We continue our series on the Future of Blockchain with the adrenaline rush that is a U.S. Government Accountability Office (GAO) report on Blockchain in Finance:Legislative and Regulatory Actions Are Needed to Ensure Comprehensive Oversight of Crypto Assets.

Joking aside, while GAO reports are in fact some of the drier fare that crosses our desk in the course of our research, this report is a window into the current thinking on U.S. regulation of the blockchain – and, for that, its clarity and straightforwardness is of value and worth a review.  

This post is designed as a baseline assessment of how the incumbent financial regulators are thinking about blockchain in the financial systems – which will inform the growth of global, financial and monetary systems based on blockchain as an official global fiat currency system, with blockchain-based capture of value and transfer of value architectures. We continue to ask:  What will be the role of U.S. regulation in this future system?  

Featured Image:  Generated with OpenAI’s DALL-E with the prompt “A financial ticker depicting crypto assets in a futuristic style”

Blockchain in Finance:  Legislative and Regulatory Actions Are Needed to Ensure Comprehensive Oversight of Crypto Assets

July 24, 2023

“GAO found gaps in regulatory authority over two blockchain-related products that raise consumer and investor protection and financial stability concerns.”

• Blockchain technology records data and transactions in a shared, tamper-resistant, decentralized digital ledger—offering the promise of faster and cheaper financial transactions with no middlemen.
• Recent price crashes, bankruptcies, and fraud involving blockchain-related products and services, such as crypto assets, raised concerns about how much regulation exists now and the risks consumers face. For example, there are gaps in federal regulation of stablecoins—a kind of crypto asset—and trading platforms for crypto assets, leaving consumers and investors subject to harm. (1)
• No federal financial regulator has comprehensive authority to regulate the spot market for crypto assets that are not securities.  In contrast, platforms that trade crypto asset securities and operate as exchanges as defined by federal securities laws are subject to registration and regulation as national securities exchanges, unless an exemption applies.
• Several platforms without federal oversight have experienced fraud and trading manipulation. By providing for more comprehensive oversight of these platforms, Congress could better ensure users’ protection from unfair and manipulative trading practices.
• Gaps in regulatory authority exist in the oversight of stablecoins (a crypto asset purported to hold a stable value relative to a fiat currency, such as the U.S. dollar). To keep their value, issuers often state their stablecoins are backed by reserve assets. But no uniform standards exist for reserve levels and risks or for public disclosure of reserves.
• This increases the risk that a stablecoin may not be able to hold its value and honor user redemption requests. To the extent these stablecoins become more integrated into the financial system, their failures could pose risks to financial stability.
• By providing for consistent and comprehensive oversight of stablecoins, Congress could better ensure protections for consumers, investors, and the financial system. (2)

Why GAO Did This Study

• Blockchain-related financial products and services have grown substantially in recent years.
• Crypto assets reached a peak market capitalization of nearly $3 trillion in November 2021.
• Recent volatility, bankruptcies, and instances of fraud in these markets illustrate the harm consumers and investors may face without adequate protections.
• Regulators and industry stakeholders are concerned regulatory gaps may limit regulators’ ability to address risks these products and services pose.
• Modernizing the financial regulatory system is on GAO’s high-risk list, partly because some entities are not subject to comprehensive regulation.
• GAO was asked to study the regulation of blockchain-related financial products and services.
• Among other objectives, this report examines regulatory gaps and coordination in regulating these applications. GAO reviewed and analyzed government and industry reports, government guidance and speeches, and laws and regulations. GAO interviewed agency officials and market participants and observers.  (2)

What GAO Found

Blockchain allows users to conduct and record tamper-resistant transactions that multiple parties make without a central authority, such as a bank, when used for financial transactions. Because of these characteristics, blockchain-related products and services have the potential to produce cost savings, faster transactions, and other benefits over their traditional counterparts. However, these benefits have not been fully realized.

Furthermore, the significant risks these products pose have been realized and negatively affected consumers and investors. For example, crypto assets have experienced price volatility. Also, the bankruptcy of FTX Trading Ltd., a prominent crypto asset trading platform, led to the discovery that a substantial portion of the platform’s assets might be missing or stolen, according to bankruptcy-related documents.

GAO found gaps in regulatory authority over two blockchain-related products that raise consumer and investor protection and financial stability concerns.

• No federal financial regulator has comprehensive authority to regulate the spot market for crypto assets that are not securities. In contrast, platforms that trade crypto asset securities and operate as exchanges as defined by federal securities laws are subject to registration and regulation as national securities exchanges, unless an exemption applies. Several platforms without federal oversight have experienced fraud and trading manipulation. By providing for more comprehensive oversight of these platforms, Congress could better ensure users’ protection from unfair and manipulative trading practices.
• Gaps in regulatory authority exist in the oversight of stablecoins (a crypto asset purported to hold a stable value relative to a fiat currency, such as the U.S. dollar). To keep their value, issuers often state their stablecoins are backed by reserve assets. But no uniform standards exist for reserve levels and risks or for public disclosure of reserves. This increases the risk that a stablecoin may not be able to hold its value and honor user redemption requests. To the extent these stablecoins become more integrated into the financial system, their failures could pose risks to financial stability. By providing for consistent and comprehensive oversight of stablecoins, Congress could better ensure protections for consumers, investors, and the financial system. 

