Global Watchdog Points at Growing Force of Crypto with Another Usual Warning

Cryptocurrency DeFi Finance Market Regulation Stablecoin

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Jaroslaw Adamowski

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Jaroslaw Adamowski

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June 26, 2023

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The Financial Stability Board (FSB), an international body that monitors and prepares recommendations about the global financial system, is increasingly ringing the alarm about crypto. The institution’s latest report claims that cryptoasset markets are rapidly evolving and could reach a point where they pose a threat to global financial stability due to their scale, structural vulnerabilities, as well as increasing interconnectedness with the traditional financial system.

“Cryptoasset market capitalization grew by 3.5 times in 2021 to [USD] 2.6 trillion, yet crypto-assets remain a small portion of overall global financial system assets,” the FSB said in a statement summarizing the report’s findings. Direct connections between crypto and systemically important financial institutions and core financial markets, it said, while growing rapidly, are currently limited.

At the same time, institutional involvement in cryptoasset markets, both as investors and service providers, has grown over the last year.

“If the current trajectory of growth in scale and interconnectedness of crypto-assets to these institutions were to continue, this could have implications for global financial stability,” according to the board.

The FSB perceives that decentralized finance (DeFi) has established itself as a fast-emerging sector, while a relatively small number of cryptoasset trading platforms aggregate various types of services and activities, such as lending and custody. 

Some of these platforms run their operations outside of a jurisdiction’s regulatory framework, or are not in compliance with applicable national laws and regulations which could potentially lead to a concentration of risks, and underscore the lack of transparency on their activities, they argued.

“Partly due to the emergence of DeFi, stablecoin growth has continued, despite concerns about regulatory compliance, quality and sufficiency of reserve assets, and standards of risk management and governance,” according to the body.

Stablecoins are presently used mainly as a bridge between fiat currencies and cryptoassets which brings implications for the stability and functioning of the global cryptoasset markets. However, if a major stablecoin were to fail, it is possible that liquidity within the broader cryptoasset ecosystem that includes DeFi could become constrained and could disrupt trading, potentially triggering stress in those markets, the FSB said.

“This could also spill over to short-term funding markets if stablecoin reserve holdings were liquidated in a disorderly fashion,” according to the board.

The FSB says it intends to continue to monitor developments and risks in the field of cryptoassets, and explore potential regulatory and supervisory implications of such unbacked assets to address relevant financial stability threats.

Considering the crypto landscape, the FSB report listed the following areas for ongoing vigilance:

• potential rising bank sector involvement in the cryptoasset ecosystem, in particular where activities give rise to balance sheet exposure to cryptoassets, not covered by, or not in compliance with, appropriate regulatory treatment;
• institutional investors expanding their exposures to crypto relative to the size of their portfolios; risks could further rise if such exposures use high levels of leverage, including via the use of derivatives referencing cryptoassets;
• acceleration in the adoption of crypto for payments – this could be made through partnerships with established payment firms or retailers/social networks;
• the rise, role, and risks associated with crypto trading platforms;
• losses in cryptoassets, when accompanied by leverage, liquidity mismatch, and interconnections with the traditional financial system, may strengthen systemic risks resulting from wealth effects; loss of confidence in stablecoins could also result in sales of their reserve assets, potentially impacting the functioning of short-term funding markets;
• the rapid growth of DeFi, in the absence of clearly identifiable intermediaries or parties responsible for governance, challenges core financial (stability) regulatory and supervisory disciplines and doctrines;
• differing regulatory approaches could trigger regulatory arbitrage, increasing potential systemic risks;
• data gaps preventing risk assessment and calibration of policy options.

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