Crypto Contagion Underscores Why Global Regulators Must Act Fast to Stem Risk

The already volatile world of crypto has been upended anew by the collapse
of one its largest platforms, which highlighted risks from crypto assets
that lack basic protections.

The losses punctuated an already perilous period for crypto, which has lost
trillions of dollars in market value. Bitcoin, the largest, is down by
almost two-thirds from its peak in late 2021, and about three-quarters of
investors have lost money on it, a new analysis by the Bank for
International Settlements

 in November.

During times of stress, we’ve seen market failures of stablecoins,
crypto-focused hedge funds, and crypto exchanges, which in turn raised
serious concerns about market integrity and user protection. And with
growing and deeper links with the core financial system, there could also
be concerns about systemic risk and financial stability in the near future.

Many of these concerns can be addressed by strengthening financial
regulation and supervision, and by developing global standards that can be
implemented consistently by national regulatory authorities.

Two recent IMF reports on regulating the crypto ecosystem are especially
timely amid the severe turmoil and disruption in many parts of the crypto
market and the repeated cycles of boom and bust for the ecosystem around
such digital assets.

Our reports address the issues noted above at two levels. First, we take a
broad approach, looking across key entities that carry out the core
functions within the sector, and hence, our conclusions and recommendations
apply to the entire crypto asset ecosystem.

Second, we focus more narrowly on

 and their arrangements. These are crypto assets that aim to maintain a
stable value relative to a specified asset or a pool of assets.

New challenges

Crypto assets, including stablecoins, are not yet risks to the global
financial system, but some emerging market and developing economies are
already materially affected. Some of these countries are seeing large
retail holdings of, and currency substitution through, crypto assets,
primarily dollar-denominated stablecoins. Some are experiencing
cryptoization—when these assets are substituted for domestic currency and assets, and circumvent
exchange and capital control restrictions. 

Such substitution has the potential to cause capital outflows, a loss of
monetary sovereignty, and threats to financial stability, creating new
challenges for policy makers. Authorities need to address the root causes
of cryptoization, by improving trust in their domestic economic policies,
currencies, and banking systems.

Advanced economies are also susceptible to financial stability risks from
crypto, given that institutional investors have increased stablecoin
holdings, attracted by higher rates of return in the previously low
interest rate environment. Therefore, we think it’s important for
regulatory authorities to quickly manage risks from crypto, while not
stifling innovation.

Specifically, we make five key recommendations in two Fintech Notes,

Regulating the Crypto Ecosystem: The Case of Unbacked Crypto Assets

Regulating the Crypto Ecosystem: The Case of Stablecoins and
, both published in September.

1. Crypto asset service providers should be licensed, registered, and
authorized. That includes those providing storage, transfer, exchange,
settlement, and custody services, with rules like those governing providers
of services in the traditional financial sector. It’s particularly
important that customer assets are segregated from the firm’s own assets
and ring-fenced from other functions. Licensing and authorization criteria
should be well defined, and responsible authorities clearly designated.

2. Entities carrying out multiple functions should be subject to additional
prudential requirements. In cases where carrying out multiple functions
might generate conflicts of interest, authorities should consider whether
entities should be prohibited to do so. Where firms are permitted to, and
do carry out multiple functions, they should be subject to robust
transparency and disclosure requirements so authorities can identify key

3. Stablecoin issuers should be subject to strict prudential requirements.
Some of these instruments are starting to find acceptance beyond crypto
users, and are being used as a store of value. If not properly regulated,
stablecoins could undermine monetary and financial stability. Depending on
the model and size of the stablecoin arrangement, strong, bank-type
regulation might be needed.

4. There should be clear requirements on regulated financial institutions,
concerning their exposure to, and engagement with, crypto. If they provide
custody services, requirements should be clarified to address the risks
arising from those functions. The recent standard by Basel Committee on
Banking Supervision on the prudential treatment of banks’ crypto assets
exposures recently is very welcome in this respect.

5. Eventually, we need robust, comprehensive, globally consistent crypto
regulation and supervision. The cross-sector and cross-border nature of
crypto limits the effectiveness of uncoordinated national approaches. For a
global approach to work, it must also be able to adapt to a changing
landscape and risk outlook.

Containing user risks
 will be difficult for authorities around the world given the rapid
evolution in crypto, and some countries are taking even more drastic steps.
For example, sub-Saharan Africa, the smallest but fastest growing region
for crypto trading, nearly a fifth countries have

enacted bans
 of some kind to help reduce risk.

While broad bans might be disproportionate, we believe targeted
restrictions offer better policy outcomes provided there is sufficient
regulatory capacity. For instance, we can restrict the use of some crypto
derivatives, as shown by Japan and the United Kingdom. We can also restrict
crypto promotions, as Spain and Singapore have.

Still, while developing global standards takes time, the Financial
Stability Board has done excellent work by providing recommendations for
crypto assets and stablecoins. Our Fintech Notes draw many of the same
conclusions, a testament to our close collaboration and shared observations
on the market. For its part, the IMF will continue to work with global
bodies and member nations to help leading policy makers working on this
topic to best serve individual users as well as the global financial

—This blog reflects research contributions by Parma Bains, Fabiana
Melo, and Arif Ismail

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