FSB warns of risks posed by multifunction crypto-asset intermediaries

Rick Steves

The report on Multifunction Crypto-Asset Intermediaries (MCIs) provides an in-depth analysis of these entities which combine various crypto-asset services and products, typically centering around a trading platform. These services can include proprietary trading, investment functions, issuance, promotion, and distribution of crypto-assets, including stablecoins.

The Financial Stability Board (FSB) has published a report assessing the risks posed by multifunction crypto-asset intermediaries (MCIs).

These MCIs, like FTX before its collapse, provide a wide range of crypto-asset services and products, often centralized around a trading platform.

In traditional finance, such diverse activities are typically not offered by a single entity due to restrictions aimed at preventing conflicts of interest and ensuring market integrity and stability.

Key points of the FSB report

The report by the Financial Stability Board (FSB) on multifunction crypto-asset intermediaries (MCIs) offers a detailed examination of the potential risks and vulnerabilities associated with these entities. The analysis reveals several key points:

Current Impact on Financial Stability: Presently, the failure of an MCI is deemed to have a limited impact on financial stability and the real economy. However, this assessment is hampered by significant information gaps. The closure of some “crypto-asset-friendly” banks underscores the risks arising from increasing interconnectedness between the crypto-asset markets and the traditional financial system​​.

Leverage Concerns: MCIs engaged in proprietary trading or market making on their platforms can contribute to the build-up of leverage, especially if governance and risk management measures are inadequate. This is particularly evident in cases where MCIs issue and trade their proprietary crypto-assets, creating additional leverage through inflated asset prices used as collateral for further borrowing​​.

Liquidity Mismatch Risks: Investment programs, including staking and yield/earn programs, create liquidity mismatches. MCIs may promise investors immediate redemption while investing the proceeds in riskier and less liquid assets, often leveraging these assets to acquire further funds​​.

Technological and Operational Vulnerabilities: MCIs face various technological and operational challenges, including susceptibility to cyber-attacks and technical issues that can disrupt platform functions like trading and withdrawals​​.

Increased Interconnectedness: By combining trading and investment functions, MCIs amplify interconnectedness within the crypto-asset ecosystem. This can lead to conflicts of interest and market manipulation, especially in the absence of robust admission rules and due diligence processes​​.

Governance and Structural Issues: Many MCIs may lack effective governance and risk management frameworks, exposing them and their clients to uncontrolled leverage and liquidity risks. Some MCIs might also intentionally avoid regulatory oversight or operate in non-compliance with existing regulations, leading to weak internal oversight​​.

Misappropriation Risks: The absence of proper segregation safeguards could lead to the misappropriation or re-hypothecation of users’ funds and crypto-assets, further exacerbating leverage and liquidity mismatches​​.

Transparency and Disclosure Deficiencies: A lack of transparency and disclosure can obscure the true risks associated with MCIs, hindering regulators and market participants from effectively assessing the safety and soundness of MCI business models​​.

Challenges in Global Operations: MCIs operating globally, especially those headquartered or incorporated in lightly regulated jurisdictions, pose challenges for national authorities in terms of monitoring and enforcing regulations​​.

Market Concentration Concerns: A few MCIs could become dominant liquidity providers in crypto-asset markets, leading to potential market disruptions if a single MCI fails. This concentration could also foster anti-competitive behaviors​​.

The report on Multifunction Crypto-Asset Intermediaries (MCIs) provides an in-depth analysis of these entities which combine various crypto-asset services and products, typically centering around a trading platform. These services can include proprietary trading, investment functions, issuance, promotion, and distribution of crypto-assets, including stablecoins. These functions often have traditional finance analogs but are not typically provided by the same entity or are heavily regulated​​.

Vulnerabilities of MCIs resemble those in traditional finance, such as leverage, liquidity mismatch, technological and operational vulnerabilities, and interconnections. However, specific combinations of MCI functions could intensify these vulnerabilities. For instance, their engagement in proprietary trading, market making, and crypto-asset lending and borrowing could lead to higher leverage. The report also highlights potential spillover effects of MCI vulnerabilities to the traditional financial system and economy, with potential adverse confidence effects and linkages to financial institutions through services, direct exposures, or MCI-issued stablecoins​​.

MCIs often lack transparency in governance and internal risk management, with concentrated decision-making among a few individuals. This can exacerbate vulnerabilities and lead to potential misappropriation of assets or misuse of customer funds​​.

The MCIs are interconnected within the crypto-asset market and have varied connections with traditional financial institutions, impacting both ecosystems. Their interconnections are extensive but opaque, involving financial dependencies, operational dependencies, and exposure among entities​​.

The report also highlights the role of MCIs in driving the evolution of the crypto-asset sector, particularly through their global operations and lack of compliance with regulations in certain jurisdictions. This has implications for market integrity and financial stability. Monitoring MCI developments is crucial for understanding financial stability concerns, but substantial data gaps and governance issues make this challenging. Potential indicators to monitor MCI developments include their overall footprint, vulnerabilities from their services, and interconnections with the traditional financial system​​.

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