Digital Assets and Financial Regulation: Lessons from Past Stresses

As pressure to tighten regulation on digital assets mounts, the application of decades-old lessons on functional regulation and consolidated supervision offers a pathway toward a solution.

As has been widely reported, recent bank failures and FTX’s collapse have led to a fierce debate regarding financial regulation in the US. A fundamental question is how to modernize the financial system and related regulation as blockchain and digital assets continue to develop globally. I believe there is a path forward based on lessons learned from past financial stresses.

To be clear, it is important to ensure safe and sound regulation of financial firms operating in the US, including banks and digital asset firms. Consumer protection is also of paramount importance. Unless changes are made to centralize digital asset supervision and provide for improved coordination, however, the door will be open for future meltdowns. At the same time, financial institutions and regulators need to develop and implement tailored risk management systems that incorporate people, processes, and emerging technologies.

As a former regulator, banker, and bank board member, I have decades of experience and a view to what is currently going on below the radar—and can therefore better anticipate what’s next. That’s why I favor a less-discussed approach to digital assets regulation, one that combines a global supervisory structure overlay of the sector with application of “functional regulation.”

The Debate on Digital Assets Regulation

As it stands, there is intense debate around the topic of digital assets regulation.

On one side are the digital asset proponents, who believe that some regulators and legislators are trying to freeze the industry out of the banking system. On the other are digital asset skeptics, like Senators Elizabeth Warren and Sherrod Brown, who have introduced legislation aimed at addressing digital asset-related risks to national security and consumer protection concerns.

US financial regulators—from the Securities and Exchange Commission (SEC) and Commodities and Future Trading Commission to the Federal Reserve, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, and state governments—are also ramping up enforcement and supervisory efforts.

Even once-promising bipartisan legislation, like a draft stablecoin proposal from Representatives Patrick McHenry and Maxine Waters, has become increasingly polarized since FTX’s bankruptcy, as evidenced by heated debate in a recent House hearing.

These competing interests have a lot at stake: advocates believe that if the US system doesn’t find a way to work with digital assets, it will cede leadership around a major innovation to places that have, like Hong Kong, Dubai, and the European Union. Skeptics, meanwhile, acknowledge that regulators need to do their jobs to ensure that consumers are adequately protected in what has often proven to be a volatile space.

Learning from FTX and BCCI: Applications of Consolidated Supervision

To map out a way forward, we would do well to review salient lessons from the past.

Before the Bank of Credit and Commerce International (BCCI) imploded in 1991, the multinational lender had assets of $23 billion and offices in more than seventy countries. Licensed in Luxembourg, the bank served the likes of Saddam Hussein and Palestinian terrorist Abu Nidal, operating in the lightly regulated shadows of the global economy and bank regulation. After losses on bank loans and currency speculation tipped the bank into insolvency, BCCI tried to cover up its financial hardships by inventing phony loans in what amounted to an international Ponzi scheme.

When the bank eventually failed and was closed, it became a symbol of how, as Acting Comptroller of the Currency Michael Hsu suggested in a recent speech, “the supervisability of global banks cannot be achieved effectively through mere coordination among authorities.”

Hsu draws comparisons between FTX and BCCI to argue that legislation like the Foreign Bank Supervision Enhancement Act (FBSEA)—passed in the wake of BCCI’s failure—could apply to the digital asset industry. In short, the FBSEA “prohibited entry of any foreign bank into the U.S. unless it was subject to comprehensive consolidated supervision by a home country agency.” (Emphasis in original.)

Consolidated supervision and information sharing among different regulators, with ultimate responsibility sitting with the “home” country where the entity is based, could go a long way toward preventing bad actors from playing local regulations off one another to hide their true risk profiles. This could apply domestically as well, allowing digital asset businesses to get a charter in one state (e.g., New York) and operate in others, with regulatory oversight from the host state—not unlike the Riegle–Neal Interstate Banking and Branching Efficiency Act of 1994, which allows banks to branch across state lines.

Next Steps: Standards, Functional Regulation, and Connectivity

What would have to happen for Hsu’s solution—a global supervisory overlay of the digital asset sector—to become a reality?

Though not all inclusive, here are a few potential next steps:

• Adopt the Basel Committee on Banking Supervision (BCBS) recommended standard on banking exposure to digital assets. Founded in 1974 to facilitate regulatory coordination among its member countries on banking issues, the BCBS plays a pivotal role in the global banking system.

The BCBS’s December 2022 paper on the prudential treatment of banks’ exposures to digital assets could help establish the global regulatory foundation needed to structure the relationship between foreign regulators. Essentially, the suggested standard would require banks to classify digital assets on an ongoing basis into two groups:

• • Group 1 meets a full set of classification conditions (e.g., tokenized traditional assets and digital assets with effective stabilization mechanisms) and is subject to capital requirements “based on the risk weights of underlying exposures set out in the existing Basel Framework”;
  • Group 2 incorporates assets that fail to meet any of the classification conditions and is thus subject to more conservative capital treatment.

• Apply “functional regulation” to digital assets in the US. Functional regulation governs the products and services offered by companies, rather than the institutions themselves. In the financial services industry, that means different agencies regulate different financial instruments. In digital assets, for instance, the SEC might regulate securities products, while bank regulators focus on loans and deposits from digital asset companies. State agencies also might play a role.

• Facilitate mechanisms to connect the digital assets and financial worlds. Debate will likely continue over whether certain digital asset products are a security or a commodity, but perhaps the most important considerations are that digital asset companies 1) need operating accounts with banks somewhere and 2) need those accounts to convert fiat to digital currency (i.e., through stablecoins).

To this end, the previously cited legislation from Reps. McHenry and Waters regarding stablecoins would be a step in the right direction. The language addresses licensure and related risks by allowing regulated banks to issue stablecoins based on specific requirements. Nonbanks would be permitted to issue stablecoins based on factors determined by the Federal Reserve. Consumer protections would be in place.

It is clear, particularly after the recent hearing, that this legislation will need to be developed further. This should include risk management principles for banks and nonbanks.

As a recent op-ed in the Wall Street Journal argues, the regulation of digital assets cannot be left to regulators alone. Legislators will need to play a role in providing clarity, whether that involves the passage of something like FBSEA and/or the above stablecoin bill.

And as we learned back in 1991, the passage of a law itself doesn’t solve the problem overnight. Implementation of the FBSEA took several years as the advisory systems were built out. It was a process of mutual adaptation.

If, however, the various interests are to come together in a similar process, these foundations are a good place to start.