Decrypting financial stability risks in crypto-asset markets

Prepared by Lieven Hermans, Annalaura Ianiro, Urszula Kochanska, Veli-Matti Törmälehto, Anton van der Kraaij and Josep M. Vendrell Simón[1]

The stellar growth, volatility and financial innovation currently seen in the crypto-asset ecosystem, as well as the rising involvement of institutional investors, show how important it is to gain a better understanding of the potential risks that crypto-assets could pose to financial stability if trends continue on this trajectory. Systemic risk increases in line with the level of interconnectedness between crypto-assets and the traditional financial sector, the use of leverage and lending activity. It is important to close regulatory and data gaps in the crypto-asset ecosystem to mitigate such systemic risks.

1 Introduction

Crypto-assets are currently the subject of intense policy debate. The different segments of crypto-asset markets include unbacked crypto-assets (such as Bitcoin), decentralised finance (DeFi) and stablecoins.[2] Crypto-assets lack intrinsic economic value or reference assets, while their frequent use as an instrument of speculation, their high volatility and energy consumption, and their use in financing illicit activities make crypto-assets highly risky instruments. This also raises concerns over money laundering, market integrity and consumer protection, and may have implications for financial stability.

Despite the risks, investor demand for crypto-assets has been increasing. This exuberance stems from, among other things, perceived opportunities for quick gains, the unique characteristics of crypto-assets (for instance programmability) compared with conventional asset classes, and the benefits perceived by institutional investors with regard to portfolio diversification. Major players in the payments industry have also stepped up their crypto-asset-based services, enabling easier retail access. While crypto-asset markets currently represent less than 1% of the global financial system in terms of size, they have grown significantly since the end of 2020. Despite recent declines, they remain similar in size to, for example, the securitised sub-prime mortgage markets that triggered the global financial crisis of 2007-08.

Risks to financial stability in the euro area stemming from crypto-assets were seen as limited in the past.[3] This special feature provides an update on crypto-asset market developments and a general overview of risks stemming from unbacked crypto-assets and DeFi, given the way in which they have evolved and their specific characteristics and risks. This article therefore abstracts from a specific discussion on risks and developments in stablecoins which, as shown by the recent TerraUSD crash and Tether de-peg, are not as stable as their name suggests and cannot guarantee their peg at all times.[4] Following a deep dive into crypto-asset leverage and crypto lending, we conclude that if the present trajectory of growth in the 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.

2 Market developments in recent years

The crypto-asset universe has increased dramatically in both size and complexity since the end of 2020, expanding beyond Bitcoin. Despite recent market developments, the overall market capitalisation of the crypto-asset class is still around seven times bigger than it was at the start of 2020, having reached a high of over €2.5 trillion on aggregate in late 2021 (Chart B.1, panel a). Although the crypto-asset universe is still relatively small compared with the biggest stock exchanges (e.g. around 10% of STOXX Europe 600 market capitalisation), by November 2021 Bitcoin and Ether were among the largest assets globally (Chart B.1, panel b). Trading volumes for the most representative crypto-assets (including Bitcoin, Ether and Tether) have at times been comparable with or even surpassed those of the New York Stock Exchange or euro area sovereign bond quarterly trading volumes. There are now more than 16,000 crypto-assets in existence (ten new crypto-assets are launched every day on average), although only around 25 crypto-assets have a market capitalisation comparable with that of a large cap equity. At the same time, selected subsegments within the crypto-asset ecosystem such as stablecoins, non-fungible tokens (NFTs) and DeFi grew particularly strongly in 2021, indicating that the potential functionalities of crypto-assets are expanding.

However, crypto-asset markets also continue to be characterised by high levels of volatility. Over the last few years, the historical volatility of crypto-assets has continued to dwarf the volatility of the diversified European stock and bond markets. For example, while the volatility of the Bitcoin price has declined over the years, it is still significantly higher than for commodities such as silver and gold. Despite volatile movements and bouts of speculation (Chart B.1, panel a), crypto-assets trended upwards throughout most of 2021, leading to all-time-high prices for most individual crypto-assets. However, since early November the price of Bitcoin, as well as that of the other main unbacked crypto-assets, has more than halved amid a changing environment (US monetary tightening and increasing geopolitical tensions).

