ECB Warns Of Financial Stability Risks From Crypto Assets

The European Central Bank, in its report “Decrypting financial stability risks in crypto-asset markets” released on Tuesday warned of the financial stability risks stemming from crypto assets.

The report cautions that systemic risks would increase in line with the level of interconnectedness between the financial sector and the crypto-asset market, the use of leverage and lending activity. To mitigate such systemic risks, closing regulatory and data gaps in the crypto-asset ecosystem was important, the report adds.

The ECB report examined the increase in interconnectedness with the wider financial system at the institutional level as well as at the retail level.

In respect of institutional investments, it cites the survey by custody and execution services provider Fidelity Digital Assets which shows that 56 percent of European institutional investors indicated that they have some level of exposure to digital assets, versus 45 percent in 2020.

In respect of retail investments, it quotes from ECB’s Consumer Expectation Survey (CES) for six large euro area countries which indicates, based on experimental questions, that as many as 10 percent of households may be owning crypto assets.

The increasing correlation of crypto-asset prices with mainstream risky financial assets during episodes of market stress, according to the ECB report, casts doubt over their usefulness for portfolio diversification. It also notes that crypto’s correlation with gold has turned negative amidst rising inflation expectations and geopolitical tensions.

The report adds that financial stability risks could be amplified by the growing options offered by crypto exchanges for investors to increase their exposure through leverage. Products such as leveraged tokens, futures contracts and options, it states, can allow investors to synthetically increase their exposure to crypto-asset returns (and risk).

The ECB report acknowledges that although crypto lending (borrowing fiat money or other crypto assets by using crypto-assets as collateral) is still limited, it has grown considerably.

According to the report, this crypto lending could fall under existing financial regulation and has come under increased regulatory scrutiny. The report warns that DeFi platforms that mimic traditional financial services would do well to ensure they comply with existing EU financial regulation before offering their services to EU clients to avoid the risk of any legal action.

Despite the risks, investor demand for crypt assets has been increasing and the crypto-asset universe has increased dramatically in both size and complexity beyond Bitcoin, the report said. It cited selected subsegments within the crypto-asset ecosystem such as stablecoins, non fungible tokens (NFTs) and DeFi as having grown particularly strongly in 2021, indicating that the potential functionalities of crypto assets are expanding.

The risks to financial stability in the euro area on account of crypto assets were seen as limited in the past. While admitting that the significant volatility of crypto assets in recent months has not resulted in contagion or any notable defaults by financial institutions, the ECB report has acknowledged that the risks of these are increasing. If current growth and market integration trends persist, then crypto assets would, according to the ECB, pose a risk to financial stability.

Source: Read Full Article