Cryptocurrencies, the ECB: “Destabilization risk, regulation is urgent”

In the new analysis of the central flagship institute on stablecoins and decentralized finance: it is necessary to accelerate on eu rules for virtual currency markets. Alarm on the green transition in finance: cryptoassets are "energy-intensive"

11 Jul 2022

Patrizia Licata

The risks to financial stability arising from cryptocurrencies require special attention in two areas: stablecoins and decentralized finance. And they demand regulatory intervention that can no longer be postponed. This is what we read in the Macroprudential Bulletin of the European Central Bank (ECB).

"New risks to financial stability are on the rise, and the cryptocurrency ecosystem has become more complex and interconnected," the authors write. "If current trends continue, cryptocurrencies will put financial stability at risk. Cryptocurrency markets must therefore be regulated and supervised effectively. The cross-border and global nature of the ever-growing universe of cryptocurrencies requires a holistic and coordinated approach among authorities."

Particularly for stablecoins, "growth, innovation and increasing global use cases require the urgent adoption of appropriate regulatory, supervisory and supervisory frameworks before further significant interconnection with the traditional financial system occurs."

The ECB highlights another aspect: the risk of climate transition for the financial sector deriving from the significant carbon footprint of some crypto-assets such as bitcoin.

The ECB's alarm: stablecoins "are not stable"

Stablecoins have created additional interconnections by acting as collateral in derivative transactions on cryptocurrencies or as liquidity providers in decentralized finance (DeFi), the bulletin reads. At the same time, the interconnections between the cryptocurrency ecosystem and the traditional financial system have grown due to the growing institutional interest.

Stablecoins are digital units of value that rely on tools to maintain a stable value against one or more currencies or other assets (including cryptocurrencies), or that use algorithms to maintain a stable value (so-called  algorithmic stablecoins). They have been developed to address the high price fluctuations of unsupported cryptocurrencies such as Bitcoin and Eter, and have relatively low price volatility that makes them suitable for a number of functions that require stability. However, events in early May, when the  algorithmic stablecoin TerraUsd crashed and the  larger stablecoin (Tether) temporarily lost its anchorage, show that stablecoins  may not be all that stable.

The TerraUsd case  and the contagion effect

In addition, developments related to the crash of the TerraUsd algorithmic stablecoin demonstrate the contagion effect within the cryptocurrency ecosystem. Due to the stress on the cryptocurrency market the price of Tether has come under pressure and the largest stablecoin has temporarily lost its anchorage.  Tether faced large outflows of more than 10% of its market capitalization, which it was forced to redeem by liquidating reserve assets.

Stablecoins do not live up to what is required by means of payment in the real economy. To date, the speed and cost of stablecoin transactions, as well as the terms and conditions of reimbursement have proven inadequate for use in payments of the real economy. Adequate regulatory, oversight and oversight frameworks need to be implemented urgently before stablecoins become a risk to financial stability, the ECB says.

Accelerating on MiCA, the EU rules for crypto-markets

The risks to financial stability arising from stablecoins in the euro area are currently still limited. However, if growth trends continue at the current pace, risks could soon multiply. For this reason, the Bulletin continues,  existing stablecoins must be urgently brought into the regulatory perimeter.

In the EU, the Cryptocurrency Markets Regulation (MiCA) proposed by the European Commission marks a significant milestone. It is a tailor-made regime for the issuance and provision of services related to stablecoins and other cryptoassets and seeks to regulate the cryptocurrency ecosystem holistically, for example by specifying that only electronic money institutions and credit institutions are allowed to issue stablecoins , and to establish authorization and prudential requirements for cryptocurrency service providers. It should be implemented as a matter of urgency.

DeFi, we need rules to contain vulnerabilities

Another segment of the cryptocurrency universe that has expanded rapidly over the past year is decentralized finance (DeFi). It represents a new way of delivering financial services that eliminates traditional centralized intermediaries and relies instead on automated protocols. To a large extent, it does not create new financial products, but imitates those provided in traditional financial markets through technological innovation. However, some characteristics such as how assets are held, how trust is generated, and how the system is governed, distinguish it from traditional finance.

DeFi is in many ways subject to the same vulnerabilities as traditional finance, including those caused by excessive leverage and risk-taking, liquidity mismatches and interconnection. However, its new technology and method of providing the service may amplify some vulnerabilities and pose additional specific risks. The collapse of the  TerraUsd stablecoin in early May exemplifies some of these vulnerabilities, as the size of DeFi as measured by the sum of all digital assets deposited in DeFi protocols  ("total locked value") declined sharply in early May.

DeFi must be effectively controlled and regulated. An internationally coordinated approach is needed to mitigate the risks.

Cryptocurrencies and climate: risks for the green transition

Finally, the ECB's Macroeconomic Bulletin highlights the risk of climate transition in light of the significant carbon footprint of some cryptocurrencies. The operation of some crypto-assets (such as bitcoin) uses a disproportionate amount of energy that clashes with public and private environmental policies and environmental, social and governance (ESG) objectives. "The risks of the climate transition are expected to increase in line with the financial sector's growing exposure to cryptocurrencies," the ECB analysis reads.

While governments are primarily responsible for climate policy, financial institutions and prudential standards also have a role to play. Public authorities will have to assess whether the outsized carbon footprint of some cryptocurrencies weakens their green transition commitments. Investors will need to assess whether investing in certain cryptocurrencies is in line with their ESG goals. Financial institutions will need to incorporate the climate-related financial risks of cryptocurrencies into their climate strategy.

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