The Growing systemic importance of Cryptocurrencies

The Growing systemic importance of Cryptocurrencies

For the first time this topic was discussed and evaluated in 2018 after according to , Bitcoin (BTC) and cryptocurrencies have reached record highs in terms of capitalization. In 2019 and 2020, the question was irrelevant. However, the discussion intensified again in the second half of 2021 after the capitalization of cryptocurrencies reached another record high in April and November 2021.

Let’s look at the arguments expressed during the discussion about the systemic importance of crypto assets, and the conclusions drawn on their basis. We comprehensively summarize and present the forecast for the most recent assessment and opinion published by the Financial Stability Board (FSB) on February 16, 2022.

The first cryptocurrency analyses

On March 13, 2018, after crypto assets reached a record capitalization level in January 2018, the FSB informed the G20 (an intergovernmental forum bringing together 19 countries and the EU) that cryptocurrencies do not pose a risk to overall stability much larger than the traditional financial system. This conclusion was based on the size of the crypto market – small compared to the size of traditional financial markets, and very limited use for the real economy and related financial transactions. However, the FSB warned that the assessment will be different if the use of crypto assets increases significantly, as well as investor confidence and interdependence with the regulated financial system increase.

The market capitalization of BTC and other cryptocurrencies. Source: FSB assessment
The market capitalization of BTC and other cryptocurrencies. Source: FSB assessment

Regarding the potential vulnerability arising from unsecured cryptocurrencies (such as BTC), the FSB notes that the links between cryptocurrencies and systemically important financial institutions are currently limited, and following the International Monetary Fund (IMF) believes that such links are more important in emerging market economies than in countries with a developed economy. The agency also notes that crypto is increasingly being acquired by non-bank structures (for example, hedge funds) and similar products.

During the “crypto winter”, the Bank of England (BoE) also confirmed on May 1, 2019 that crypto assets do not pose a risk to the overall stability of the much larger traditional financial system. The conclusion was based on the fact that the market capitalization of the cryptocurrency market is too small compared to the multi-trillion global financial market.

On May 14, 2019, the European Central Bank (ECB) came to a different conclusion, warning that the dynamics of cryptocurrency markets means that serious threats to the financial stability of the EU cannot be ruled out, and that careful monitoring is needed. On February 28, 2019, the US Federal Reserve System (FRS) included the collapse of the Bitcoin market among the stressful events conducted by to assess the risk to the US financial market. On July 1, 2019, the G20 confirmed that crypto assets do not pose a threat to global financial stability, but acknowledged that their development should be closely monitored.

Problems of financial stability in connection with the growth of crypto assets

After the capitalization of the crypto increased from 191 billion US dollars on January 1, 2020, to 2.3 trillion US dollars in October 2021, the Bank of England concluded that, although the risks to financial stability remain limited, current events in the cryptocurrency markets raise concerns about financial stability due to the growing interconnectedness with the traditional banking and financial system, the emergence of leveraged players in the unregulated sector and the growth of decentralized finance (DeFi) and stablecoins.

In October 2021, the International Monetary Fund (IMF) noted that in some emerging markets, the macroactuality of cryptocurrencies is higher than in developed economies, due to the wider adoption and penetration of cryptocurrencies compared to developed economies.

The average daily trading volume of crypto assets over the past 3 years. Source: FSB Report
The average daily trading volume of crypto assets over the past 3 years. Source: FSB Report

On February 16, 2022, the FSB acknowledged that the crypto asset market is developing rapidly and is approaching to pose a threat to global financial stability. They came to the conclusion that it has become more difficult than before to determine the moment when the risks to financial stability can quickly increase.

The market capitalization of crypto assets remains small compared to all assets that make up the financial system, and the degree of interconnectedness is still limited. However, non-banking organizations and banks are increasingly active in crypto assets, and participate in the crypto sector through specialized and sometimes leveraged financial products: investors and consumers still have a low level of understanding of cryptocurrencies, and there is uncertainty about the degree of operational stability of some players.

Shortcomings identified by FSB

Regarding the risks associated with stable coins, FSB notes that the nature and composition of foreign reserves of organizations issuing and managing stablecoins may create market risks: deficiencies in management, risk management and operational activities may affect investor confidence. FSB also notes that the critical payment systems on which the real economy depends may suffer if stable coins are used for payments on a large scale. This is especially true for global stablecoins. The following issues also constitute a problem:

  • Products (ETP) and funds offering leverage trading strategies.
  • Provision of services by financial institutions and banks for storing cryptocurrencies, trading them and other services.
  • The impact on wealth and confidence that can cause sudden market shocks
  • The extent to which these crypto assets are used in payments and settlements (which is still limited)

Regarding DeFi, the FSB emphasizes that risks to financial stability may arise due to the growing size of DeFi, insufficient regulation and supervision.

Total Deposited Value (TVL) of assets in DeFi transactions in 2020 and 2021. Source: FBS Report
Total Deposited Value (TVL) of assets in DeFi transactions in 2020 and 2021. Source: FBS Report

The Bank concluded that the risks to financial stability created by the cryptocurrency markets have become more real than before. As crypto assets are introduced by traditional financial sectors and players, the relationship between traditional and cryptocurrency markets is increasing, which contributes to the transfer of shocks emanating from cryptocurrency markets to traditional financial markets.

The authorities still have gaps in identifying and quantifying the financial stability risks created by cryptocurrency markets. Therefore, the FSB has continued monitoring the risks posed by crypto markets and will consider potential regulatory and supervisory measures to address threats to financial stability, including improving data collection and expanding cross-border and intersectoral cooperation/information exchange.

The opinion of regulators has changed over time

The assessment of whether crypto assets and related markets pose a systemic risk to the financial system has been regularly reviewed by regulators such as the FSB, the IMF, the ECB, the Fed and the Bank of England since 2018. As always, it was concluded that the crypt currently does not pose a systemic risk. The relative size of crypto markets and the degree of interconnectedness with traditional financial markets are the main factors on which the assessment is based.

However, this conclusion has evolved over time. The introduction of banking investment products and other institutional investment mechanisms, initiatives of the banking sector to develop crypto services, the emergence of DeFi solutions and stablecoin offerings, as well as the growth in the overall popularity of crypto assets have strengthened the relationship between crypto markets and traditional financial markets.

In conclusion

This development exposes traditional financial markets to shocks that destabilize cryptocurrency markets to a greater extent than it has been in the past. Regulators are responding by increasing data collection and monitoring, as well as expanding cross-border cooperation.

As cryptocurrencies become more integrated into traditional markets and increase in market capitalization, it is reasonable to expect that the supervision of cryptocurrencies by the regulated sector will be strengthened, that the Basel Committee on Banking Supervision (BCBS) will complete the work on supervision of banks’ cryptocurrency risk, and that the work on extending the regulatory framework to crypto players will be accelerated.