Today the Bank for International Settlements (BIS) published a paper on the institutional adoption of cryptocurrencies. Based on somewhat stale data at the end of 2020, it found adoption by banks to be negligible, with an exposure of just $180 million. However, it recognizes the situation is changing fast. At the same time, relatively unregulated crypto exchanges have grown rapidly and represent potential counterparty risks. Hence, cryptocurrency exchanges need regulation which will lead to consolidation.
Regulation of cryptocurrency exchanges
At a big picture level, although the original purpose of cryptocurrencies was to create a trustless system, in reality, there are just a different set of intermediaries. Instead of banks, cryptocurrency exchanges are acting as trusted intermediaries. Except they are currently lightly or unregulated.
Hence these new institutions need to have greater regulation and oversight regarding financial stability, consumer protection, and compliance with AML and KYC. It’s suggested that rather than requiring reporting, there will be embedded supervision which is usually based on blockchain network monitoring. However, it’s unclear how this will impact the internal transactions performed on centralized crypto exchanges.
The paper made some specific suggestions that include “supervisory oversight of crypto exchanges with regard to the provision of financial services (eg intraday credit, margin financing, provision of custody services), while applying a conservative bank prudential regulatory treatment for cryptocurrency exposures.” The Basel Committee has made initial proposals about balance sheet exposures for banks with aggressive capital requirements.
The report also suggests that exchanges need to beef up their balance sheets considerably. That’s because the regulations will require it – particularly if there are rules like Basel III – and there will be a higher expectation of cryptocurrency exchange creditworthiness as counterparties. In turn, this will likely drive consolidation in the sector.
Other issues mentioned include the need for more data. While some services provide statistics on exchanges based on their wallet activity on public chains, which wallets are owned by exchanges are sometimes not known definitively.
Also addressed is the potential increased interlinking with mainstream finance. Because cryptocurrency exchanges have become so dominant, banks will end up dealing with them. From a regulator perspective, there are two approaches. Either create a level playing field with regulation and oversight of cryptocurrency exchanges. Or don’t allow them to be interlinked. And it’s recognized that the opportunity for the second avenue has passed.
Hence if banks are to be increasingly interlinked with cryptocurrency exchanges, those exchanges have to be regulated.