Chart B.1

The market value and complexity of the crypto-asset ecosystem has increased dramatically

Sources: Bloomberg Finance L.P., Crypto Compare and ECB calculations.
Notes: Crypto-asset market capitalisation is calculated as the product of circulating supply and the price of crypto-assets. If the circulating supply were adjusted for the lost bitcoins which are proxied by those that have not been used for longer than seven years, it would be around 20% lower. The selected major altcoins are Cardano (ADA), Bitcoin Cash (BCH), Dogecoin (DOGE), Link (LINK), Litecoin (LTC), Binance Coin (BNB), Ripple (XRP), Polkadot (DOT) and Solana (SOL). The selected major stablecoins are Gemini USD (GUSD), True USD (TUSD), USD Coin (USDC), Tether (USDT), Binance USD (BUSD) and Pax Dollar (USDP). Algorithmic stablecoins were excluded.

The increasing correlation of crypto-asset prices with mainstream risky financial assets during episodes of market stress casts doubt over their usefulness for portfolio diversification. There was an increase in the correlation between crypto-asset returns and stock returns during (and following) the market stress of March 2020, as well as during the December 2021 and May 2022 market sell-offs. This may suggest that, during periods of risk aversion across wider financial markets, the crypto-asset market has become more closely tied to traditional risk assets – a trend that may be due in part to the increased involvement of institutional investors.[5] Conversely, the correlation with gold has turned negative during a period of rising inflation expectations and geopolitical tensions.

Interconnectedness with the wider financial system has been growing. Linkages between crypto-assets and the euro area banking sector have been limited so far, although market contacts indicate there was growing interest in 2021, mainly via expanded portfolios or ancillary services associated with digital assets (including custody and trading services). Major payment networks have also stepped up their support of crypto-asset services, leveraging their retail networks and making crypto-assets more easily accessible to consumers and businesses. Some institutional investors (hedge funds, family offices, some non-financial firms and asset managers) are now also investing in Bitcoin and crypto-assets more generally.[6] In addition, market intelligence suggests that the growing involvement of asset managers is largely in response to demand from their own clients.

Demand from institutional investors in Europe has also risen. For example, 56% of European institutional investors surveyed by custody and execution services provider Fidelity Digital Assets[7] indicated that they have some level of exposure to digital assets – up from 45% in 2020 – with their intention to invest also trending upwards. One reason could be that measures taken by the public authorities may have been interpreted as endorsing crypto-assets, even though the latter remain largely unregulated. For example, since July 2021 German institutional investment funds have been allowed to invest up to 20% of their holdings in crypto-assets. This is further aided by the increasing availability of crypto-based derivatives and securities on regulated exchanges, such as futures, exchange-traded notes, exchange-traded funds and OTC-traded trusts, which have increased in popularity over the last few years in Europe and the United States. These products, together with clearing facilities, have made crypto-assets more accessible to investors as they can be traded on traditional stock exchanges, with the end user no longer having to deal with the complexities of custody and storage. However, the European crypto-asset management landscape is still relatively limited and is home to only 20% of total global crypto-assets funds in terms of primary office location.

Retail investors represent a significant part of the crypto-asset investor base. Recent results from the ECB’s Consumer Expectation Survey (CES)[8] for six large euro area countries[9] indicate, based on experimental questions, that as many as 10% of households may own crypto-assets (Chart B.2, panel a). Most crypto-asset owners reported holding less then €5,000 in crypto-assets, with a slight predominance of smaller holdings (below €1,000) in this group. At the other end of the spectrum, around 6% of crypto-asset owners confirmed that they held more than €30,000 in crypto-assets (Chart B.2, panel b). Looking at the income quintiles of the respondents, the pattern is largely U-shaped: the higher a household’s income, the more likely it is to hold crypto-assets, with lower-income households more likely to hold crypto than middle-income households (Chart B.2, panel c). On average, young adult males and highly educated respondents were more likely to invest in crypto-assets in the countries surveyed. 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.

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Decrypting financial stability risks in crypto-asset markets

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