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The Need for Oversight in Crypto Markets

As volatile asset classes go, few exceed the violent and gyrating price swings seen in crypto-currencies. Even so, the events of the last month have resulted in serious questions being asked of crypto-currencies, with some calling for greater regulation of the asset class.

A small chorus of institutional investors – dominated mainly by family offices, high net worth individuals,  smaller hedge funds, and specialist crypto-fund managers –  have built up exposures to crypto-currencies and StableCoins, a type of crypto-currency designed to have a stable price which is pegged to a fiat currency or another tangible asset.

However,  many – including a number of IIMI members –  have chosen to avoid crypto-currencies altogether. Their reasons for avoiding crypto are well-documented. Crypto-currencies are unregulated; have been used extensively to facilitate illegal activities such as money laundering and terrorist financing, while some experts question the basic macro fundamentals and valuations behind the asset class. 

Nonetheless, two events in May are likely to trigger even more regulatory scrutiny of crypto-assets.

Not-so StableCoins

The first involves StableCoins.  StableCoins act as a medium of exchange between the traditional financial world and the crypto-universe, meaning that their values are pegged to conventional assets (e.g. USD, Euro, etc.) so as to avoid some of the volatility which is endemic in crypto-currencies like Bitcoin.

That one of the largest StableCoins – Tether – broke its one on one peg with the USD is likely to invite regulatory intervention. A number of regulators have repeatedly warned that StableCoins – despite the comforting name – could suffer serious losses or become illiquid during stressful market events.

This is partly because of concerns about the nature of the reserve assets underpinning StableCoins amid fears that some StableCoin issuers have provided only limited details about their underlying holdings and how they are managed. In the case of the latter, Tether, for instance, has said this is strictly proprietary information.   

However, a recent article in the Financial Times notes that half of Tether’s $80 billion of reserve assets comprise of US Treasuries, while corporate debt accounts for 25% of its holdings. Nonetheless, a lot of this corporate debt – according to reports – has been issued by Chinese companies.

This is not the first time that Tether’s reserve assets have been challenged by the authorities. In October 2021,  Tether was fined $41 million by the  Commodity Futures Trading Commission for making misleading statements and omissions about its reserves.

While the $180 billion StableCoin market is not systemically important per se,  it has grown exponentially in the last two years and its price movements could one day have a wider market impact than what they do today. As such, the volatility witnessed earlier in the month could usher in further oversight of StableCoins and their holdings.

The crypto-custody model faces tough Questions

The second incident to tarnish the crypto-asset market follows an SEC (Securities and Exchange) regulatory filing made by Coinbase, a publicly listed crypto-custodian which is widely considered to be the dominant provider in this growing space.

Coinbase’s filing warned that custodied crypto-assets “could be subject to bankruptcy proceedings and such customers could be treated as our general unsecured creditors.” Although Coinbase’s CEO and analysts were quick to point out the company had significant liquidity, the statement has raised eyebrows in institutional circles.

Given that Coinbase is one of the most sophisticated providers in its field, the revelations prompted intense debate about the operating models of the countless other –  and arguably less cutting edge-   crypto-custodians in the market. 

While some traditional bank custodians are looking to develop solutions supporting digital asset trading, incumbent providers have made it clear that firmer regulation is needed in the crypto-custody market.

Crypto will face a regulatory reckoning

The latest turmoil afflicting crypto markets will likely result in sweeping regulations being introduced across these asset classes beyond what is being lined up already.