Assessment of Risks to Financial Stability from Crypto-assets 16 February 2022 The Financial Stability Board (FSB) coordinates at the international level the work of national financial authorities and international standard-setting bodies in order to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies. Its mandate is set out in the FSB Charter, which governs the policymaking and related activities of the FSB. These activities, including any decisions reached in their context, shall not be binding or give rise to any legal rights or obligations. Contact the Financial Stability Board Sign up for e-mail alerts: fsb/emailalert Follow the FSB on Twitter: FinStbBoard E-mail the FSB at: fsbfsb Copyright 2022 Financial Stability Board. Please refer to the terms and conditions iii Table of Contents Executive summary . 1 1. Introduction . 3 2. Vulnerabilities concerning unbacked crypto-assets . 4 2.1. Financial sector exposures . 4 2.2. Wealth effects . 6 2.3. Confidence effects . 7 2.4. Use in payments and settlement . 8 3. Vulnerabilities concerning stablecoins . 11 3.1. Financial sector exposures . 11 3.2. Wealth effects . 12 3.3. Confidence effects . 13 3.4. Use in payments and settlement . 14 3.5. Potential future global stablecoins . 14 4. Decentralised Finance (DeFi) and Crypto-asset Trading Platforms . 15 5. Data gaps . 18 6. Conclusion and next steps . 19 Annex 1: Available metrics and data gaps when evaluating financial stability risks from crypto-assets . 21 Annex 2: Glossary . 25 iv 1 Executive summary 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. The rapid evolution and international nature of these markets also raise the potential for regulatory gaps, fragmentation or arbitrage. Although the extent and nature of use of crypto-assets varies somewhat across jurisdictions, financial stability risks could rapidly escalate, underscoring the need for timely and pre-emptive evaluation of possible policy responses. Crypto-asset market capitalisation grew by 3.5 times in 2021 to $2.6 trillion, yet crypto-assets remain a small portion of overall global financial system assets. Direct connections between crypto-assets and systemically important financial institutions and core financial markets, while growing rapidly, are limited at the present time. Episodes of price volatility have, so far, been contained within crypto-asset markets and have not spilled over to financial markets and infrastructures. Moreover, currently crypto-assets are not widely used in critical financial services (including payments) on which the real economy depends. However, it is challenging to assess inflection points given the rapid evolution of these markets and the significant data gaps that impede authorities risk assessments. These gaps stem, in part, from the fact that participants, products and markets, including crypto-asset trading and lending platforms, fall outside the regulatory perimeter and the associated reporting requirements or, in some cases, may be failing to comply with applicable laws and regulations. These data gaps make it difficult to assess the full scope of crypto-assets use in the financial system. Institutional involvement in crypto-asset markets, both as investors and service providers, has grown over the last year, albeit from a low base. Systemically important banks and other financial institutions are increasingly willing to undertake activities in, and gain exposures to, crypto-assets. The prevalence of more complex investment strategies, including through derivatives and other leveraged products that reference crypto-assets, also has increased. If the current trajectory of growth in scale and interconnectedness of crypto-assets to these institutions were to continue, this could have implications for global financial stability. There are also vulnerabilities that could undermine the integrity and functioning of crypto-asset markets. These include low levels of investor and consumer understanding of crypto-assets including costs, fees, conflicts of interest and lack of redress and/or recovery and resolution mechanisms, and uncertainties around the operational resilience of some crypto-asset focused institutions. It is possible, given the public prominence of crypto-assets and crypto-asset trading platforms, the rapidly growing retail investor adoption, and the use of leverage that any loss of confidence in crypto-assets could have implications that exceed those commensurate to the actual magnitude and direct financial interconnectedness of crypto-asset markets. Additional vulnerabilities may arise from the environmental impact of energy intensive consensus mechanisms used for certain crypto-assets. There are also wider public policy issues related to crypto-assets beyond the FSBs remit that have important implications, such as the use of crypto-assets in the context of money laundering, cyber-crime and ransomware. The report examines developments and associated vulnerabilities relating to three segments of the crypto-asset markets: unbacked crypto-assets (such as Bitcoin); stablecoins; and 2 decentralised finance (DeFi) and crypto-asset trading platforms. These three segments are closely interrelated in a complex and constantly evolving ecosystem, and need to be considered holistically when assessing related financial stability risks. DeFi has recently become a fast-emerging sector, providing financial services using both unbacked crypto-assets and stablecoins. In part because of the emergence of DeFi, stablecoins issuers have experienced considerable growth and their reserve assets may make them significant holders of short-term debt instruments. The structure of stablecoins means they are exposed to liquidity mismatch, credit and operational risks, which makes them susceptible to sudden and disruptive runs on their reserves. Moreover, a relatively small number of crypto-asset trading platforms that aggregate multiple types of services and activities, including lending and custody, account for the majority of crypto-assets traded. Some of these platforms operate outside of a jurisdictions regulatory perimeter or are not in compliance with applicable laws and regulations. This presents the potential for concentration of risks, as well as underscores the lack of transparency on their activities. Stablecoin growth has continued, despite concerns about regulatory compliance, quality and sufficiency of reserve assets, and standards of risk management and governance. At present, stablecoins are used mainly as a bridge between traditional fiat currencies and crypto-assets, which has implications for the stability and functioning of crypto-asset markets. Were a major stablecoin to fail, it is possible that liquidity within the broader crypto-asset ecosystem (including in DeFi) could become constrained, disrupting trading and potentially causing stress in those markets. This could also spill over to short-term funding markets if stablecoin reserve holdings were liquidated in a disorderly fashion. The FSB and other standard-setting bodies are already working to address threats associated with so-called “global stablecoins”. The FSB will continue to monitor developments and risks in crypto-asset markets, based on the framework published in 2018. In 2022, the FSB will also explore potential regulatory and supervisory implications of unbacked crypto-assets, including the types of actions FSB member jurisdictions have taken, or plan to take, to address any associated financial stability threats. Examining the regulatory gaps and challenges that may exist, including those that arise from the cross-border and cross-sectoral nature of crypto-assets, will be a key element of this work. The FSB will also continue to monitor and share information on regulatory and supervisory approaches to ensure the effective implementation of its high-level recommendations for the regulation, supervision and oversight of “global stablecoin” arrangements. 