Contagion is a scary term. Systemic risk is its friendlier sibling but both raise eyebrows. Today, the European Central Bank (ECB) is bringing attention to the possibility of crypto contagion as interest grows in digital assets and recent events highlight the ability for a rapid collapse of individual crypto assets that can spill into other areas.
Earlier this month, ironically labeled “stablecoin” TerraUSD (UST) imploded. The dollar-based algorithmic stablecoin was tied to a separate crypto LUNA in a way that drove the crypto to valuations in the billions. The house of cards fell apart as a “run on the bank” event took place destroying value in a matter of days. Today, UST is effectively worth zero. LUNA has lost hundreds of millions in value. Many investors got completely wiped out. The credibility of the creators behind the effort has been destroyed.
The dramatic collapse has, once again, caught the attention of regulators and policymakers concerned that innovation has taken a step too far as retail money is being vaporized. Earlier this week, ECB President Christine Lagarde was quoted describing crypto as “worth nothing.”
In an ECB paper by Lieven Hermans, Annalaura Ianiro, Urszula Kochanska, Veli-Matti Törmälehto, Anton van der Kraaij and Josep M. Vendrell Simón, entitled Decrypting financial stability risks in crypto-asset markets, the authors attempt to decipher the potential for systemic risk caused by digital asset markets. The paper announces that volatility in recent months has not resulted in contagion, but the risk of this is rising. As well, the use of leverage and derivatives in crypto markets can accelerate volatility in times of stress.
Noting that the risk to financial stability has been deemed limited in the past, increasing interest by both consumers and institutions demands more scrutiny as to the potential for contagion climbs. The authors’ state:
“if financial institutions become increasingly involved with crypto-assets, then crypto-assets will pose a risk to financial stability.”
This is not the type of news we want to read as global economies sputter, inflation is rising and war is at the doorstep of Europe.
The cautionary note states that crypto-assets do not provide “portfolio diversification” something touted by many in the industry until recently as crypto markets now appear to be more correlated with traditional securities.
Demand from institutional money may exacerbate this risk and payment networks that leverage fiat alongside crypto is driving “interconnectedness.”
The authors bluntly state that:
“crypto-assets are not suitable for most retail investors (either as an investment or store of value, or as a means of payment) who could lose a large amount (or even all) of the money they have invested. Consumer protection risks include (i) misleading information, (ii) the absence of rights and protections such as complaints procedures or recourse mechanisms, (iii) product complexity with leverage sometimes embedded, (iv) fraud and malicious activities (money laundering, cyber crime, hacking and ransomware), and (v) market manipulation (lack of price transparency and low liquidity).”
Crypto lending earns criticism too as the authors worry that the “chances of a breach of LTV limits and could cause liquidity to vanish very quickly in the case of a big shock” as existing regulation may fall short of its mission.
“DeFi platforms that mimic traditional financial services would do well to ensure they comply with existing EU financial regulation before offering their services to EU clients to avoid the risk of any legal action.”
In the end, the authors state what should be obvious; policymakers need to “close regulatory gaps.” The MiCA regulation that is meandering its way through the European Commission needs to pick up its pace as a “matter of urgency.” Standardized reporting and disclosure requirements are coming. That is certain. What is not clear is how rigid new rules will be. This is an area where the digital asset industry, join in unison and work to create rules that provide sufficient transparency and disclosure so regulators and investors have a clear view of intrinsic risk and the value proposition of any digital asset offering.
The ECB paper is available here.