Crypto-assets have shown a remarkable evolution over the past two years that highlights their relevance for society as a whole. There have been large inflows and outflows in these markets.
There have been polarised debates between crypto believers and sceptics.
There have been warnings by authorities that investors could lose their money. In spite of those warnings, crypto-assets continued to exert a strong attraction to a substantial proportion of the population; approximately 14% of the Dutch population holds them.
This raises questions: what makes crypto-assets so attractive? What opportunities and risks do they pose for society? And how can policymakers ensure that societal risks will be mitigated while leaving room for innovation? As crypto-asset markets evolve, so does the regulatory response.
More than a decade after crypto-assets were first introduced, their development is still at an early stage. Their future evolution is uncertain.
But whatever one’s view on the pros and cons, it seems plausible that these assets and markets are here to stay. Since crypto ecosystems try to replicate existing financial, payment and monetary functions, their relevance for financial regulation, payment systems and financial stability is a given.
During the past years, DNB’s crypto-asset supervision was geared towards legislation regarding anti-money laundering, countering the financing of terrorism and sanctions screening.
Tailored crypto-asset regulation was not yet in force for the other traditional objectives of financial regulation related to financial stability, prudential supervision and consumer and investor protection.
This will change over the coming years as new crypto-asset regulations enter into force. However, regulation and supervision are still evolving and will not eliminate all risks.
Consumers and investors should remain aware of the risks before investing in these markets.
The aim of this study is therefore to: (i) deepen our understanding of the underlying technology and functions of crypto-assets;
(ii) revisit their main opportunities and risks, and
(iii) summarise our view on regulation, supervision and enforcement.
In DNB’s view, the main implications are the following. First, the future path of innovation driven by the underlying technology is uncertain, which calls for continuous monitoring. More than a decade after its introduction, Distributed Ledger Technology (DLT) has facilitated the emergence of entire crypto-asset ecosystems, with their own issuers, assets, service providers and users.
DLT has been a major innovation since it facilitates the storage and transfer of tokenised assets without a trusted central intermediary. The technology has its flaws, as illustrated by cases of high energy use and settlement congestion although newer releases show improvements.
This may help to deliver on what are widely regarded as the main opportunities:
(i) to improve the efficiency of global cross-border payments, and
(ii) as a platform for innovation, to facilitate the storage and transfer of tokenised-assets.
New use cases are being explored, such as those related to Web3 and Decentralised Finance, which brings new challenges. The path of future innovation is uncertain, as always, and it is rarely the case that major breakthroughs are predicted in advance.
It remains important to continue to monitor the evolution, opportunities and risks of crypto-ecosystems as a whole as well as their constituent parts.
Second, unbacked crypto-assets are not suitable as money, and mainly serve as a speculative investment.
While traditional analyses on the attraction of crypto-assets emphasise the “crypto promise” of disintermediated payments and finance, recent research highlights a complementary explanation: the desire to gamble. Unbacked crypto-assets have no underlying assets, which makes it difficult to value them.
A large part of supply is taken out of circulation by investors and developers, which increases price volatility due to shifts in demand.
Large price swings and strong social media attention trigger psychological factors such as fear of missing out and the difficulty to disengage. On the one hand, the volatility of unbacked cryptos increases their attractiveness as a speculative investment.
On the other hand, it implies that they lack the stability that is needed for money. In Summary advanced economies, unbacked cryptos are hardly ever used as a means of payment.
They are too volatile, and national and European payment infrastructures already support instant payments.
There is no monetary authority to stabilise their value, no prudential regulation and no deposit guarantee fund. Buyers should be very cautious and aware of the risks before investing in these markets, and market conduct authorities should be given adequate tools to monitor and mitigate related risks.
Third, stablecoins may have the potential to function as a means of payment for specific use cases, but only if risks are adequately mitigated. Stablecoins aim to solve two of the major flaws of unbacked cryptos, i.e. to create a verifiable stable value, and to use the same unit-of account-function as fiat money.
Both of these features may increase their suitability as a means of payment. This could improve the efficiency of cross-border payments and the settlement of tokenised assets.
It could facilitate new use cases related to Web3. However, stablecoins also give rise to significant risks to monetary policy (since they fall outside the monetary policy framework), and financial stability, due to their link with the real economy, vulnerability to runs, and risks related to settlement.
A major issue concerns the transparency, composition and redeemability of the asset backing, and inherent incentives for issuers to dilute it or restrict redeemability. Regulation is therefore needed to mitigate these risks.
Fourth, market participants must adhere to relevant existing requirements and prepare for forthcoming requirements.
Due to their complexity, anonymity and opaque governance structures, crypto markets are more prone to market failures than traditional financial markets.
Users and developers are largely anonymous, which makes crypto-assets vulnerable to money laundering, scams, theft, market manipulation and Ponzi schemes.
This is exacerbated by the fact that there is no central entity that can be held responsible for the security and integrity of the network, while service providers can operate remotely without complying with regulations.
Crypto-assets fulfil different functions, e.g. as (speculative) securities, electronic money or derivatives, which are subject to existing regulation in line with the principle: “same activity, same risk, same regulation”.
To further clarify the regulatory regime, a broad international consensus has emerged on the need for a coordinated regulatory response due to the cross-border reach of crypto-assets. International regulatory standard setting bodies have issued recommendations, such as the Financial Stability Board’s consultative report on the regulation, supervision and oversight of crypto-asset activities and markets of October 2022.
In the EU, the Market in Crypto-Asset Regulation (MiCAR) was agreed at the political level in the summer of 2022. MiCAR represents a welcome first step towards clarifying the regulatory approach.
DNB calls on market participants to prepare for the new regulations, such as the MiCAR rules, which are expected to take effect in 2024. Fifth, forthcoming regulatory changes continue to affect the objectives and tasks of DNB as an integrated central bank and supervisory authority.
At the international level DNB will continue to contribute to the development of international standards by the Financial Stability Board (FSB) and other standard-setting bodies such as the Basel Committee on Banking Supervision (BCBS) and the Committee on Payments and Market Infrastructures (CPMI).
DNB’s mandate will be affected by forthcoming changes to European and national financial supervision, including those related to MiCAR (in close cooperation with the Dutch Authority for the Financial Markets, the AFM) and legislation regarding AML/CFT related supervision. Moreover, proposed changes to international standards will also continue to affect supervisory tasks, such as the proposed revisions to bank capital adequacy rules for crypto-asset exposures, and international standards for the transfer function of systemically important stablecoin arrangements.
In sum, DNB stands ready to continue to monitor crypto-asset ecosystems and to contribute to the ongoing elaboration of the regulatory regime as well as its implementation.