypto-assets, some of which have no intrinsic value beyond the faith of
their owners, the law of gravity will eventually apply, as it did with the tulip frenzy in
Holland more than 400 years ago. Experience has shown that crypto-assets can face the
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same fundamental liquidity and credit risks as traditional assets, and can be highly
correlated with other traditional risks, rather than being hedges against such risks.
While purveyors of crypto-assets have represented to customers that they are
protected through the decentralized nature of the underlying technology, customers are
often at a greater risk because those purveyors often find ways to function outside a
robust supervisory and regulatory system. In the absence of regulatory compliance,
customers don't have the information they need to assess and mitigate their risks.
Investors do not have the structural protections they have relied on for many decades. As
a result, many have been victims of classic cases of fraud and abuse-some appropriately
classified as "Ponzi schemes" under a high-tech veneer. Moreover, while crypto-assets
are hyped as "decentralized," there has been an emergence of new, quite centralized
intermediaries that are either not subject to or not compliant with appropriate regulation
and supervision, which has perpetuated harm to consumers. Complicating matters
further, these entities often seek out jurisdictions with loose or less developed legal and
regulatory frameworks for financial activities. And the lack of consolidated home
country supervision and coordination with host country supervisors rekindles the kind of
abuses that bank regulators long ago quashed. While such cross jurisdictional regulatory
arbitrage is not new, the digital nature of these activities provides for greater opportunity
to expand the reach of such entities to customers around the world.
For example, the prominent collapse of the FTX crypto-asset trading platform has
reportedly wiped out the holdings of a million people, costing them billions of dollars.6
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Unfortunately, that is not the only example. Since last summer, we saw the collapse of
one crypto intermediary after another.7 As these cases are working their way through the
bankruptcy courts, we are seeing indications of misuse of client funds,
misrepresentations, obfuscation about availability of deposit insurance, and potential
fraud.
Crypto has also been implicated in numerous cases of illicit financing. Crypto-
assets pose significant money laundering and terrorism financing risks due to the
pseudonymous actors that are parties to transactions, the ease and speed of transfer, and
the general irrevocability of transactions-all of which make crypto-assets attractive for
use in money laundering and terrorist financing. Indeed, enforcement agencies-
including the Financial Crimes Enforcement Network, the Office of Foreign Assets
Control, and the Department of Justice-have taken numerous public enforcement
actions against entities or individuals dealing in crypto-assets.8
This kind of behavior can cause substantial harm to investors and consumers as
well as to our financial system. The federal bank regulatory agencies, including the
Federal Reserve Board, have a statutory responsibility to ensure that the activity of the
entities we supervise is conducted in a safe and sound manner, and in compliance with all
applicable laws. While the effects of the events in the crypto sector on Federal Reserve-
See also U.S. Securities and Exchange Commission, "Defendant Concealed His Diversion of FTX
Customers' Funds to Crypto Trading Firm Alameda Research While Raising More Than $1.8 Billion from
Investors," news release, January 19, 2023, https://www.sec.gov/litigation/litreleases/2023/lr25616.htm.
7
For example, Celsius Network LLC; Voyager Digital Holdings; BlockFi Inc.; FTX Trading Ltd.; Three
Arrows Capital, Ltd.; and Genesis Global Holdco LLC.
8
See, e.g., U.S. Department of the Treasury, National Money Laundering Risk Assessment (Washington:
Department of the Treasury, February 2022), 40-45,
https://home.treasury.gov/system/files/136/2022National-Money-Laundering-Risk-Assessment.pdf. See also Department of the Treasury, National
Terrorism Financing Risk Assessment (Washington: Department of the Treasury, February 2022), 21-23,
https://home.treasury.gov/system/files/136/2022-National-Terrorist-Financing-Risk-Assessment.pdf.
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supervised banks have been limited in the aggregate thus far, recent experience has made
it clear that crypto could pose risks to those banks. In response, we have worked with the
other federal bank regulatory agencies to provide clarity and guidance on what is
permissible, safe and sound, and compliant with anti-money-laundering and anti-terrorist
financing laws as well as consumer and investor protections. And we've set out our
supervisory expectations for banks engaging with new product types and activities. As
noted above, this is not just a domestic issue. We are also working with our international
counterparts to minimize the possibility of regulatory arbitrage across jurisdictions.
