Financial Markets

February’s report on crypto assets from the Financial Stability Board is a call to arms as it contemplates the sector’s rapid growth and potential threat to financial stability. By Kate Gee and Elliott Fellowes.

In identifying potential problems at a macro systemic level, the report is both stark and unambiguous: “Crypto assets markets are fast evolving and could reach a point where they represent a threat to global financial stability due to their scale, structural vulnerabilities and increasing interconnectedness with the traditional financial system.” 

The Financial Stability Board (FSB) makes recommendations to the G20 nations on financial rules. Its report serves as a clear sign that international regulators must act now in order to mitigate potential risks to global financial markets posed by crypto assets. This sense of urgency permeates the report. Entitled ‘Assessment of Risks to Financial Stability from Crypto assets’, the FSB report examines developments and associated vulnerabilities relating to various sections of the crypto asset markets, including unbacked crypto assets (such as bitcoin), stablecoins, decentralised finance (defi) and crypto asset trading platforms.

Vigilance called for

Overall, there are few surprises in the areas identified by the FSB as requiring ongoing vigilance across the crypto-asset landscape:

• increasing bank sector involvement in the crypto-asset ecosystem, especially where activities give rise to balance sheet exposure to crypto-assets, not captured by (or not in compliance with) appropriate regulatory treatment;

• institutional investors increasing their exposure to crypto assets relative to the size of their portfolios. Risks could increase further if such exposures employ high levels of leverage, including through the use of derivatives referencing crypto-assets;

• acceleration in the adoption of crypto assets for payments. This could happen via partnerships with established payment firms or retailers/social networks;

• the growth, role and risks associated with crypto-asset trading platforms; 

• losses in crypto assets, where accompanied by leverage, liquidity mismatch and interconnections with the traditional financial system, may amplify the level of systemic risk. Loss of confidence in stablecoins could also trigger sales of their reserve assets, potentially affecting the functioning of short-term funding markets;

• the rapid growth of defi, which has occurred in the absence of clearly identifiable intermediaries or parties who are responsible for governance. The total value of assets currently locked in defi transactions – commonly referred to as the total value locked – stood at around $100bn in December 2021;

• differing regulatory approaches could lead to regulatory arbitrage, thus increasing potential systemic risks; and

• data gaps impeding risk assessment and calibration of policy options.

Threat to stability 

While presenting these conclusions, the FSB keeps front and centre its overarching concern about the potential for destabilisation of the global economy due to risks posed by the growing crypto asset market: “Direct connections between crypto assets and systemically important financial institutions and core financial markets, while growing rapidly, are limited at the present time. Episodes of price volatility have, so far, been contained within crypto asset markets and have not spilled over to financial markets and infrastructures. Moreover, currently crypto assets are not widely used in critical financial services (including payments) on which the real economy depends.”

However, the FSB also highlights the data gaps which stem from core aspects of the crypto asset market falling outside the established regulatory framework, making it difficult to assess the full extent of the use of crypto assets in the financial system. Taking this in the context of a market which grew by a factor of 3.5 in 2021 alone (to a market capitalisation of $2.6tn), the FSB concludes: “If the current trajectory of growth in scale and interconnectedness of crypto assets to these institutions were to continue, this could have implications for global financial stability.”

Elsewhere, it highlights some of the potential risks: “A disorderly run due to a loss in confidence on a [global stablecoin] that has reached significant scale could lead to disruptions in the real economy and spillovers into the broader financial system.”

The spike of market activity during 2021 brought with it various new crypto assets, as well as drawing in tens of millions of new market participants across multiple jurisdictions, each of whom faces diverse potential risks. Despite its inherent volatility, there are other signs of the crypto market’s maturity. One notable example was Tesla’s announcement last year that it would accept bitcoin as a means of payment.  

The public policy concern, as summarised by the report, extends beyond “low levels of investor and consumer understanding of crypto assets”, to include problems such as money-laundering, cybercrime and ransomware. With such a diverse spectrum of risks, the FSB notes: “Crypto assets also raise broader policy issues, such as the need for consumer and investor protection; strong market integrity protocols; anti money-laundering and combating the financing of terrorism regulation and supervision, including implementation of international sanctions; regulatory measures to prevent tax evasion; the need to avoid circumvention of capital controls; and concerns relating to the facilitation of illegal securities offerings.” These factors are the subject of work at national and international levels and are outside the primary focus of the FSB’s remit, although clearly there must be co-operation and co-ordination at a global level.

Plugging regulatory gaps

The report says: “The rapid evolution and international nature of these markets also raise the potential for regulatory gaps, fragmentation or arbitrage. Although the extent and nature of use of crypto assets varies somewhat across jurisdictions, financial stability risks could rapidly escalate, underscoring the need for timely and pre-emptive evaluation of possible policy responses.”

This year, the FSB will continue to work on recommendations for global standards for digital assets. It intends to explore potential regulatory and supervisory implications of unbacked crypto assets, including “the types of actions FSB member jurisdictions have taken, or plan to take, to address any associated financial stability threats”. Examining the regulatory gaps and challenges that may exist will be a key element of this.  

The report makes it clear that crypto is now mainstream and regulators need to take urgent action to address the potential risks to other areas of the economy. To date, the decentralised and (largely) unregulated crypto market has meant that the courts have encountered crypto assets in the context of – civil or criminal – misconduct; that is expected to continue, and claimants must take prompt steps to ensure that any claim has assets to enforce against, by way of tracing and/or freezing. However, increased regulation of this market will – it is hoped – provide investors with more information and greater transparency about their investments and strengthen the basis for claims against bad actors in this space, on a global level.  

Kate Gee is counsel and Elliott Fellowes is associate at Signature Litigation LLP.

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