BIS proposes three options for crypto regulation: prohibition, isolation, and regulation

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BIS proposes three options for crypto regulation: prohibition, isolation, and regulation

The Bank for International Settlements (BIS) has released a report on managing risks of cryptocurrencies, which outlines three distinct yet non-exclusive policy approaches to address the risks associated with cryptocurrencies. These include a complete ban on cryptocurrencies, segregating cryptocurrencies from traditional finance, and regulating cryptocurrencies akin to traditional finance. Introducing retail fast payment systems and encouraging reasonable innovations in central bank digital currencies (CBDCs) are also key elements for enhancing financial efficiency.

Regulatory Objectives in Response to Risks

The objectives for addressing the risks posed by cryptocurrencies should align with those supporting traditional finance over the past decades, including: i. appropriately protecting consumers and investors; ii. maintaining market integrity to prevent fraud, manipulation, money laundering, and terrorist financing; iii. safeguarding financial stability.

For central banks, another crucial consideration is maintaining the integrity of the monetary system. This issue is more urgent for many emerging market economies, especially in countries with high inflation and economic instability, where residents may have an incentive to move assets into more stable goods, and stablecoins pegged to major currencies provide a convenient tool. This phenomenon, known as "cryptocurrencyization" and akin to currency substitution, not only impacts monetary sovereignty but may also divert resources from the real economy.

The report highlights three regulatory options as follows:

Prohibiting Specific Cryptocurrency Activities

An extreme choice is to completely or selectively ban cryptocurrency activities. The advantage is that, assuming the ban is effective, it would eliminate any potential harm from cryptocurrency activities on the financial system, and investors would not suffer losses due to misconduct by cryptocurrency service providers. The drawback is that it could impede or delay beneficial cryptocurrency innovations.

Enforcing a ban would face enforcement challenges. For decentralized cryptocurrency activities, their borderless nature makes enforcement difficult. While activities by centralized entities may be easier to regulate, they could shift to jurisdictions without bans in place, and investors may seek ways to circumvent the ban, engaging in activities that existing rules do not clearly cover or regulate.

Isolating Cryptocurrencies from Traditional Finance and the Real Economy

The second option is to incorporate cryptocurrencies into existing systems but in an isolated manner, making them a niche activity. The simplest way is by restricting the flow of funds into and out of cryptocurrencies and limiting their connection to traditional finance.

If successful, this option would prevent problems generated and spread within the cryptocurrency market from harming traditional finance. Importantly, this option avoids giving cryptocurrencies a "stamp of approval." However, this approach has two main disadvantages. Firstly, the firewall may not be entirely effective in practice, introducing more complexity.

For instance, preventing banks and some asset management firms from becoming conduits for cryptocurrency activities may be a more flexible approach. While the SEC has consistently denied approval for physically backed Bitcoin ETFs, entities with fewer investment constraints may still be attracted by promised high returns, engaging in overleveraging and indirectly threatening their primary broker.

Secondly, even if the flow of funds from new investors into the cryptocurrency system continues, albeit with financial stability risks in traditional finance under control, regulators still need to address investor protection and market integrity issues.

Regulating Cryptocurrencies Similar to Traditional Finance

This approach involves handling cryptocurrencies in a manner similar to traditional finance, applying the same principles and tools. To adopt this approach, regulators can start with the "function," identifying the key economic functions performed by cryptocurrency activities and then evaluate how regulation impacts these functions. In practice, this would require mapping activities conducted in the cryptocurrency market to traditional finance and regulating cryptocurrency activities using similar guiding principles.

This method can ensure consistency in regulating financial activities and help promote the core policy objectives of existing regulatory frameworks. Additionally, it allows responsible participants to innovate through compliance and supervision. The challenge lies in establishing appropriate mappings between the two. For example, regulators are considering whether stablecoins can be managed as banks, payment systems, or non-banks such as non-bank payment service providers.

In fact, some cryptocurrency proponents believe this approach is an impossible task, especially concerning DeFi protocols. Even entities identifiable as in CeFi, such as stablecoins or exchanges, may not fit well under current regulatory and supervisory tools.

The Role of Central Banks

Central banks sit at the core of the monetary and financial system, thus possessing unique advantages to contribute more effectively to the monetary system by encouraging sound innovation in traditional finance. One option is to introduce retail instant payment systems, such as India's UPI, Brazil's Pix, the upcoming FedNow system in the U.S., or SEPA in the Eurozone.

Another option is to issue central bank digital currencies (CBDCs). If designed and implemented properly, such measures can support sound private sector innovation, help reduce payment costs, enhance financial system inclusivity, and promote user control over data and privacy.

Central banks can leverage innovations in certain cryptocurrency areas to improve how services are provided in traditional finance, particularly in terms of programmability, composability, and tokenization, thereby enhancing the efficiency of traditional finance.

Regarding the three regulatory options mentioned above, regulators can individually or in combination apply them based on the distinctive characteristics of the target features and the relative circumstances of each feature. For example, specific jurisdictions may ban energy-intensive proof-of-work or algorithmic stablecoin distributions; some intermediaries connecting traditional finance and cryptocurrencies may be subject to regulation, and so forth.

The BIS concludes that the cryptocurrency market has experienced a series of booms and busts, often resulting in significant investor losses. While it has not yet spilled over into traditional finance or the real economy, with DeFi becoming more intertwined with traditional finance, authorities must start considering various policy approaches, striving to improve the existing monetary system for the public interest.