The Federal Reserve's Approach to Supervising Banks' Engagement with Crypto
One overarching principle of the Federal Reserve's financial oversight is that
activities that are fundamentally the same should be regulated the same, regardless of
where or how the activity occurs or the terms used to describe the activity. We have a
somewhat complicated financial services regulatory framework in the United States, and
there are several regulatory authorities with oversight of financial services activities. But
we know how important it is for entities interested in providing financial services with
new technologies to engage on a level playing field. That is why we have worked closely
with the other bank regulatory agencies to develop a consistent approach. Our overall
stance is that, at this stage of the development, banks should take a careful and cautious
approach to engaging in crypto-asset related activities and the crypto sector.
Overview of Recent Federal Reserve Actions
Over decades, federal bank regulators have articulated supervisory expectations
for managing, monitoring, and controlling risks to safety and soundness. These
expectations are generally principles-based-meaning they can be applied in a broad
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range of circumstances. Given emerging interest in crypto-asset activities, we have
worked to provide clear and transparent guidance. Last August, we published a
supervisory guidance letter for banks engaging in or seeking to engage in crypto-related
activities.9 In the letter, we reminded firms that the first step when considering engaging
in crypto-related activities is to establish that the activities are legally permissible, and
that there are sufficient controls in place to ensure these activities can be conducted in a
safe and sound manner and in compliance with all applicable laws. Against the
background of possible crimes that some crypto companies are now under investigation
for, this is not a box-checking exercise. Our letter also lets banks know that they are
expected to notify the Federal Reserve if they intend to engage in crypto-asset related
activities and to engage in a robust supervisory conversation.
The letter said, in effect, "Don't jump in and plan to figure out risk management
later." It stated that "Federal Reserve-supervised banking organizations should have
adequate systems and controls in place to conduct crypto-asset-related activities in a safe
and sound manner prior to commencing such activities."
In the ensuing months, a lot happened in the crypto world, including the turmoil
discussed earlier. On January 3, after learning from these developments, the Board and
other bank regulatory agencies issued another statement advising banks to be focused on
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a list of several key risks.10 The list ranges from the risk of fraud and scams of crypto
participants to money laundering and terrorist financing, to stablecoin run risks.11
Later in January, the Board issued a policy statement making it clear to the banks
we supervise that the Board would apply the same permissibility standards to activities,
including crypto-asset-related activities, regardless of a bank's deposit insurance status.12
The preamble to the statement made clear that we would likely view it as unsafe and
unsound for banks to directly own crypto-assets on their balance sheets. In addition, we
clarified that the banks we supervise seeking to issue stablecoins or dollar tokens would
have to show that they have controls in place to do so in a safe and sound manner and
that they would need to obtain a non-objection notice from Federal Reserve supervisors
before proceeding.
On February 23, we provided additional clarity about supervisory expectations
through another statement issued jointly with other bank regulatory agencies.13 This
statement was also informed by recent supervisory experience. The statement
highlighted to our supervised institutions that they need to be aware of the liquidity risks
associated with certain crypto sector-affiliated deposits. We always expect banks to
10
Board of Governors of the Federal Reserve System, "Joint Statement on Crypto-Asset Risks to Banking
Organizations," news release, January 3, 2023,
https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230103a.htm.
11
The eight specific risks highlighted are as follows: (1) the risk of fraud or scams among crypto
participants; (2) legal uncertainty about custody practices, redemptions, and ownership rights; (3) crypto
companies claiming they carry deposit insurance; (4) volatility in crypto asset values; (5) run risk from
stablecoins; (6) the risk of contagion from interconnected crypto participants; (7) practices that may be
unfair, deceptive, or abusive, contributing to significant harm to retail and institutional investors,
customers, and counterparties; and (8) risk management that lacks "maturing and robustness."