What Next?  

Overall, a very discouraging, but classic, level of GAO-recommended overregulation wrapped up the report – with no promise of what will and will not happen next. We break it down for you, and for our research efforts, as a baseline of governmental thinking on the future of blockchain in finance.  Count on us over the course of our series on the blockchain to surface the way the future of blockchain in finance is really manifesting in the market and in the global financial system.  Experience and research to date indicate that it will not form fit to many, if any, of the regulatory body synergies recommended by the GAO. 

So, for now – from the report: 

“Regulators lack an ongoing coordination mechanism for addressing blockchain risks in a timely manner. For example, regulators identified financial stability risks posed by stablecoins in 2019, but they did not identify the need for Congressional action to address the risks until November 2021 (in a report issued through the President’s Working Group on Financial Markets).

A formal coordination mechanism for addressing blockchain-related risks, which could establish processes or time frames for responding to risks, could help federal financial regulators collectively identify risks and develop timely and appropriate responses. In turn, this could improve protections for consumers and investors, mitigate illicit finance and threats to financial stability, and promote responsible innovation and U.S. competitiveness.” (2)

As markets for crypto assets and other blockchain-related products and services have grown, so has the need for federal financial regulators to
address the risks they pose to consumers, investors, and financial stability. Recent market turmoil and instances of fraud related to crypto assets, stablecoins, and trading platforms illustrate the significant risks to consumers and investors. And the potential for risks to financial stability will increase as blockchain products and services continue to grow and integrate into the mainstream financial system.

However, gaps in regulators’ authority limit their ability to effectively mitigate these risks:

1. First, trading platforms that serve as spot markets for nonsecurity crypto assets are generally narrowly regulated—they may be
   overseen by states in the context of money transmitter regulation and federally by FinCEN for BSA/AML oversight. As a result, they may not be subject to requirements intended to protect investors from fraud and market manipulation and to promote market integrity. By providing for more comprehensive federal oversight of spot markets for nonsecurity crypto assets, Congress could better ensure that users of the platforms receive such protections.
2. Second, there are gaps in regulatory authority over prudential risks posed by stablecoins. Issues that we and others identified include the limited public information available on reserve assets, the extent of redemption rights, and inconsistent or lacking capital and liquidity requirements. By providing for consistent and comprehensive oversight of stablecoins, Congress could better ensure protections for consumers, investors, and markets. For instance, such legislation could establish which institutions are eligible to issue stablecoins. Other elements of such legislation could establish or provide for minimum requirements related to the composition of reserve assets, public disclosure and regular audits

The rapid pace of change that marks blockchain underscores the importance of a coordinated response by federal regulators. Yet regulators’ coordination efforts to date have not always addressed risks posed by crypto assets in a timely manner.

Establishing or adapting an existing formal coordination mechanism for addressing blockchain-related products and services could help federal financial regulators collectively identify risks and develop appropriate regulatory responses, and to do so in a timely manner. In turn, this could improve protections for consumers and investors, mitigate illicit finance and threats to financial stability, and promote responsible innovation and U.S. competitiveness.

Matters for Congressional Consideration

The GAO report recommended two matters for congressional consideration:

• Congress should consider legislation that designates a federal regulator to provide for comprehensive regulatory oversight of spot markets for nonsecurity crypto assets, including requirements intended to protect investors from fraud and market manipulation and to promote market
  integrity.
• Congress should consider legislation providing for consistent and comprehensive oversight of stablecoin arrangements. Such legislation might include provisions identifying which institutions are eligible to issue such stablecoins; establishing minimum requirements for the composition of reserve assets and requirements for regular audits of and public disclosures of reserve assets and audit results; establishing prudential standards; and establishing redemption rights. 

Recommendations for Executive Action

THe GAO report made a total of seven recommendations (one each) to CFPB, CFTC, FDIC, the Federal Reserve, NCUA, OCC, and SEC:

