The Bank for International Settlements (BIS) has released a report on how to address the risks of cryptocurrencies. The report lists three different but not mutually exclusive management approaches to deal with the risks of cryptocurrencies, including an outright ban on the crypto industry, Cryptocurrencies are isolated from traditional finance and regulated like traditional finance. The introduction of retail fast payment systems and encouraging reasonable innovation of central bank digital currency (CBDC) are also key elements to improve financial efficiency.

Competent authority’s risk response objectives

Addressing the risks posed by crypto should be addressed with the same goals that have underpinned traditional finance for decades, including: (i) appropriately protecting consumers and investors; (ii) safeguarding market integrity and preventing fraud, manipulation, money laundering and terrorist financing doctrine; (iii) Maintain financial stability.

Another important consideration for central banks is maintaining the integrity of the monetary system. This issue is even more pressing for many emerging market economies, especially in countries with high inflation and economic instability, where residents have incentives to move their assets to more stable items, and stablecoins pegged to major currencies are a Handy tool. This phenomenon, known as “cryptocurrency” and similar to currency substitution, will not only affect monetary sovereignty, but may also divert resources away from the real economy.

The report cites three management options as follows:

Prohibit certain cryptographic activities

The extreme option is a blanket or targeted ban on crypto activities. The advantage of this is that, assuming the ban is effective, this move will eliminate any potential harm to the financial system from crypto activities, and investors will not suffer any losses due to the misconduct of crypto service providers. The downside is that it can prevent or delay helpful crypto innovation.

Enforcing a ban would face enforcement challenges. For decentralized crypto activities, their borderless nature can make enforcement difficult. It will be easier for the activities of centralized institutions, but the activity may be transferred to jurisdictions that have not implemented the ban, and investors may also find ways to avoid the ban and then seek similar activities that are not explicitly covered by existing rules or have less supervision. .​

Isolate cryptocurrencies from traditional finance and the real economy

The second option is to include cryptocurrencies within the existing system, but in a segregated manner, making it a niche activity. The simplest way is by restricting the inflow and outflow of cryptocurrency funds and limiting its connection to traditional finance.​

If this option succeeds, problems arising and spreading in crypto markets will not harm traditional finance. Importantly, this option avoids giving cryptocurrencies a “seal of approval” directly. But this method also has two major disadvantages. First, firewalls may not be fully effective in practice and introduce additional complexity. For example, preventing banks and some asset managers from becoming conduits for crypto activities may be a more flexible approach (for example, the SEC has consistently refused approval of spot Bitcoin ETFs). However, entities with less restrictive investment mandates may still be promised high returns. attracted, over-betting and indirectly threatening their prime brokers. Secondly, if new investor funds continue to flow into the crypto system, even if the financial stability risks of traditional finance are controlled, the competent authorities will still need to address the issues of investor protection and market integrity.

Regulate like traditional finance

This approach would approach cryptocurrencies in a similar way to traditional finance, applying the same principles and tools. To adopt this approach, authorities could start with “functions,” identifying the key economic functions that crypto activities perform and then assess how regulation affects those functions. In practice, this would require mapping the activities performed in crypto markets to traditional finance and then using similar guidelines to regulate crypto activities.

This approach ensures consistency in regulating financial activities and helps promote policy objectives that are core to the existing regulatory framework. Furthermore, it will allow responsible players to innovate through compliance and oversight. The challenge is to establish an appropriate mapping between the two. For example, authorities are considering whether stablecoins can be regulated as banks, payment systems or non-banks (such as non-bank payment service providers).​

In fact, some crypto proponents believe this approach is mission impossible, especially for DeFi protocols. Even if entities like CeFi are identifiable (such as stablecoins or trading platforms), they may be less susceptible to regulatory and supervisory tools under current standards.​

The role of central banks

The central bank is at the core of the monetary and financial system and therefore has a unique advantage. It can contribute to the monetary system more effectively by encouraging sound innovation in traditional finance. One option is to introduce a retail fast payment system, such as UPI in India, Pix in Brazil, the upcoming FedNow system in the United States, or SEPA in the Eurozone; another option is to issue a central bank digital currency (CBDC). If properly designed and implemented, such measures can support sound private sector innovation. They can help reduce payment costs, enhance financial inclusion in the system, and promote user control over data and privacy. Central banks can leverage certain innovations in crypto to improve the way services are provided in traditional finance, particularly programmability, composability and tokenization, thereby increasing the efficiency of traditional finance.

As for the above three supervision options, the competent authority can use them individually or in combination according to the target characteristics of the listing and the relative situation of each characteristic. For example, individual jurisdictions could prohibit the distribution of energy-intensive proof-of-work or algorithmic stablecoins; some intermediaries connecting traditional finance and cryptocurrencies may be regulated, and so on. BIS also pointed out at the end of the article that the crypto asset market has experienced a series of boom and bust cycles, often causing investors to suffer huge losses. Although it has not yet affected the traditional financial system or the real economy, as DeFi and traditional finance become closer, relevant authorities must begin to consider various policy methods while working to improve the existing monetary system for the public interest.

This article BIS proposes three options for encryption management: ban, quarantine and regulation first appeared on Chain News ABMedia.