New Guidance on Safeguarding Crypto Assets

In 2022, the value of the cryptocurrency market — including Bitcoin and Ethereum — tumbled by trillions of dollars. Despite this volatility, many people expect crypto assets to rise in significance in the coming years. In March 2022, President Biden issued an executive order that tasked financial regulators with recommending ways to address financial stability risks and regulatory gaps posed by crypto.

In response to Biden’s order, the Financial Stability Oversight Council (FSOC) unanimously voted on October 3, 2022, to approve a report that recommends ways to address three specific gaps in the regulation of crypto-asset activities in the United States.

1. “Spot Markets” for Non-Security Crypto Assets

The FSOC was created by the Dodd-Frank Act of 2010 to monitor and address any risk buildup in the financial system. It’s chaired by U.S. Treasury Secretary Janet Yellen. Other members include the leaders of the Securities and Exchange Commission (SEC), the Federal Reserve and other federal financial regulatory agencies.

Today, there’s limited direct oversight of the spot market for crypto assets that aren’t securities. The spot market is where financial instruments, such as commodities, currencies and securities, are traded for immediate delivery. The FSOC report suggests that Congress should pass legislation giving rulemaking authority to financial regulators over such a market. The rulemaking authority should cover the following areas:

• Conflicts of interest,
• Abusive trading practices,
• Public trading reporting requirements,
• Recordkeeping, and
• Governance standards.

“This report provides a strong foundation for policymakers as we work to mitigate the financial stability risks of digital assets while realizing the potential benefits of innovation,” said Treasury Secretary Yellen. The report concludes that crypto activities could pose risks to the stability of the U.S. financial system and emphasizes the importance of appropriate regulation, including enforcement of existing laws.

2. Opportunity for Regulatory Arbitrage

In this context, the term “arbitrage” refers to the practice of using more favorable rules in one market to circumvent less favorable rules elsewhere. To address regulatory arbitrage, the FSOC recommends continued coordination among regulators to supervise crypto-asset entities. Moreover, the report advises Congress to pass legislation that would create a comprehensive prudential framework for all crypto assets.

Further, the report noted that crypto-asset entities’ operations and organizational structures may cause them to have different regulatory regimes for different affiliates or subsidiaries. This means that no single regulator will have a comprehensive view of these entities’ activities. So, the FSOC asked Congress to pass legislation that gives regulators authority to address regulatory arbitrage. For example, the FSOC wants regulators to be able to put restrictions on entity and affiliate activities and to impose capital and liquidity requirements.

3. Crypto Trading Platforms

In terms of platforms that investors use to trade crypto assets, the FSOC is concerned that retail customers aren’t properly protected. These platforms have proposed offering customers direct access to markets by vertically integrating the services provided by intermediaries, such as brokers or futures commission merchants.

“Financial stability and investor protection implications may arise from retail investors’ exposure to certain practices commonly proposed by vertically integrated trading platforms, such as automated liquidation,” said Yellen.

To tackle this shortcoming, the FSOC recommends that member agencies assess the impact of vertical integration on conflicts of interest and market volatility. This includes examinations of whether vertically integrated market structures should be overseen under existing laws and regulations.

SEC Endorsement

The FSOC report is part of a larger interagency effort to mitigate the downside risks of crypto assets, including increased enforcement of existing laws. At the same time, agencies want to harness the potential benefits of crypto and its underlying technology. SEC Chair Gary Gensler endorsed the recommendations in the report.

During the FSOC meeting, Gensler called crypto “a volatile and speculative investment class.” He believes the vast majority of the nearly 10,000 tokens in the crypto market are securities that should be regulated by the SEC, and many crypto intermediaries should register with the SEC. He concluded that there’s substantial noncompliance with the securities laws in the crypto market — and enhanced disclosures could help promote financial stability and protect investors, consumers and businesses from fraud and theft in the crypto markets.

How Should Cryptocurrency be Reported on a Balance Sheet?

Currently, cryptocurrencies and other digital assets are accounted for as intangible assets under Accounting Standards Codification Topic 350, Intangibles — Goodwill and Other. This means that they’re reported on the balance sheet at historical cost, and they may be deemed “impaired” whenever the price goes down. But, if the price goes back up, that impairment can never be recovered. Some investors in crypto have complained that current accounting rules don’t accurately reflect the underlying economics for digital assets.

On October 12, 2022, the Financial Accounting Standards Board (FASB) voted to issue a proposal that would require cryptocurrencies to be measured at fair market value. The guidance would be limited to fungible tokens, deemed to be intangible assets, secured through cryptography on a blockchain or distributed ledger, and don’t provide the asset holder “with enforceable rights to or claims on underlying goods, services or other assets.”

If approved, the proposal would apply to both public and private entities. It would require crypto assets to be measured in accordance with Topic 820, Fair Value Measurement, and gains and losses to be recognized in comprehensive income in each reporting period. The FASB said this approach would best align the measurement of crypto assets with that of other assets held for investment purposes, such as financial instruments that are recorded at fair value.

The FASB also voted for costs to acquire crypto assets — such as commission and transaction fees — to be expensed as incurred. This decision aims to provide simplicity and greater visibility into the holding of gains and losses due to price changes. It would also eliminate the potential for diversity in practice.

At a future meeting, the FASB will discuss how crypto assets should be presented on the financial statements and which disclosures should be required. A proposal is expected in the first half of 2023, according to a recent statement from FASB Chair Richard Jones.

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