= Crypto-assets and decentralised finance=
In June 2022 the High-Level Exploratory Group on Crypto-Assets and Decentralised Finance (HLEG) established by the European Systemic Risk Board (ESRB) delivered a report outlining its findings on the scope and priorities for the analysis of crypto-assets and decentralised finance (DeFi) from a financial stability perspective. The report concluded that while potential systemic implications stemming from crypto-assets, service providers and DeFi applications appeared limited, systemic risks could arise quickly and suddenly. If the rapid growth trends observed in recent years were to continue, crypto-assets could pose risks to financial stability. The ESRB General Board welcomed the report and established the Task Force on CryptoAssets and Decentralised Finance (CATF). The General Board asked the CATF to submit a report at its meeting in the first quarter of 2023, focusing on two priority areas: Priority 1: Policy options Consider the role of financial stability and macroprudential policy for crypto-assets, their service providers and DeFi applications. Priority 2: Systemic implications Identify systemic implications of the crypto-asset market, its service providers and DeFi applications in the EU. This report by the CATF notes the rapid growth of crypto-assets and DeFi in recent years, which has attracted increasing attention among academics, central banks, regulators and policymakers, including with respect to the role of the ESRB in this area.1 Since the latest peak in November 2021, crypto-asset markets have contracted sharply (with a rebound in 2023). Numerous corporate failures have been reported, and there is an increasing perception of fundamental issues concerning corporate governance, conduct, market abuse and business models. Policy discussions on how to approach the regulation of crypto-asset markets have progressed in jurisdictions around the world, with a focus on consumer and investor protection2 and the need to ensure crypto-assets and DeFi are not used to launder money or facilitate illicit activity. But the broader financial stability implications remain unclear. The ESRB has therefore considered the systemic implications of crypto-asset markets and DeFi applications for the stability of the EU financial sector. Notwithstanding important consumer and investor protection issues, and from a macroprudential perspective, the report takes into account ongoing efforts in various jurisdictions to address challenges arising from the growth of crypto-assets and DeFi. In addition, the report identifies areas in which the ESRB, with its broad European membership, could best complement and deepen ongoing policy work at the EU and international level. 1 See McGuinness (2021). 2 See European Securities and Markets Authority (2022). Executive summary Crypto-assets and decentralised finance May 2023 Executive summary 3 Given the vast scope of the crypto-asset universe, the report distinguishes among the specific areas that concern financial stability. The report first defines the three distinct types of crypto-assets considered from a financial stability perspective: (i) native tokens, (ii) reserve-backed stablecoins, and (iii) algorithmic stablecoins3. The report also provides a description of the DeFi ecosystem. There are significant warnings about the interpretation of the terminology adopted in the crypto-asset universe. Therefore, caveats on the availability and quality of data are important, in particular since most of the data are gathered from commercial sources. Turning to market developments, the report focuses on reported prices, market capitalisation, price volatility, trading volumes and participants in the system. Prices for native tokens have dropped drastically since their peak in November 2021, more than for global equities during the same period, but are rising again in 2023. When considering market capitalisation, concentration is stark, with the top ten native tokens accounting for 75% of total crypto-asset market capitalisation. Yet the crypto-asset market remains only a fraction of the size of the global capital market.4 Prices for native tokens are quite volatile, whereas for reserve-backed stablecoins volatility is limited yet still not zero as it should be. To get a more informative picture, the report considers trading volume data in comparison with market capitalisation: reported trading within the crypto-asset space is much higher on a daily basis than in equity markets. Finally, using the limited means available to measure the size of DeFi, the report concludes that it is currently very small and exclusively serves the crypto-asset world, with no significant connection yet to traditional finance. In the absence of dedicated regulatory data, it is difficult to identify investors in crypto-asset markets and the direct bearers of risks. On-chain data suggest growing use by retail investors, sizeable cross-investments among crypto-asset providers and some investment by traditional finance, especially alternative investment funds (AIFs). But both bank sector and fund sector exposures remain de minimis at present. From a geographical perspective, estimates using onchain data show the EU with roughly the same trading volume as the United States, although offchain trading involving fiat currency is dominated by USD. Linkages between crypto-assets and the traditional financial system could be an important channel of shock transmission and require specific attention to understand any systemic risks that may emerge from a growing crypto-asset universe. First, an estimate of the value of the crypto-asset world shows it is just 0.8% of the size of the EU financial sector5. Second, there is only sporadic correlation between the booms and busts of crypto-assets and traditional finance. Furthermore, including crypto-assets in a portfolio of equities, bonds and gold would not appear to lead to an improvement in the risk-return profile. Finally, EU banks’ engagement in crypto-asset activities is very limited. The report nevertheless emphasises the clear and growing connections 3 Section 5.2 provides an overview of the terminology applied in the EU’s MiCA regulatory framework and a mapping of the concepts. 