1. The Director of the Consumer Financial Protection Bureau should jointly establish or adapt an existing formal coordination mechanism with CFTC, FDIC, the Federal Reserve, NCUA, OCC, and SEC for collectively identifying risks posed by blockchain-related products and services and formulating a timely regulatory response. To facilitate these objectives, this mechanism could include formal planning documents that establish the frequency of meetings and processes for identifying risks and responding to them within agreed-upon time frames.
2. The Chairman of the Commodity Futures Trading Commission should jointly establish or adapt an existing formal coordination mechanism with
   CFPB, FDIC, the Federal Reserve, NCUA, OCC, and SEC for collectively identifying risks posed by blockchain-related products and services and formulating a timely regulatory response. To facilitate these objectives, this mechanism could include formal planning documents that establish the frequency of meetings and processes for identifying risks and responding to them within agreed-upon time frames.
3. The Chairman of the Federal Deposit Insurance Corporation should jointly establish or adapt an existing formal coordination mechanism with CFPB, CFTC, the Federal Reserve, NCUA, OCC, and SEC for collectively identifying risks posed by blockchain-related products and services and formulating a timely regulatory response. To facilitate these objectives, this mechanism could include formal planning documents that establish the frequency of meetings and processes for identifying risks and responding to them within agreed-upon time frames.
4. The Chair of the Board of Governors of the Federal Reserve System should jointly establish or adapt an existing formal coordination mechanism with CFPB, CFTC, FDIC, NCUA, OCC, and SEC for collectively identifying risks posed by blockchain-related products and
   services and formulating a timely regulatory response. To facilitate these objectives, this mechanism could include formal planning documents that establish the frequency of meetings and processes for identifying risks and responding to them within agreed-upon time frames. 
5. The Chairman of the National Credit Union Administration should jointly establish or adapt an existing formal coordination mechanism with CFPB, CFTC, FDIC, the Federal Reserve, OCC, and SEC for collectively identifying risks posed by blockchain-related products and services and formulating a timely regulatory response. To facilitate these objectives, this mechanism could include formal planning documents that establish the frequency of meetings and processes for identifying risks and responding to them within agreed-upon time frames.
6. The Comptroller of the Currency should jointly establish or adapt an existing formal coordination mechanism with CFPB, CFTC, FDIC, the Federal Reserve, NCUA, and SEC for collectively identifying risks posed by blockchain-related products and services and formulating a timely regulatory response. To facilitate these objectives, this mechanism could include formal planning documents that establish the frequency of meetings and processes for identifying risks and responding to them within agreed-upon time frames.
7. The Chairman of the Securities and Exchange Commission should jointly establish or adapt an existing formal coordination mechanism with CFPB, CFTC, FDIC, the Federal Reserve, NCUA, and OCC for collectively identifying risks posed by blockchain-related products and services and formulating a timely regulatory response. To facilitate these objectives, this mechanism could include formal planning documents that establish the frequency of meetings and processes for identifying risks and responding to them within agreed-upon time frames. (2)

https://oodaloop.com/archive/2022/03/31/web3-security-how-to-reduce-your-cyber-risk/

https://oodaloop.com/archive/2023/07/18/ripple-labs-wins-a-landmark-sec-ruling-and-blackrock-is-bullish-on-cryptocurrency-based-investment-vehicles/

https://oodaloop.com/archive/2023/05/02/de-dollarization-new-fronts-in-the-global-war-being-waged-against-the-u-s-dollar/

https://oodaloop.com/archive/2023/05/05/the-stifling-of-the-u-s-crypto-innovation-ecosystem-has-begun-while-the-eu-takes-the-lead-globally/

https://oodaloop.com/archive/2023/05/25/the-canton-network-institutional-blockchain-interoperability-in-the-financial-services-sector/

Further Resources – Generated by OpenAI’s ChatGPT

“What are the insights and recommendations of the U.S. Government Accountability Office (GAO) on Blockchain in Finance?”

As of my last update in September 2021, the U.S. Government Accountability Office (GAO) has issued reports and conducted studies on various aspects of blockchain technology in the financial sector. While I don’t have specific information on all their reports, I can provide some general insights and themes based on their previous work:

1. Regulatory Environment: GAO has emphasized the need for clear and consistent regulatory guidance for blockchain and cryptocurrencies in the financial industry. The evolving nature of blockchain technology has created challenges for regulators in ensuring consumer protection, preventing fraud, and maintaining market stability.

2. Data Privacy and Security: GAO has highlighted concerns related to data privacy and security in blockchain applications. While blockchain is often touted for its decentralized and immutable nature, it also raises questions about how personal and sensitive financial data should be handled and protected.

3. Smart Contracts: GAO has examined the use of smart contracts in the financial industry and has emphasized the importance of robust testing and auditing procedures to ensure the accuracy and reliability of smart contract execution.

4. Interoperability: GAO has acknowledged that interoperability between different blockchain systems is a challenge, particularly in cross-border financial transactions. Ensuring seamless communication between different blockchain networks is crucial for fostering widespread adoption in the financial sector.

5. Scalability and Efficiency: The GAO has discussed the scalability limitations of certain blockchain networks, especially public blockchains like Bitcoin and Ethereum, which may impact their ability to handle a large volume of financial transactions efficiently.

6. CBDCs (Central Bank Digital Currencies): As central banks explore the possibility of issuing digital currencies, GAO has examined the potential benefits and risks of CBDCs in the context of the broader financial system.

7. AML and CFT Compliance: GAO has highlighted concerns about the use of cryptocurrencies and blockchain technology in facilitating money laundering and terrorist financing. Addressing these risks has been an area of focus for regulators and financial institutions.

It’s important to note that the insights and recommendations from the GAO may have evolved since my last update, as blockchain technology and its applications in finance continue to develop rapidly. For the most current and detailed information on the U.S. Government Accountability Office’s findings and recommendations on blockchain in finance, I recommend checking their official website or accessing their latest reports and studies on the subject.