US Regulators Recommend Oversight for Bitcoin and Distributed Ledgers

A major financial oversight body within the US government created in the wake of the financial crisis has identified bitcoin and distributed ledger systems in general as a potential systemic risk.

The Financial Stability Oversight Committee (FSOC) said in the new report released yesterday that the technology represented an innovation that “appear[s] poised for substantial near-term growth” and that it is reflective of a shifting landscape that merits attention from regulators.

As a broad recommendation, the committee said that regulators should prepare to adjust accordingly if the technology sees broader adoption or outright supplants certain market intermediaries. The issues identified focus on the lack of experience with these systems among participants in financial markets, exposing them to operational and fraud risks.

Beyond that, the FSOC said that the global nature of the technology – and the fact that it transcends legal jurisdictions and national boundaries – will potentially require regulatory cooperation on a similar scale.

The report notes:

"Furthermore, since the set of market participants which makes use of a distributed ledger system may well span regulatory jurisdictions or national boundaries, a considerable degree of coordination among regulators may be required to effectively identify and address risks associated with distributed ledger systems."

The FSOC was created with the passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act, which was drafted in response to the 2008-09 financial crisis. Signed into law in 2010, the bill was a controversial one, and to this day draws arguments that it either regulates the financial system too much or not enough.

The committee itself was given a broad mandate to investigate possible systemic risks, and according to the law, is empowered to designate market issues and take action against activities or market participants it deems an immediate risk to the US financial system.

The FSOC is currently chaired by the Treasury Secretary Jack Lew. Its voting members include Federal Reserve chair Janet Yellen as well as the heads of the Securities and Exchange Commission, the Commodity Futures Trading Commission and the Comptroller of the Currency, among other agencies within the Treasury Department.

Fraud issues

The report suggests that inexperience using the technology could result in deployment problems, and it went on to highlight scalability and fraud risks in particular.

It’s here that the committee specifically cited bitcoin, pointing to recent network capacity issues as an example of what might adversely affect a person or business new to the experience.

”Market participants have limited experience working with distributed ledger systems, and it is possible that operational vulnerabilities associated with such systems may not become apparent until they are deployed at scale,” the authors write.

The report continues:

”For example, in recent months, bitcoin trade confirmation delays have increased dramatically and some trade failures have occurred as the speed with which new bitcoin transactions are submitted has exceeded the speed with which they can be added to the blockchain."

This inexperience could expose some market participants to fraud as well, the report argues.

"Similarly, although distributed ledger systems are designed to prevent reporting errors or fraud by a single party, some systems may be vulnerable to fraud executed through collusion among a significant fraction of participants in the system," it states.

The need to adapt to a changing landscape, according to the report, is driven in part by the idea that market intermediaries with which regulators have worked and gathered information from could change or become obsolete.

For now, the FSOC writes, regulators should keep close watch, stating:

“Financial regulators should continue to monitor and evaluate the implications of how new products and practices affect regulated entities and financial markets and assess whether they could pose risks to financial stability."

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