Is “crypto” a financial stability risk?

Speaking at SIBOS, the Bank of England’s Sir Jon Cunliffe, set out his thoughts on “crypto finance” risks.  

This post sets out some of the most important aspects of the speech which will be relevant for clients considering their UK and international regulatory strategy.

Crypto-assets are growing fast and there is rapid development of new applications for the technology. The bulk of these assets have no intrinsic value and are vulnerable to major price corrections. The crypto world is beginning to connect to the traditional financial system and we are seeing the emergence of leveraged players. And, crucially, this is happening in largely unregulated space.

Financial stability risks currently are relatively limited but they could grow very rapidly if, as the BOE expects, this area continues to develop and expand at pace. How large those risks could grow will depend in no small part on the nature and on the speed of the response by regulatory and supervisory authorities.

Within finance, the crypto label covers a multitude of different innovations in financial assets, markets and services. From a financial stability and from a regulatory perspective, what matters is not the underlying technology but how it is used and for what purpose.

In other words, we should not regulate technologies but rather the activities the technology is performing. And in doing so, we need to ensure a consistent approach to risks, regardless of the technology used.

Unbacked cryptoassets

Unbacked cryptoassets make up nearly 95% of the $2.3 trillion. They are essentially non-replicable strings of computer code that can be owned and transferred without intermediaries. Bitcoin is the most prominent example, but there are now nearly eight thousand unbacked cryptoassets in existence. These have no intrinsic value – that is to say there are no assets or commodities behind them: the value of the cryptoasset is determined solely by the price a buyer is prepared to pay at any given moment.

Changing attitudes

Attitudes to unbacked cryptoassets, however, appear to be shifting – in the UK fewer holders now say they see them as a gamble and more see them as an alternative or complement to mainstream investment. Around half of existing holders say they will invest more.

Institutional

At the same time, core wholesale finance and financial market infrastructure firms are putting their toes in the water. Several global banks are offering, or are planning to offer, digital asset custody services. Some international banks have started to, or are looking at, trading cryptoasset futures and non-deliverable forwards; and offering wealth management clients cryptoasset investments, following client demand. Others have developed exchange platforms facilitating matched trades, or offer customers access to other crypto exchanges through their apps. Leading payment firms are also exploring ways of allowing people and businesses to use certain stablecoins for payments and for the settlement of transactions within their networks.

There is evidence of significant and growing interest from traditional hedge funds – in one recent survey of hedge funds, 21% of respondents indicated they were currently investing in digital assets and digital assets averaged 3% of their assets under management.

Banks on the other hand have much more limited direct exposure to crypto with their activities largely consisting of agency services. However, there is clearly a prospect for the degree of interconnectedness to rise in the near future. We are starting to see proposals not just for agency services like custody and trading platforms but also for balance sheet exposure including offering broker-dealer services.

Financial System

The financial system is far more resilient today than it was in the recent past, following the reforms put in place in the post-crisis period. Of course, this does not mean there are no challenges, as the market disruption at the onset of COVID-19 (the ‘Dash for Cash’) reveals.

A massive collapse in cryptoasset prices, similar to what we have seen in tech stocks and sub-prime, is certainly a plausible scenario. In such a price correction scenario, the first question that arises is the degree of interconnectedness between crypto and the conventional financial sector.

Taking together the volatility of unbacked and largely unregulated cryptoassets, their nascent but
fast-growing integration into the financial sector and the appearance on the scene of leveraged players, the conclusion is that while a severe price correction would not cause financial stability problems now, all else equal, the current trajectory implies that this may not be the case for very long.

Stablecoins

Stablecoins constitute a relatively small proportion of cryptoassets – at $130bn they make up just over 5% of all cryptoassets, though they have more than doubled since 2020, when they represented around 2% of the total. Their use in crypto payment systems has so far been mainly for payments within crypto markets, though there are some signs that they are just beginning to be used by wholesale financial market players and large corporates.

There are, however, in prospect, a number of proposals, including from big tech platforms, to expand existing schemes or develop new ones as payment systems for use at scale by the general public.

Crypto technology offers the prospect of further transformation in the way we pay and the use of money as a means of transaction. However, the development of stablecoins for general purpose use at scale cannot be allowed to come at the cost of lower standards or higher risks to financial stability. Regulatory authorities will need to ensure that the standards that apply to current systemic payment systems apply equally effectively to any systemic or likely to be systemic payment system using stablecoins.

However, applying this principle of ‘same risk, same regulation’ to systemic payment systems based on stablecoins and crypto technology poses a number of a challenges.

Unlike existing payments systems which operate in central bank or commercial bank money, stablecoin payment systems issue their own money, the ‘coin’. This raises fundamental issues around the safety and interoperability of private money used in our economies. Stablecoin arrangements can be decentralised on public networks, with no overarching entity responsible for their operation. They can also be structured in novel ways as sets of separately operated yet interdependent functions that can frustrate comprehensive, end to end, risk management.

A major step towards ensuring the consistent application of international standards to crypto-based financial services was the publication by CPMI-IOSCO last week of a report, for consultation, on how the international standards for systemic payment systems, the Principles for Financial Market Infrastructures (PFMI) should apply to stablecoin arrangements.

The guidance will provide the foundation for regulation to bring systemic stablecoins within the regulatory perimeter. It will remain, of course, a decision for individual jurisdictions whether and, if so, under what regulation to permit the operation of systemic or likely to be systemic stablecoin payment systems.

Decentralised Finance – ‘DeFi’

DeFi is a development that demonstrates the increasing complexity, and potentially growing risk in the crypto ecosystem. The label refers to decentralised, algorithm-based financial services that rely on smart contracts and are delivered over DLT platforms without intermediaries. The most prominent use for DeFi at present is the provision of credit. Lending currently represents nearly half of the DeFi market. However, the DeFi model and technology can be deployed to replicate a range of financial services such as savings, trading, insurance and derivatives.

DeFi is very small at present but growing very fast, from less than $10bn at the start of 2020 to nearly $100bn last month.

The highly decentralised and global structure of the DeFi sector along with the difficulty to trace end users provide a unique set of challenges for regulators.

Even on an initial view it is clear that the sector is opaque, complex and undertakes financial activities that carry risk – activities that are regulated with the traditional financial sector.

DeFi is still in its early infancy but its rapid growth means that regulators, domestically and internationally, need to think seriously now about the risks of a broad range of financial services being effected through DeFi platforms and how to ensure risks are managed in the DeFi world to the same standards as they are managed in traditional finance.

Conclusions

Although crypto finance operates in novel ways, well-designed standards and regulation could and should enable risks to be managed in the crypto world as they are managed in the world of traditional finance.

Bringing the crypto world effectively within the regulatory perimeter will help ensure that the potentially very large benefits of the application of this technology to finance can flourish in a sustainable way.

It is not the responsibility of financial stability authorities to preserve any particular business models, including in banking. However, financial stability authorities do have a legitimate interest in ensuring any transition is smooth and does not generate instability.

Therefore, regulators internationally and in many jurisdictions need to pursue regulation as a matter of urgency.

Full speech available here:

Is ‘crypto’ a financial stability risk? - speech by Jon Cunliffe | Bank of England

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