Can crypto-assets be a threat to financial stability?

In a recent interesting report, the Financial Stability Board argues that cryptocurrency markets are evolving at a rate that could pose a threat to global financial stability, writes Nikolaos Akkizidis from LegacyFX.

The three main reasons for this assessment are:

• Their scale.
• Their structural vulnerabilities.
• The increasing interconnectedness with the traditional financial system.

Also, the rapid development and international nature of cryptocurrencies increase the potential for regulatory gaps, fragmentation, and arbitrage.

The risk is currently limited

It is noted, however, that direct connections between cryptographic assets and systemically significant financial institutions and key financial markets, although rapidly growing, are currently limited. This is despite the fact that the capitalization of the cryptocurrency market has increased 3.5 times in 2021 to $ 2.6 trillion, as cryptographic assets remain a small part of the total global assets of the financial system.

A source of risk to financial stability could be the high volatility in cryptocurrency prices. However, price volatility has, so far, been contained within crypto-asset markets and have not spilt over to the financial markets. This is probably due to the fact that cryptocurrencies are not currently widely used in critical financial services on which the real economy depends.

(Source:  Financial Stability Board/CoinGecko )

Sources of uncertainty

However, given the rapid development of these markets and the significant data gaps that hinder risk assessments by the authorities, it is difficult to assess potential flashpoints for a crisis. Data gaps make it difficult to assess the full extent of the use of cryptocurrencies and their derivatives in the financial system. These gaps stem, in part, from the fact that participants, products, and markets, including cryptocurrency trading and lending platforms, do not all fall within the regulatory perimeter and related reporting requirements. or, in some cases, may not comply with current legislation.

Another source of risk stems from the fact that systemically important banks and financial institutions are increasingly willing to be exposed to cryptocurrency assets. More sophisticated investment strategies, including through derivatives and other leverage products that refer to crypto-assets, has also increased. The current scale of growth and interconnection of crypto-assets with important banks and financial institutions, if continued, could have a significant impact on global financial stability.

Vulnerabilities

Vulnerabilities that could undermine the integrity and functioning of cryptocurrency markets include low levels of understanding of cryptocurrency assets by investors and consumers. These relate to costs, fees, conflicts of interest, and lack of redress and/or recovery and resolution mechanisms. Also, uncertainties about the operational soundness of certain institutions that focus on cryptocurrencies.

Additional vulnerabilities may arise from the environmental impact of the energy-intensive mechanisms used to mine certain cryptocurrencies. There are also broader public policy issues related to the use of cryptocurrencies in the context of money laundering, cybercrime, and ransomware.

Given the publicity of cryptographic assets and cryptocurrency trading platforms, the rapidly increasing adoption of retailers and the use of leverage, enable any loss of confidence in cryptographic assets to have implications that go beyond the analogy of the actual size and financial interconnection of cryptocurrency markets.

The crucial components

Stablecoins, Decentralized Financing (DeFi), and cryptocurrency trading platforms are three components that are closely linked to a complex and ever-evolving ecosystem and should therefore be considered holistically when assessing the relative risks to financial stability. Partly due to the advent of DeFi, stablecoin issuers have seen significant growth and their reserves could make them major holders of short-term bonds. The structure of stablecoin means that they are exposed to liquidity mismatch, credit, and operational risks.

In addition, a relatively small number of cryptocurrency trading platforms that bring together multiple types of services and activities including lending and custody, account for the majority of cryptocurrency assets. Some of these platforms operate outside the regulatory perimeter of jurisdiction or do not comply with applicable laws and regulations. This presents the possibility of concentrating risks, as well as emphasizes the lack of transparency in their activities.

With regard to Stablecoin, despite concerns about compliance with regulations, the quality and adequacy of cash and risk management, and governance standards, their growth has continued. At present, stablecoins are mainly used as a bridge between traditional fiat currencies and cryptocurrencies, but this has implications for the stability and operation of cryptocurrency markets. So if a significant stablecoin fails, liquidity in the wider cryptocurrency ecosystem (including DeFi) is likely to be limited, disrupting trading and potentially causing stress in these markets. This could also be transmitted to short-term financing markets if stablecoin reserves were liquidated in a disorderly manner.

Conclusions

In summary, although the extent and nature of the use of cryptographic data varies somewhat between jurisdictions, financial stability risks could escalate rapidly for some areas that require constant vigilance, such as the areas listed below:

• Risk of financial stability from increasing involvement of the banking sector in the cryptocurrency ecosystem, especially where the activities lead to exposure of the balance sheet to cryptocurrencies, which are not covered by (or do not comply with) the appropriate regulatory approach.
• Risk of financial stability from institutional investors who increase their exposure to cryptographic assets in relation to the size of their portfolios. The risks could be further increased if such exposures use high levels of leverage, including through the use of cryptocurrency derivatives.
• Risk of financial stability from acceleration in the adoption of cryptographic data for payments. This could be through partnerships with established payment companies or retailers / social networks.
• Risk of financial stability from the development, role, and risks associated with cryptocurrency trading platforms.
• Risk of financial stability from losses in cryptographic assets, when accompanied by leverage, liquidity mismatch, and interconnections with the traditional financial system, where they may reinforce the systemic risk arising from the impact on wealth.
• Risk of financial stability from the rapid development of DeFi, in the absence of clearly identifiable intermediaries or parties responsible for governance.
• Risk of financial stability due to different regulatory approaches that could lead to regulatory arbitrage, thus increasing the potential systemic risks.
• Risk of financial stability from data gaps that hinder risk assessment and calibration of policy options.

To address all of the above and given the international and diverse nature of cryptocurrency markets, authorities around the world will prioritize cross-border and cross-sectoral cooperation. Where there will be a greater focus is on significantly enhancing monitoring to minimize regulatory arbitrage through further collaboration and exchange of information to keep pace with developments in cryptocurrencies.