The crypto industry’s deepening ties to banks and asset managers will pose a risk to financial stability, the European Central Bank has warned, in the latest sign of how central banks and governments are stepping up their scrutiny of the market.
The ECB said on Tuesday it had done “a deep dive into cryptoasset leverage and crypto lending” and found evidence that these activities were becoming more risky, complex and interconnected with traditional institutions.
“Investors have been able to handle the €1.3tn fall in the market capitalisation of unbacked cryptoassets since November 2021 without any financial stability risks being incurred,” the ECB said. “However, at this rate, a point will be reached where unbacked cryptoassets represent a risk to financial stability.”
The first such warning from the ECB, published as part of its twice-yearly financial stability review, followed similar messages from US and UK authorities, which have been unnerved by a series of recent failures in the crypto market.
Bitcoin, the world’s flagship cryptocurrency, has halved in value since November and recently fell below $30,000 for the first time since last summer. The market’s most important stablecoin, tether, momentarily lost its peg to the US dollar, while its rival terraUSD all but collapsed.
US Treasury secretary Janet Yellen warned recently that stablecoins present the same kind of risks associated with bank runs, echoing a similar comparison by the Federal Reserve.
ECB president Christine Lagarde said on Dutch television at the weekend that a crypto token was “worth nothing, it is based on nothing, there is no underlying asset to act as an anchor of safety”. Fabio Panetta, an ECB executive, recently likened the sector to a “Ponzi scheme” and called for a regulatory clampdown to avoid a “lawless frenzy of risk-taking”.
The central bank is working on a digital euro and aims to build a prototype for testing by next year before deciding whether to launch it three years later. Lagarde said its own central bank backed digital currency would be “vastly different to many of those things”.
Links between eurozone banks and crypto assets “have been limited so far”, the ECB said in its report on Tuesday, adding: “Market contacts indicate there was growing interest in 2021, mainly via expanded portfolios or ancillary services associated with digital assets (including custody and trading services)”.
It said large payment networks had “stepped up their support of cryptoasset services” and institutional investors were “now also investing in bitcoin and cryptoassets more generally”.
Noting that German institutional investment funds have been allowed to put up to a fifth of their holdings into crypto assets since last year, it said such investments had been aided by the availability of crypto-based derivatives and securities listed on exchanges.
The ECB also cited risks from decentralised finance, or DeFi, in which cryptocurrency-based software programs offer financial services without the use of intermediaries such as banks.
“Crypto credit on DeFi platforms grew by a factor of 14 in 2021, while the total value locked was hovering at around €70bn until very recently, on a par with small domestic peripheral European banks,” it said. Rehypothecation, in which collateral for a loan can be repledged against another loan, increased the chances of leverage limits being breached.
Some crypto exchanges are offering loans to customers to allow them to increase their exposures by as much as 125 times their initial investment, the ECB said. But “significant informational and data shortcomings persist”, which meant “the full extent of possible contagion channels with the traditional financial system cannot be fully ascertained”.
As many as one in 10 EU households “may own cryptoassets”, though most had less than €5,000 invested in the sector, according to a recent ECB survey. Similarly, a Fed survey released on Monday found 12 per cent of US adults held or used cryptocurrencies in 2021.
The EU is finalising legislation, called markets in crypto assets, but the ECB said it would not come into force until 2024 at the earliest. “Given the speed of crypto developments and the increasing risks, it is important to bring cryptoassets into the regulatory perimeter and under supervision as a matter of urgency,” it said.
Additional reporting by Scott Chipolina in London