The Bank of International Settlements (BIS) has published a new report titled “Addressing the risks in crypto: laying out the options,” which looks at the risks present in the crypto ecosystem and puts forward solutions that can potentially address the major issues

The authors of the paper suggested that the crypto ecosystem utilizes “shadow financial functions” that share many of the same vulnerabilities common in traditional finance (TradFi) but carry an elevated level of risk due to “high leverage, liquidity and maturity mismatches and substantial information asymmetries.”

“Policy responses should consider how to address these sources of risk appropriately, given the borderless nature of crypto,” the authors said. The three “non-mutually exclusive” solutions put forward in the report include an outright ban, containment and regulation.

The report also put forward alternative policy actions that can help address inefficiencies in traditional fiance and reduce the demand for crypto, including the introduction of central bank digital currencies (CBDCs), which the BIS and other banks have more power to control.

The motivation for writing the report and attempting to sway the public away from investing in crypto centers around the fact that while the crypto ecosystem is not yet large enough to threaten global financial stability, “this could change if retail or institutional investor interest does not abate,” the BIS said.

“Interconnections with the real economy and TradFi could also increase should crypto become less self-referential, in particular if asset tokenization makes inroads. Discussions on the appropriate policy response to crypto are therefore timely,” the authors warned. “The recent failures in crypto asset markets underscore the need to address the risks presented by crypto before those markets become systemic.”

The authors called for a selective ban on certain cryptos and crypto activities to help reduce the potential for harm investors are exposed to but admitted that doing so “could conflict with founding principles of society,” making it a challenge to enforce.

“For decentralized crypto activities, their borderless nature makes enforcement difficult. The ban would be more effective for the activities of centralized intermediaries, but the activity could move to jurisdictions that do not impose the ban and investors may find ways to evade it,” the report said.

The option of containment could be achieved by limiting the flow of funds into and out of the crypto ecosystem and by limiting other connections with TradFi. This option carries the risk of not being fully effective and leaves the door open for some entities “with less constrained investment mandates” to be lured into the market due to promises of high returns.

Containment would also require that any linkages with the real economy be eliminated, including the use of crypto as a means of payment for goods and services or in response to the tokenization of real-world assets. And with a large number of companies around the world developing products along these lines, it's highly unlikely that these services could be effectively eradicated.

Global banks only have a 0.01% exposure to crypto, according to the BIS

To regulate the industry, crypto would need to be treated with the same principles and tools used to regulate TradFi.

“This approach would ensure consistency in regulating financial activities – whether performed by crypto players or TradFi – and help to promote the policy goals at the core of existing regulatory frameworks,” the authors said. “Moreover, it would allow responsible actors to innovate with regulatory compliance and oversight.” The main issue with this approach is once again enforcement.

The approach that the BIS seemed to favor most was the creation of a CBDC to provide consumers with an alternative to cryptocurrencies. One of the main purposes of introducing CBDCs – besides the fact that they are under the complete control of the central banks – is that they can help improve the quality and reduce the cost of payments.

“If properly designed and implemented, such initiatives could support sound private sector innovation. They could help reduce the cost of payments, enhance financial inclusion, bolster the integrity of the system and promote user control over data and privacy.”

Overall, the BIS is calling for global authorities to consider a variety of policy approaches for cryptocurrencies and to work on improving the existing monetary system in order to get a better handle on the crypto ecosystem before it is in the position to have a greater effect on the traditional financial system or the real economy.