12
Board of Governors of the Federal Reserve System, "Federal Reserve Board Issues Policy Statement to
Promote a Level Playing Field for All Banks with a Federal Supervisor, Regardless of Deposit Insurance
Status," news release, January 27, 2023,
https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230127a.htm.
13
Board of Governors of the Federal Reserve System, "Agencies Issue Joint Statement on Liquidity Risks
to Banking Organizations Resulting from Crypto-Asset Market Vulnerabilities," news release, February 23,
2023, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230223a.htm.
assess and manage the liquidity risks of their funding sources. As the statement makes
clear-and as has been obvious throughout the last few months-crypto sector depositors
may have assets that can be affected by volatility in the sector. This volatility can lead to
unpredictable, rapid, and correlated deposit inflows and withdrawals, and thus the
liquidity risks of their deposits, of course, require some additional attention. These
liquidity concerns are particularly acute for banks that have a meaningful portion of their
balance sheets funded with such deposits.
Again, we took these steps to make clear that we have the same expectations for
all the institutions that we supervise and which seek to engage in novel activities. These
expectations are not new. We expect supervised entities to ensure that they conduct their
activities in a safe and sound manner and in compliance with all relevant laws, including
anti-money-laundering laws. These public statements are transparent and provide the
same information for everyone, including for small banks that may not have large teams
of analysts assessing industry developments, large banks with more resources, and, of
course, the public. We plan to continue to publish guidance of this kind as we continue
to examine activity in the sector.
In addition to sharing what we learn with the public on an ongoing basis, we are
also enhancing our supervision of these activities. We are creating a specialized team of
experts that can help us learn from new developments and make sure we're up to date on
innovation in this sector.
Special Risks Associated with Stablecoins
I want to wrap up today by talking about stablecoins. As Chair Powell has said,
stablecoins are a type of private money, and there is a long and messy history of private
money in the United States that shows the need for robust regulation and oversight.14
Any entity issuing money denominated in the U.S. dollar and drawing on the trust of the
Federal Reserve needs to be subject to federal prudential regulation and supervision. I
am not saying anything new here. This has been our consistent approach.
Stablecoin issuers seek to have-but don't-some of the same characteristics as
federally insured bank deposits. Stablecoin issuers represent that their liabilities can be
redeemed on demand at par, a dollar for a dollar. In fact, however, the assets backing the
liability can fluctuate in value. Even if the assets backing the claim are high quality, they
cannot necessarily be immediately monetized, and operational risks are quite high. As
we have seen all too often, depositors sometimes want or need their money immediately,
especially in times of stress. This mismatch in value and liquidity is the recipe for a
classic bank run. Issuers are not supervised by the Fed and lack capital and liquidity as a
backstop. The banks we regulate, in contrast, are well protected from bank runs through
a robust array of supervisory requirements.
Consider the consequences if a stablecoin not subject to appropriate supervision
and regulation were to be adopted as a widespread means of payment, which some
stablecoin developers state as a goal. Stablecoins have the potential to scale quickly
because of network effects. An unregulated, unsupervised, deposit-like asset could create
tremendous disruptions, not just for financial institutions but for people who might rely
on the coin if it were to get wide adoption. We must learn from the past to ensure that we
do not allow for new forms of unregulated private money subject to classic forms of run
risk, and with the associated spillovers and systemic implications for households,
businesses, and the broader economy.
Conclusion
That gets me back to the central point of my remarks, which is the need to balance
innovation with safeguards. Our goal is to create guardrails, while making room for
innovation that can benefit consumers and the financial system more broadly. We are
working with the other bank regulatory agencies to consider whether and how certain
crypto-asset activity can be conducted in a manner that is consistent with safe and sound
banking. We are also working toward providing additional clarity on our views of risks
and effective risk management practices across a range of crypto-related activity. We
will continue to be transparent with the banking sector and the public about our
expectations. We will also work with the other agencies to align our approach to ensure
that the same risks receive the same treatment. As we continue our efforts, we will work
to support innovation by establishing the guardrails essential for sustainable, safe, and
transparent markets. Thank you.