New Insights on Financial Stability Risks of Cryptocurrencies
The Bank for International Settlements (BIS), often referred to as the central bank for central banks, has recently published a comprehensive paper examining the financial stability threats posed by cryptocurrencies and decentralized finance (DeFi). While the subject has been explored previously, including by some of the same authors in earlier works, the current paper presents a clear and updated perspective. Traditionally, many central bankers have maintained that the cryptocurrency sector is too small and insular to pose any significant risks to financial stability. However, this report suggests that the crypto market has achieved a “critical mass,” even though it still has limited connections to traditional finance (TradFi). Nevertheless, developments such as Bitcoin exchange-traded funds (ETFs) and the rise of stablecoins, as well as the tokenization of real-world assets, are beginning to alter this landscape.
Wealth Redistribution Concerns
A striking element of the report is a graphic illustrating a trend where, during financial crises, smaller investors tend to increase their investments in cryptocurrencies, while wealthier individuals often withdraw their funds. The authors conclude that this trend indicates that the cryptocurrency market may serve as a mechanism for redistributing wealth from less affluent individuals to those with greater financial resources. This observation parallels sentiments expressed by another central banker, Ulrich Bindseil from the European Central Bank, who argues that Bitcoin facilitates the transfer of wealth from late investors to early adopters, who are typically affluent.
Potential Spillover Effects of Crypto
The 2023 financial stability report outlines three potential policy approaches regarding cryptocurrency: prohibition, containment, or regulation, with the authors arguing firmly against a ban. The paper begins from this standpoint and delves into the risks that TradFi might face in relation to the crypto and DeFi sectors. From a financial stability viewpoint, the authors identify four key “transmission channels” that could introduce risks: exposure of TradFi to crypto, crypto-linked financial products or entities with exposure, confidence effects stemming from price fluctuations, and the use of cryptocurrencies for transactions or settlements. Furthermore, the report raises three additional concerns: the potential incorporation of DeFi smart contracts into TradFi, the risk of emerging market economies adopting cryptocurrencies as a refuge from unstable local currencies, and the need to protect the interests of participants in the DeFi market.
Expanding Connections Between Crypto and TradFi
The authors highlight two significant trends that are increasing the interconnectedness between the cryptocurrency market and traditional finance. First, in January 2024, the U.S. Securities and Exchange Commission (SEC) approved the launch of spot Bitcoin ETFs, which simplifies the process of gaining exposure to cryptocurrencies for investors. Additionally, TradFi asset managers and brokerage firms are becoming increasingly involved in the crypto space. The second trend involves the tokenization of real-world assets, which is expanding the assets available in DeFi beyond just cryptocurrencies. The authors suggest that decentralized exchanges (DEXs) may soon be more widely adopted by TradFi firms, potentially leading to their integration into mainstream finance. Consequently, they advocate for a “containment” strategy to ensure that traditional finance entities adequately evaluate the associated risks. An example of this is the Basel Committee’s current stance on cryptocurrencies, which categorizes permissionless blockchains as high-risk and discourages banks from engaging in tokenization on these platforms. As DeFi gains traction, the authors recommend imposing similar regulatory requirements on it as those in TradFi, such as compliance with know-your-customer (KYC) regulations, proper disclosures, and ensuring that market professionals possess adequate training and qualifications. The paper also mentions a consultation in the UK regarding a possible new legal role related to “establishing or operating a protocol.”
Future Directions for Financial Stability
There has been considerable discussion surrounding the regulation of DeFi, and the report calls for further investigation into the role of decentralized autonomous organizations (DAOs) in governance, their implications for financial stability, and how regulators might engage with them. In clarifying DeFi’s functioning, the authors differentiate between a DeFi protocol and a decentralized application (dApp), which typically includes a user interface and a “centralization vector,” marking dApps as potential points for regulatory scrutiny. The authors prioritize research into the financial stability implications of real-world asset tokenization, focusing on systemic risks arising from tighter connections between DeFi and TradFi. They also emphasize the crucial role stablecoins play within DeFi and highlight the need for further analysis regarding their potential volatility. Earlier in the paper, the authors noted that disturbances in payment and settlement systems could have far-reaching economic consequences. Lastly, they express a desire to investigate the risks associated with the adoption of cryptocurrencies in emerging market economies, a concern that has been underscored by the International Monetary Fund (IMF) for some time.
