The European Central Bank issued a warning report on the urgency of regulation of the crypto industry, given its increased risk to the global economy. The traditional financial institutions engage and incorporate cryptocurrencies and digital assets as payment. In its biannual financial review, ECB warns that Crypto’s progress into financial institutions and asset managers poses a significant financial stability risk. The urgency of regulation is to address this risk before it becomes uncontrollable.

The ECB’s biannual financial review report on crypto’s financial stability risks
The biannual financial review of the ECB warns of the increasing complexity of the financial market due to crypto interconnecting with mainstream finance. This is another scrutiny of the cryptocurrency industry as reported by Crypto Lists. The ECB announced that it managed a deep dive into crypto assets and lending to conclude the financial risks based on the evidence gathered. It was part of its report titled, “Decrypting financial stability risks in crypto-asset markets”. It further stated that the historical volatility of crypto assets continues to dwarf the volatility of the diversified European stock and bond markets. Investors have managed the €1.3tn slump in market capitalisation of unbacked crypto-assets since November 2021. There were no financial stability risks.

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Despite this volatility, investor appetite surged cryptos to all-time highs. Financial institutions such as banks, asset managers, and institutional investors fastened exposure to digital assets. Their clients had easier access to trading these cryptocurrencies to stimulate crypto growth and increase the financial risk. The ECB insists that at this rate, a time will reach where unbacked crypto-assets represent a risk to financial stability. The trajectory of the growing size and complexity of the crypto-asset ecosystem continues.

This was the first such warning from the ECB. There were similar messages from the US and UK authorities following a series of recent slumps in the crypto industry. The leading cryptocurrency, Bitcoin, fell below the $30,000 mark causing significant concern for the ECB. It is half the value it was back in November. However, the crypto market is booming, with major exchanges such as Binance processing close to $700bn in spot trading and $1.1tn in bitcoin futures in the previous month. According to the ECB, these trading volumes are similar to the New York Stock Exchange and Euro Area sovereign bond quarterly trading volumes. These exchanges also offer loans that increase clients’ exposure by 125 times their initial investments. Significant data shortcomings persist causing uncertainty over the full extent of possible contagion channels within the traditional financial system.

The ECB report places significant worry on a possible crypto market crash, similar to recent transpiration, which would cause a comparable crash in the traditional markets. It associates such a crash with the subprime mortgage market that caused a global financial crisis in 2008.

ECB President view on the posing threat
The President of the ECB, Christine Lagarde, claims that a crypto token has no value and is based on nothing. There is no underlying asset to act as security. It reiterates the claims of Fabio Panetta, an ECB Executive, that the sector is similar to a Ponzi Scheme. He had also advised on a regulatory clampdown to avoid the lawless frenzy of risk-taking.

The linkage between Eurozone banks and crypto-assets is limited so far. Some international and eurozone banks are trading regulated crypto derivatives even though they do not hold an underlying crypto asset inventory. Payment networks and institutional investors support crypto assets services. Most notably, German institutional investment funds hold a fifth of their holdings in crypto assets since last year. Furthermore, the ECB highlights the risk posed by decentralised Finance(DeFi) where crypto-based software programs provide financial services without intermediaries like banks. The crypto credit on DeFi platforms surged by a factor of 14 in 2021 while the total value locked was close to €70bn until very recently. This is at par with small domestic peripheral European banks.

Lagarde mentioned that the ECB is developing a digital euro that will undergo testing via a prototype by next year. It will then decide on whether to launch after three years. The president mentioned that its CBDC will be vastly different from many of the digital assets. The European Union is finalising legislation called markets in crypto-assets with its earliest implementation in 2024. The ECB urges the EU to implement it immediately to create a legal framework for regulating the crypto industry within the EU.

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