BIS Report: Adoption of Cryptographic Assets on the Rise, Financial Stability Risks a Concern, Regulatory Framework Key

The Bank for International Settlements (BIS) has released a report stating that cryptocurrencies have not reduced financial risks in emerging markets. The recommended approach is effective regulation rather than outright prohibition.

Adoption of Cryptographic Assets on the Rise, Financial Stability Risks a Concern

The report states that digital finance is rapidly evolving. Technological innovations have paved the way for new ways of conducting financial activities, potentially bringing swift and significant changes to the financial system. One key development is the growth in the scale and scope of cryptographic assets. In 2021, both the public interest and market value of cryptographic assets in advanced economies (AE) and emerging market economies (EME) rose rapidly.

Supporters of cryptographic assets claim that they offer lower transaction costs, faster payments, disintermediation, anonymity, and potential high investment returns. In November 2021, the market value of cryptographic assets peaked at around $3 trillion. However, a bubble burst in early 2022, triggered by the collapse of TerraUSD, the third-largest stablecoin at the time. Cryptographic assets lost nearly two-thirds of their value. In November 2022, FTX, one of the world's largest cryptocurrency exchanges, went bankrupt, further exacerbating market pressures and ushering in a cryptographic winter. While there were no significant spillover effects on traditional financial markets, policymakers have been discussing the implications of closer integration between cryptographic assets and traditional financial systems.

In emerging market economies, the adoption rate of cryptographic assets is steadily increasing. For some users, cryptographic assets offer an alternative investment and savings tool, while for others, they appear to provide a safe haven from the volatility of their domestic currency. Financial authorities in emerging economies monitor the cryptographic asset market and assess vulnerabilities that could affect the stability risks of the traditional financial system. To address this, the Americas Consultative Council (CCA) of the Bank for International Settlements (BIS) Financial Stability Board set up a working group specifically to explore the financial stability risks of cryptographic assets, with a focus on risks in emerging market economies. The working group also discussed some potential policy guidance to mitigate these financial stability risks.

Risks Cryptographic Assets May Face

• Given that high price volatility of cryptographic assets may lead to losses for investors directly or indirectly exposed to the cryptographic asset market, financial markets may face market risk.
• Investors may face liquidity risk due to factors such as lack of transparency in cryptographic asset operations and trading being concentrated in a few large cryptocurrency exchanges.
• Credit risk may arise from the lack of accountability or robust governance in the cryptographic asset market and the overleveraging present in decentralized markets.
• Due to the reliance of cryptographic assets on networks and smart contracts, they are susceptible to operational risk from network attacks and system failures.
• The widespread adoption of cryptographic assets may pose currency substitution risks. Consumers shifting from deposits to cryptographic assets could lead to bank disintermediation.
• Payment for cross-border transfer purposes may lead to capital flow risks.

These vulnerabilities in cryptographic asset markets could serve as transmission channels for financial stability risks. Transmission channels include direct ownership, use as collateral, confidence effects, wealth effects, and indirect impacts through connections with cryptographic asset market participants. Risk catalysts can strengthen or weaken these transmission channels, increasing or decreasing a country's vulnerability to financial stability risks. The report identified three catalysts, namely economic and financial conditions, technological penetration, and regulatory stance.

Regulatory Principles for Cryptographic Asset Markets in Emerging Markets

The report points out that regulatory authorities face multiple policy choices to address the risks associated with cryptographic assets, ranging from outright bans to containment to regulation. If bans and containment are effective, they may prevent the emergence of financial stability risks. However, there are risks associated with overly restrictive responses. For example, activities may be driven underground, and it may be more challenging to engage responsible participants in the sector. The report offers three key recommendations for regulation:

Establish Clear Regulatory Mandates

Regulatory and supervisory bodies must align and clearly define their roles and responsibilities. They should assess existing laws and their compatibility with this new cryptographic asset framework. This includes authorities responsible for anti-money laundering/counter-terrorism financing requirements, cyber risks, digital identity, and data protection policies. In terms of synergies, central banks and/or financial authorities will be granted new authorities to regulate and supervise activities, processes, or business models related to cryptographic assets, such as cryptocurrency exchanges.

Differentiate Activity-based Regulation from Entity-based Regulation

The second step is to establish standards and regulatory requirements for entities, business models, activities, or services related to cryptographic assets. The criterion is "same risks, same activities, same regulation."

Address Data Gaps

The lack of transparent, consistent, and reliable data on how cryptographic asset markets operate significantly hinders authorities' ability to identify and assess their financial stability risks. Because cryptographic asset markets are inherently decentralized, identifying counterparties involved in transactions remains challenging, despite on-chain transactions being recorded directly on the blockchain and data being publicly accessible. These data gaps also mean that supervisory authorities currently have limited understanding of the structure and functioning of cryptographic asset markets, making it difficult to monitor the evolution of these markets and assess their financial stability risks.

The BIS believes that responsible innovation, technology, and new entrants can reduce friction and inefficiencies in payment systems and lower barriers to entry. Throughout history, technology has been a key driver of improvements in financial services and increased resilience. While cryptographic asset-related activities have not yet realized their intended goals, the technology can still be applied in various constructive ways. How to create a regulatory framework to guide innovation in directions beneficial to society will be a key challenge in the future.