4 It is tempting to liken the size of the crypto-asset market to that of the US subprime mortgage market in 2007. Prior to the financial crisis, the latter accounted for less than 1% of global capital market capitalisation. Such a comparison would be misleading since there is a critical difference. Not only was the quality of the subprime mortgages and mortgage pools opaque, traditional financial intermediaries were exposed. But both the scope and depth of that exposure were unknown. As a result, when the quality of subprime mortgages came into question, so did the creditworthiness of a broad range of counterparties. By contrast, we know both the quality of crypto-assets – they have no fundamental value – and the fact that traditional intermediaries are not now significantly exposed. So, the analogy does not hold. 5 Sources: 2023 ESRB Non-Bank Financial Intermediation Risk Monitor and ESRB calculations. Crypto-assets and decentralised finance May 2023 Executive summary 4 between crypto-assets and traditional finance: reserve-backed stablecoins themselves, and the use of traditional intermediaries by crypto-asset players. From the perspective of the ESRB, the central issue is how the crypto-asset market could become systemically relevant. Crypto-asset markets, especially after collapsing since November 2021, are not systemic in size and interconnections. Since they may expand again in the future (as evidenced by their behaviour in early 2023) and have in the past demonstrated their potential for staggering growth dynamics, this report considers conditions under which crypto-asset markets could become systemically relevant. In this regard, it is difficult to estimate the time required for the sector to reach systemic proportions, which calls for caution in using current observations to guide policy. Three scenarios are discussed: (i) a run on a stablecoin, (ii) greater integration between the crypto-asset and traditional finance worlds, and (iii) a major expansion in transacting with cryptoassets instead of traditional means of payment. These scenarios illustrate the risks of the potential evolution of crypto-asset markets. The report also considers potential policy implications, taking into account the extent to which existing policy measures, including the EU’s Regulation on Markets in Crypto-assets (MiCA),6 are sufficient to mitigate financial stability and macroprudential risks. These considerations are based on a comprehensive review of crypto-asset market developments, the analysis of the revised text for the proposed European legislation, as well as regulatory initiatives in key third countries and at the international level (e.g. proposed by the Basel Committee on Banking Supervision, BCBS, and the Financial Stability Board, FSB). Given the strong cross-border nature of crypto-asset markets, the success of implementing the regulatory and supervisory framework will depend on the level of coordination and cooperation among the competent regulatory and supervisory authorities in EU Member States, as well as between the EU and third-country bodies. The findings of this report suggest that it is necessary to improve the capacity of public authorities, including in the EU, to monitor potential contagion channels between the cryptoasset sector and the traditional financial sector, as well as within the crypto-asset sector. MiCA will subject issuers and crypto-asset service providers to requirements designed to safeguard consumers, market integrity and financial stability. The applicable legal framework should provide authorities with access to data useful in identifying potential risks to financial stability posed by the crypto-asset sector and mitigating them. Moreover, it will be beneficial to carry out assessments of risks posed by (i) crypto-asset conglomerates7 (i.e. entities and groups carrying out combinations of significant crypto-asset-related activities, such as issuance and exchange), taking account of market developments following the application of MiCA; and (ii) leverage using crypto-assets, and to identify potential additional actions to mitigate observed risks. Furthermore, the report endorses the continued exchange of knowledge between public authorities in the EU on market developments, focusing on several areas where potential risks may emerge, notably regarding (i) operational resilience, (ii) DeFi, and (iii) crypto-asset staking and lending. Finally, the principle of 6 Following a provisional political agreement in June 2022, the European Parliament and Council formally adopted the final text in April and May 2023 respectively, which paves the way for publication in the EU’s Official Journal and entry into force shortly. 7 Where reference is made to crypto-asset conglomerates in the report, it is not meant as an equivalent to any definition of conglomerate within EU law (i.e. Directive 2002/87/EC of the European Parliament and of the Council of 16 December 2020). Crypto-assets and decentralised finance May 2023 Executive summary 5 proportionality should be given due consideration as well as the need to ensure a harmonised EU reporting framework.
