The Board of Governors of the Federal Reserve System and the other federal financial regulatory agencies are issuing this joint statement to remind banking organisations of their obligations related to liquidity risk management and to provide an overview of the relevant market risks posed by crypto-assets.
This statement sets forth the principles and supervisory expectations necessary for banking organisations to appropriately manage liquidity risk arising from their businesses involving crypto-assets.
The Federal Reserve System (the Federal Reserve or the System) is the central bank of the United States. Congress established it in 1913 and consists of 12 regional Banks and 24 Branches. The Federal Reserve System’s mandate is to promote an efficient, resilient financial system and a healthy economy that serves all Americans.
The Board of Governors in Washington, DC plays a key role in our mission. The seven Governors are appointed by the President and confirmed by the Senate for 14-year terms, making them among our government’s most independent policy makers. Responsible for overseeing both monetary policy and supervision/regulation of financial institutions, they work to ensure U.S. monetary policy achieves maximum employment, stable prices, and moderate long-term interest rates while ensuring that banking organisations are safe and sound. As part of these responsibilities, they use monetary tools — such as setting interest rates on discount window loans — to encourage economic growth without fanning the fires of inflation or deflationary pressures.
Joint Statement on Liquidity Risks to Banking Organizations Resulting from Crypto-Asset Market Vulnerabilities
The Board of Governors of the Federal Reserve System has issued this statement to provide an overview of its duties and responsibilities, its role within our nation’s financial system, and to explain the policies and activities that guide the Federal Reserve’s relationship with other entities in the economy. This statement is intended to serve as an introduction to the Federal Reserve System for those unfamiliar with it. It is also intended to remind members of Congress, other public sector officials and citizens throughout our nation of this critical institution’s duties.
This statement also outlines various initiatives the Federal Reserve Board of Governors took in pursuit of its mandate from Congress, which is to promote maximum employment, stable prices and moderate long-term interest rates. It details how these initiatives—such as setting monetary policy, supervising banks and regulating payments systems—are carried out. Furthermore, it discusses how certain statutory requirements; for instance concerning open market operations undertaken by The Federal Open Market Committee (FOMC) , work in concert with Federal Reserves other tools for conducting monetary policy.
Finally, this statement highlights why maintaining credibility in conducting these activities over a prolonged period is key for ensuring longer-term price stability in our economy.
This joint statement applies to all banking organisations supervised by the Federal Reserve and to state-chartered banks, savings associations, and credit unions with total consolidated assets of $100 billion or more, referred to in this document as large banking organisations. All banking organisations with total consolidated assets of less than $100 billion are intermediate-size and community banking organisations.
This joint statement sets forth the expectations of the Federal Reserve and other federal financial supervisors concerning liquidity risks related to crypto-assets held by banking organisations.
Liquidity risk refers to the risk that a company will not be able to meet its financial obligations when they come due, because it does not have sufficient liquidity or cash on hand. This could be due to a lack of assets that can be easily converted into cash, such as deposits in liquid accounts, assets with a readily available market or hard assets such as real estate.
Liquidity risks can have short-term and long-term effects on a company’s ability to generate income and meet its financial obligations. To manage this type of risk, companies need to identify sources of liquidity and plan for any potential threats. In addition, businesses need to understand the difference between solvency risks – those associated with having too much debt relative to income – and liquidity risks – those associated with having too little cash on hand when needed most.
Depending upon the type of business being operated and the industry trends, some common sources from which businesses can secure liquid funds include: customers (collections/accounts receivable), suppliers (payment/vendor financing), banks (lines of credit), government programs (grants), investors (private placements) and venture capitalists (equity investments). Companies should also consider their ability to generate funding sources through profitable operations such as increased accounts receivable turnover ratio or reduced capital expenditures.
Businesses need to carefully monitor their liquidity levels by regularly reviewing their current cash balances, investments available for easy sale, overdraft preventions plans in place with lenders, current minimum balance requirements set on any liquid accounts held at banks, terms in place with suppliers who provide vendor financing opportunities and other important metrics associated with operating activity levels. They also need to ensure they are planning both short term and long term strategies regarding sources of liquidity available for needs that may arise in the future. Implementing appropriate strategies related to managing focuses first on understanding the underlying reasons for these needs by evaluating economic trends and business prospects related to expected performance over time.
