Top Fed official warns of ‘serious vulnerabilities’ in crypto industry

Federal Reserve vice-chair Lael Brainard has said recent crypto volatility has exposed “serious vulnerabilities” in an industry in need of tighter regulation.

Brainard told a Bank of England conference in London on Friday that crypto is not yet “so large or so interconnected” with traditional finance to pose systemic risk but raises familiar regulatory concerns.

“While touted as a fundamental break from traditional finance, the crypto financial system turns out to be susceptible to the same risks that are all too familiar from traditional finance, such as leverage, settlement, opacity, and maturity and liquidity transformation,” Brainard said.

“As we work to future-proof our financial stability agenda, it is important to ensure the regulatory perimeter encompasses crypto finance.”

The crypto markets have come under relentless pressure in recent weeks, with several key players including crypto hedge fund Three Arrows unravelling as a result of plunging markets. Since November’s all-time high, popular tokens such as bitcoin and ether have lost roughly 70 per cent of their value.

In the wake of this market crash, Brainard questioned the often-made case for cryptocurrencies such as bitcoin acting as a hedge against inflation.

“Contrary to claims that crypto assets are a hedge to inflation or an uncorrelated asset class, crypto assets have plummeted in value and have proven to be highly correlated with riskier equities and with risk appetite more generally,” she said.

Brainard’s speech also focused on the stablecoin industry, a key factor in the broader health of the crypto market writ large. A stablecoin is supposed to track real-world currencies, and provide crypto market stability by offering a quick route for traders to change digital tokens for dollars.

“It is vital that stablecoins that purport to be redeemable at par in fiat currency on demand are subject to the types of prudential regulation that limit the risk of runs,” she added.

Brainard’s comments regarding stablecoins follow the collapse of once-popular stablecoin terraUSD and sister token luna, a crash that wiped out billions of dollars for investors. Terra relied on computer algorithms and market demand to keep its value steady.

“The terra crash reminds us how quickly an asset that purports to maintain a stable value relative to fiat currency can become subject to a run. The collapse of Terra and the previous failures of several other unbacked algorithmic stablecoins are reminiscent of classic runs throughout history.”

Brainard also pointed to tether — the industry’s largest stablecoin — and the significant outflow pressure the stablecoin provider experienced in May. “As highlighted by large recent outflow from the largest stablecoin, stablecoins pegged to fiat currency are highly vulnerable to runs,” she added.

In addition, Brainard’s address took aim at cryptocurrency companies that might mirror the activities of traditional finance without equivalent regulatory standards.

She noted that many crypto trading and lending platforms had no comparable regulation but “also combine activities that are required to be separated in traditional financial markets”.

“It is important to address non-compliance and any gaps that may exist,” she said.