July 22, 2022
Crypto-assets are becoming increasingly popular, although they have been operating for more than ten years without having a big impact on the financial system. Since the release of bitcoin in 2008, a wide range of digital assets including stablecoins, decentralised finance (DeFi), and non-fungible tokens (NFTs) as well as a sophisticated and expanding ecosystem surrounding them have evolved. Their explosive development since 2020 and growing interconnections with other components of the financial system have resulted in an ongoing global policy discussion concerning their significance and risks for the financial system.
The most recent investigation of the Financial Stability Board (FSB) and the European Central Bank (ECB) reveals that the size and makeup of the crypto-asset markets are changing quickly. If current trends continue, crypto-assets will be a threat to the stability of the financial system. In the absence of prompt regulatory intervention, disruptions in markets where crypto-assets are employed could have an impact on regulated financial markets. Thus, a comprehensive and coordinated response among authorities is required given the cross-border and international nature of the ever-expanding crypto-asset world.
While significant, unbacked crypto-assets like bitcoin and ether continue to be the most well-known of these assets in the crypto universe, other categories of crypto-asset have significantly expanded over the past two years. This has made the ecosystem of crypto-assets more complex and provided new features. For example, stablecoins have forged further interconnections by acting as collateral in crypto-asset derivative transactions or as liquidity providers in DeFi. Simultaneously, due to growing institutional interest, connections between the ecosystem of crypto-assets and the conventional financial system have also increased.
Stablecoins are digital units of value that rely on tools or algorithms to maintain a stable value relative to one or several currencies or other assets (including crypto-assets). They were developed to address the high price fluctuations of unbacked crypto-assets. However, when the algorithmic stablecoins TerraUSD crashed and the largest stablecoin (Tether) temporarily lost its peg, in early May, reveal that stablecoins may not be so stable after all. Additionally, since the largest stablecoins are crucial for the liquidity of the crypto-asset markets, a run on or failure of one of them might have far-reaching effects on the crypto-asset markets. If at some point in the future crypto-asset markets start to threaten financial stability, this might have ripple repercussions for the entire financial system. Through massive redemptions of reserve assets, which often consist of conventional assets like government bonds or commercial paper, a run on a stablecoin might also have catastrophic consequences on the financial system. The events surrounding the collapse of the algorithmic stablecoin TerraUSD serve as an example of how the crypto-asset ecosystem is contagious. The largest stablecoin temporarily lost its peg because of the subsequent stress on the crypto-asset market, which put pressure on the price of Tether. Tether had to liquidate reserve assets to recoup significant withdrawals of more than 10% of its market capitalization. Other significant collateralised stablecoins, meanwhile, have only received modest inflows.
In the real economy, the requirements for actual payment methods are not met by stablecoins. Stablecoins have so far shown to be unsuitable for use in real economy payments due to their slow transaction speeds, high transaction costs, and unfavorable redemption terms. Furthermore, while stablecoin marketplaces have not seen much activity from European payment service providers thus far, there are significant regional differences in activity. Stablecoin-related threats to the euro area’s financial stability are now minimal. However, this could alter in the future if growth trends continue at their current rate. As such, it is urgent to include stablecoins currently in use inside the regulatory framework. The Markets in Crypto-assets (MiCA) Regulation proposed by the European Commission is a key step for the EU.
DeFi, is another area of the crypto-asset universe that has grown quickly over the past year. It represents an innovative approach to offering financial services which uses automated protocols rather than the conventional centralised intermediates. However, DeFi is subject to the same vulnerabilities as traditional finance, including those brought on by excessive leverage and risk-taking, liquidity mismatches, and interconnection. Some of these weaknesses were demonstrated by the meltdown of the stablecoin TerraUSD in early May, when the sum of all digital assets deposited in DeFi protocols, which measures the size of DeFi, sharply declined in that month.
DeFi should therefore follow the tenet of “same business, same risk, same rule”. Policymakers face difficulties in enforcing effective regulation and oversight due to the absence of conventional centralized entry points for regulation and its opaque and anonymous nature. To reduce the risks from DeFi, a globally coordinated strategy is required as vulnerabilities start to accumulate. This would require a thorough investigation to differentiate between actual regulatory loopholes and a lack of enforcement. Where regulatory gaps are discovered, relevant entry points for regulation as well as regulatory standards are required.
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