Crypto-Asset Market Vulnerabilities
Crypto-assets, digital assets created and stored electronically, and their markets exhibit a range of features with promise and risk. On the one hand, crypto-assets and distributed ledger technologies may offer innovative approaches to improve the efficiency of financial intermediation, enhance the available means to store value, touch customer demand for broader asset choices, and provide the basis for more efficient business processes. But, on the other hand, they also present vulnerabilities in seeking wider acceptance.
Crypto-asset market vulnerabilities include an overall lack of transparency in how prices are determined; reliance on largely unregulated exchanges; wide interexchange price variations; information asymmetry among users; potential concentrations of positions among individual brokers or individual investors; a susceptibility to potential cyberattacks given their lack of physical form; lack of recourse or resolution should events or activities go wrong or be misunderstood; and their potentially greater risk in times of financial distress based on rapid contractions in liquidity coupled with illiquidity risks from long recovery intervals.
As part of the Board of Governors of the Federal Reserve System’s ongoing efforts to promote safe and sound banking practices, the Board recently issued a Joint Statement on Liquidity Risks to Banking Organizations Resulting from Crypto-Asset Market Vulnerabilities.
This statement is intended to clarify to banking organisations about the expectations of the Federal Reserve concerning the management of liquidity risk associated with crypto-asset activities.
Sound Risk Management Practices
Sound risk management practices are essential to the safety and soundness of banking organisations. The Federal Reserve expects banking organisations to maintain robust risk management frameworks and processes commensurate with their complexity, activities, size, and scope. Such expectations encompass a range of functions including, but not limited to:
• The development and maintenance of comprehensive policies and procedures for identifying, measuring, monitoring, controlling, mitigating, stressing and reporting threats posed by material risks.
• A process for robust independent risk management oversight.
• The establishment of appropriate organisational structures to segregate duties within the entity.
• The establishment of significant limits on concentration risks in liabilities and assets.
• An effective system governing internal capital adequacy assessments.
• Establishing quantitative measures for monitoring liquidity adequacy;
• Establishing sound practices in data governance;
• Overseeing transactions related to legal persons over which the entity does not exercise control; and
• Identifying potential conflicts-of-interest across business lines or activities or between clients/counterparties of the institution.
Prudent Liquidity Risk Management
The Federal Reserve Board of Governors is encouraging financial institutions to pursue prudent liquidity risk management practices, including maintaining appropriate portfolio diversification and accurately evaluating potential sources and uses of liquidity. In addition, institutions should regularly review their liquidity profiles to identify any potential risks that may be affected by market volatility or changes in the composition of their assets or liabilities.
A strong liquidity risk management practice requires a robust understanding of currency, interest rate, and counterparty risks.
Institutions should strive to maintain a robust framework for assessing their liquidity positions continuously considering their strategic objectives and external influences. Institutions should consider including stress scenarios when analysing future cash position projections. Furthermore, as part of its overall liquidity risk management framework, an institution should maintain reserves sufficient to cover expected levels of withdrawals under various scenarios such as extreme market stress or unexpected changes in customer behaviour.
A strong governance framework for robust policymaking should include established processes for independent review and monitoring party performance to assess compliance with the institution’s policies on managing liquidity risk.
Stress testing is a critical step in the supervision of financial institutions, as it assesses their ability to perform under difficult market conditions. In addition, it allows supervisors to identify weaknesses and vulnerabilities to address them before they become a problem. As a result, stress testing is an essential tool for ensuring the strengths of the financial system, particularly in times of uncertainty.
At its core, stress testing involves a numerical simulation of how a company’s balance sheet and income statement might react to altering economic conditions or events. By assessing how certain scenarios may impact their assets, liabilities, income and expenses, supervisors can gain insight into which firms might face greater risks or weaknesses.
The effects of changing macroeconomic conditions on each institution’s capital ratios drive supervisory expectations for stress testing. The results must inform decisions on capital levels and risk management measures at individual firms. Supervisors will also use stress test results to apply more rigorous supervisory actions where appropriate. Adequate attention must also be paid to corporate governance issues; CEOs and senior management should ensure that their companies’ boards understand the importance of stress tests as part of their oversight role while not taking any operational risk themselves.