The FSB has concluded in a recent report that “Crypto-assets markets are fast evolving and could reach a point where they represent a threat to global financial stability due to their scale, structural vulnerabilities and increasing interconnectedness with the traditional financial system”.

So how integrated is crypto with the traditional financial system?

The FSB considered the following areas of interconnectedness between cryptoasset markets and the traditional financial system.

Of particular note is that whilst hedge funds were found to be allocating increasing amounts of their funds to cryptoassets, mainstream asset managers were not following that trend – put off by high volatility, lack of regulatory compliant products and platforms, a shortage of regulated custody services and broader regulatory uncertainty.  On the other hand, some large financial institutions have announced plans to launch institutional cryptoasset brokerage and exchange services. 

Use of crypto in payments and settlement

The FSB observed that thus far, the use of cryptoassets for payments remains limited. The most popular cryptoassets lack stability as a store of value, do not function as a unit of account, and have performance shortcomings (speed, cost and capacity) that limits their usefulness for mainstream payments.

With particular reference to cryptoassets using proof of work consensus mechanisms, the FSB noted that their significant energy consumption makes them highly vulnerable to changes in jurisdictions’ climate policies and may place strains on local utility infrastructure.

Concerning stablecoins - a category of crypto-assets that aim to maintain a stable value with reference to a specified asset (typically US dollars), or basket of assets and which theoretically therefore are better placed to perform the store of value function of money – the FSB noted that the current generation of stablecoins are not yet used as a widespread means of payment.  The most frequent uses of stablecoins included:

• Acting as a bridge between traditional fiat currencies and a variety of (typically more volatile) digital assets;
• Serving as collateral in crypto-asset derivative transactions; and
• Facilitating trading/ lending/borrowing and acting as collateral in DeFi

The FSB highlighted a series of risks and vulnerabilities arising in relation to stablecoins, in particular global stablecoins.  The FSB is concerned that, whilst international work on standards and recommendations for regulatory frameworks for stablecoins is ongoing, there is a risk that a stablecoin could launch and scale rapidly before such regulatory frameworks are in place – the FSB referred in particular to the sale by the Diem Association of assets relating to the running of the Diem Payment Network to Silvergate Capital Corporation at the end of January 2022.

What is the current state of play with Decentralised Finance (DeFi)?

The FSB commented that the total value of assets currently ‘locked’ in DeFi transactions –that is to say total value of reserves locked into smart contracts - stood at around $100 billion in December 2021, about four times as much as at end-2020 and far exceeding the $35 billion raised by Initial Coin Offerings (ICOs) between 2016 to 2019.

DeFi is based on distributed ledger technology (DLT) (typically public and permissionless blockchains) to offer financial services and products purportedly without the need for intermediaries. Though DeFi projects claim to be decentralised, DeFi applications and products often exist along a spectrum of centralisation.  DeFi applications and platforms offer lending, borrowing, trading and custody of crypto-assets. They also include a broader collection of unregulated financial services that mimics that of the mainstream financial system.

The FSB highlights the key regulatory threat posed by DeFi: where governance is decentralised via the issuance of governance tokens it can be challenging for public authorities and regulators to identify an entity or individual accountable for meeting regulatory obligations and in an extreme case, where a DeFi platform is completely decentralised, there may be no single person or entity that could be held responsible for the functioning of the protocol.  (This is not thought to be the case in the current generation of decentralised governance arrangements).  Of particular concern to regulators is the lack of know your customer checks, facilitation of law evasion, operational and cybersecurity incidents and failures of governance.

Next steps

The FSB is going to keep a watching brief on the potential for cryptoassets to threaten global financial stability.  Taking into account the ever increasing prevalence and interconnectedness of cryptoassets with the financial system, together with the wide range of vulnerabilities identified by the FSB, it is anticipated that this sector will become increasingly heavily regulated.