ECB Crypto-Asset Report Calls for Greater Regulatory Oversight

Key Insights:

• On Tuesday, the ECB published a crypto-asset review assessing financial stability risks.
• The report identified that retail investors represented a sizeable part of the crypto investor base.
• Over the weekend, ECB President Christine Lagarde spoke out, saying that cryptos are worthless.

Since late 2021, the threat of increased regulatory oversight contributed to the broad-based crypto sell-off. Governments globally have called for a global regulatory framework to address risks posed to financial stability.

In February, Russia’s invasion of Ukraine raised concerns about Russia circumventing sanctions via the crypto market. This added further incentive for governments and regulators to roll out a more robust framework.

The collapse of TerraUSD (UST) and Terra LUNA, however, placed the crypto market under the microscope of governments and central banks and will expedite the introduction of more stringent regulations.

This week, the ECB published a report titled ‘Decrypting Financial Stability Risks in Crypto-Asset Markets.’ The findings support the EU’s view on the crypto market and the need for greater oversight.

ECB Identifies Crypto-Asset Risk to Financial Stability

The report identifies issues for lawmakers to consider. These included,

• Rising investor demand for crypto-assets despite risks:

“Despite recent declines, they remain similar in size to, for example, the securitized sub-prime mortgage markets that triggered the global financial crisis of 2007-08.”

• In the past, risks from crypto-assets on financial stability in the euro area were limited.

“If the present trajectory of growth in size and complexity of the crypto-asset ecosystem continues, and if financial institutions become increasingly involved with crypto-assets, then crypto-assets will pose a risk to financial stability.”

• Correlation with mainstream risky assets raise question marks over their usefulness for portfolio diversification.

“There was an increase in the correlation between crypto-asset returns and stock returns during the market stress of March 2020, as well as during the December 2021 and May 2022 market sell-offs.”

• Institutional investor demand has risen. 56% of European institutional investors surveyed indicated that they have some exposure to digital assets (2020: 45%).
• Retail investors make up the lion’s share of the crypto-asset investor base. As many as 10% of households across the six large euro area countries may own crypto-assets.

“With regard to financial literacy, respondents who scored either at the top level or the bottom level in terms of financial literacy scores were highly likely to hold crypto-assets.”

Crypto Asset Risks to Financial Stability Are on the Rise

The report then focused on risks attributed to crypto-assets, stating that,

“European supervisory authorities have recently reiterated their warning that crypto-assets are highly risky and speculative.”

The report then went on to say,

“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.”

Interestingly, the review noted that significant volatility in recent months did not result in contagion or any financial institution defaults. The report did, however, state that risks are on the rise. Greater financial institution involvement could drive growth and increase financial stability risk.

With regards to financial stability, the report stated,

“Unbacked crypto-assets can have financial stability implications through four main transmission channels: wealth effects, confidence effects, financial sector exposures, and the use of crypto-assets as a form of payment.”

In conclusion, the ECB makes two telling observations:

• • Interconnectedness remained small despite the rise in the interconnectedness between cryptos and the financial sector.
  • Systemic risk is correlated with the level of interconnectedness, leverage, and lending activity.
  • Lawmakers need to approve MiCA Regulation to close the regulatory and data gaps in the crypto ecosystem.

While ECB President Christine Lagarde views cryptos as worthless, the report suggests that retail and institutional investors and financial institutions think otherwise.

The report, however, does suggest that a regulatory overhaul is on the horizon.