Federal Reserve suggests new margin framework to address crypto volatility

The Federal Reserve has proposed a new margin scheme treating cryptos as an asset class of their own. The proposal would help better manage crypto’s high price volatility and address some of the risks associated with derivatives, in which traders borrow money and must provide collateral. 

Current systems fail to capture crypto’s specific risks, the central bank found, and new rules could help establish a safer, more stable trading environment. The proposal stems from a working paper published on Wednesday by Federal Reserve researchers Anna Amirdjanova, David Lynch, and Anni Zheng. 

They caution that crypto assets should be classified separately when calculating initial margin requirements. Initial margin is the amount traders must deposit before entering into derivative trades. This collateral serves to protect both sides when one party falls short of its obligation. 

The trio focused on “uncleared” derivatives markets, meaning markets that included over-the-counter trading. These transactions do not go through centralized clearinghouses and are thus more risky, since there is no one to verify the legitimacy of the exchange. 

Margin requirements are especially critical to risk management in such markets. Margin requirements are currently determined using the Standardized Initial Margin Model. This approach aggregates assets into segments, including interest rates, equities, foreign exchange, and commodities. 

However, the authors found that cryptocurrencies didn’t fit into any of these categories. Crypto assets are unlike conventional investments. They experience rapid price fluctuations, and unlike stocks or currencies, their prices are influenced by additional factors. 

As a result, existing categories can lead to an underestimation/misrepresentation of their risks. To address this, the Federal Reserve researchers recommend assigning specific risk weights to crypto assets. 

They call for separating “floating” cryptocurrencies, whose prices fluctuate freely, from “pegged” cryptocurrencies, or stablecoins, which aim to maintain a stable value.

Crypto volatility increases collateral requirements

The proposal’s biggest argument is about crypto’s lack of predictability. The price volatility of assets such as Bitcoin, Ether, and others can swing rapidly. This increases the likelihood that traders will not be able to make up for their losses. 

Traders in derivatives markets tend to leverage borrowed funds to raise potential profits. But that also raises the chances of losing money. Margin requirements serve as a buffer against financial risk. When assets are highly volatile, investors need to deposit more collateral to reduce the risk of default. 

The researchers proposed building a benchmark crypto index that combined both floating cryptocurrencies and stablecoins. Not only would this index reflect overall behavior on both asset classes, but the whole crypto ecosystem would also be able to make an accurate approximation of overall market volatility. 

This index would help both regulators and financial institutions calculate margin requirements with more precision. By tracking the performance of this combined index, financial companies could then make necessary adjustments to collateral requirements in response to real market conditions. 

This would make risk management more accurate, enabling investors and institutions to more closely monitor whether the market has an adjustment point, thereby protecting both traders and financial institutions from unexpected shocks. 

The idea is that regulators are treating crypto as a separate financial category rather than pushing it into existing frameworks for traditional assets.

Fed signals broader shift toward crypto integration

The working paper also reflects a broader shift in regulators’ views of cryptocurrencies. Instead of ignoring or restricting crypto, the Federal Reserve is preparing systems that can safely include it within the financial system.

In December, the Federal Reserve reversed its 2023 guidance that had limited banks’ engagement in crypto-related activities. Previously, banks supervised by the Federal Reserve faced stricter oversight when dealing with digital assets.

The updated approach means banks and crypto-related firms may operate under clearer and more consistent rules. This could make it easier for financial institutions to offer crypto-related services while still maintaining safety standards.

The Federal Reserve has also discussed allowing crypto companies access to specialized bank accounts known as “skinny” master accounts. These accounts would allow crypto firms to connect directly to the central banking system, but with fewer privileges than those of full-service bank accounts. This approach could improve oversight while still allowing innovation.

Get seen where it counts. Advertise in Cryptopolitan Research and reach crypto’s sharpest investors and builders.