3 1. Introduction This report provides the FSBs view on recent developments in crypto-asset markets and their implications for global financial stability. Crypto-assets, as the term is used in this report, are a type of private sector digital asset that depends primarily on cryptography and distributed ledger or similar technology. Crypto-assets can function as, or have characteristics of, digital means of exchange that are not backed by an issuer (such as bitcoin), or other digital tokens, including securities tokens, asset-backed tokens representing ownership interests in property, so-called utility tokens used to obtain access to goods or services on a particular digital platform, or non-fungible tokens used as collectibles or investment instruments. There are a range of instruments based on crypto-assets, and their classification may vary by jurisdiction. This report focuses on private sector crypto-assets and does not consider digital assets issued by public sector entities, including central bank digital currencies. The vulnerabilities in crypto-asset markets relating to leverage, liquidity/maturity mismatch, operational/technological fragilities and interconnectedness are similar to those in traditional finance. The transmission channels through which these vulnerabilities might have implications for financial stability were set out in the FSBs report on crypto-asset markets in 2018.1 These channels include: (i) financial sector exposures to crypto-assets, related financial products and entities that are financially impacted by crypto-assets; (ii) wealth effects, i.e. the degree to which changes in the value of crypto-assets might impact their investors, with subsequent knock-on effects on the financial system; (iii) confidence effects, through which developments concerning crypto-assets could impact investor confidence in crypto-asset markets (and potentially the broader financial system); and (iv) extent of crypto-assets use in payments and settlements. The report is structured as follows. The next section examines vulnerabilities concerning unbacked crypto-assets, and the transmission channels through which these might affect financial stability. Vulnerabilities concerning stablecoins both existing stablecoins, and potential future so-called “global stablecoins” are examined in the third section. The fourth section examines recent developments concerning DeFi and crypto-asset trading platforms. The fifth section discusses data gaps for crypto-asset risk assessments (Annex 1 provides an overview of metrics and data gaps). A final sixth section concludes and describes next steps.2 This document also contains a glossary (Annex 2) that defines certain terms relating to crypto-assets. To the extent possible, these are aligned with terminology used in FSB work and by other international organisations and standard-setting bodies. However, the use of these terms does not involve a judgment as to their appropriateness in all cases given the rapidly evolving crypto-asset markets for instance, the distinction between unbacked crypto-assets and stablecoins does not imply that the latter are (fully or at all) backed by assets; stablecoins may not have stable values; and DeFi market structures often exist along a spectrum of centralisation. 1 See FSB, Crypto-asset markets: potential channels for future financial stability implications, October 2018. 2 In some cases, this report refers to specific crypto-assets or firms providing related services as examples. These examples are not exhaustive and do not constitute an endorsement by the FSB or its members for any crypto-asset, firm, product, or service. 4 2. Vulnerabilities concerning unbacked crypto-assets 2.1. Financial sector exposures Connections between crypto-assets and systemically important financial institutions and core financial markets, though expanding, remain limited at the present time. Episodes of price volatility have, so far, been contained within crypto-asset markets and have not spilled over or presented a threat to the resilience of broader financial markets and infrastructures. However, much of the trading activity in crypto-assets, as well as in futures and other derivatives referencing them, takes place on platforms that may be operating outside the regulatory perimeter (or, in some cases, may be failing to comply with applicable laws and regulations) and without regulatory oversight that would provide transparency on the nature and extent of these exposures. If current trends continue, and absent effective regulation and supervision, financial stability risks may emerge as crypto-assets become increasingly interconnected with the wider financial system. This is especially the case in emerging market and developing economies (EMDEs) where crypto-assets may in some situations replace the domestic currency, or offer opportunities to circumvent exchange restrictions, and capital account management measures. Over the course of 2020-21, there has been growing institutional investor participation in crypto-assets, in addition to the substantial retail ownership of crypto-assets. Hedge funds are allocating increasing amounts of their funds to crypto-assets.3 That said, amongst mainstream asset managers, interest in crypto-asset investments remains limited, owing to high volatility, lack of regulatory compliant products and platforms, a shortage of regulated custody services, as well as broader regulatory uncertainty.4 Growing institutional investor involvement in crypto-asset derivatives may both increase access to crypto-assets exposure, and heighten the risk of spill-overs to core markets, for example if investors need to sell other assets to meet margin calls on their crypto-asset positions. A growing number of financial service providers are offering or plan to offer crypto-asset custodial and trading services. Some large financial institutions have also announced plans to launch institutional crypto-asset brokerage and exchange services. And a number of private non-financial corporates began holding bitcoin as a treasury asset, although volumes are small from a system-wide perspective. The emergence of crypto-asset exchange traded funds (ETFs) has been the subject of much commentary, with some suggesting this could significantly expand mainstream institutional exposure to crypto-assets.5 In October 2021, the first US-based crypto-asset CME futures ETF launched, the ProShares Bitcoin futures ETF (ticker BITO), and began trading on the New York 3 See “Hedge funds expect to hold 7% of assets in crypto within five years”, Financial Times, 15 June 2021. A recent survey by Intertrust group of 100 hedge funds CFOs found that, on average, these expected to allocate 7.2% o