The European Central Bank (ECB), in the latest edition of its Macroprudential Bulletin, has stated that the financial stability risks from bitcoin (BTC) and other cryptocurrencies are on the rise. The apex bank also points its searchlight into centralization in decentralized Finance (DeFi), stablecoin risks, and environmental effects of proof-of-work (PoW) mining.
ECB’s Macroprudential Report
In the July edition of the European Central Bank’s (ECB) Macroprudential Bulletin, researchers at the 24-year-old apex bank point their searchlights into cryptocurrencies, stablecoins, and decentralized finance (DeFi).
The ECB has always seen blockchain-based cryptocurrencies such as bitcoin (BTC), ether (ETH), and other altcoins as a huge threat to the traditional financial system and it reaffirmed this stance in its latest report.
The researchers argue that the exponential growth witnessed by the industry so far, coupled with the interlinkages between the cryptoverse and traditional financial system brought about by increasing institutional interest, has significantly increased the financial stability risks of digital assets. Therefore, authorities in the European Union must increase their regulatory oversight in the space.
“Financial stability risks from crypto-assets are rising and could reach a systemic threshold. A recent analysis by the Financial Stability Board (FSB) and the ECB suggests that the nature and scale of crypto asset markets are evolving rapidly. If current trends continue, crypto assets will pose risks to financial stability. Crypto markets thus need to be effectively regulated and supervised,” stated the ECB.
Stablecoins, DeFi, and PoW Mining
In February 2021, the ECB urged lawmakers in the region to formulate rules that will bring stablecoin issuance in the region under its absolute control. The sudden collapse of the Terra USD stablecoin in May, and the subsequent de-pegging of other stablecoins from the USD have brought more regulatory scrutiny to these so-called stablecoins.
Now, the ECB has stated that though stablecoins account for just 10 percent of the total cryptocurrency market cap, they have grown from being just hedges against negative crypto market volatility, to becoming a crucial part of the crypto industry due to their frequent use as bitcoin and altcoins tradings pairs on exchanges and for liquidity provision on DeFi protocols.
The ECB notes that collateralized stablecoins such as tether (USDT), USDC, and Binance USD account for roughly 90 percent of the total stablecoin market, with the total trading volumes of these stablecoins surpassing those of unbacked crypto in 2021 to hit EUR 2.96 trillion, almost reaching those of equities on the New York Stock Exchange (EUR3.12 trillion).
Against that backdrop, the ECB says stablecoins may pose risks to financial stability through various contagion channels, including financial sector exposure, wealth effects (i.e the extent to which a crash in the value of a stablecoin might affect its investors, with a subsequent knock-on effect on the traditional financial system), confidence effects (i.e the degree to which negative developments concerning crypto-assets could affect investor confidence in crypto and potentially the broader financial system) and the extent of stablecoins’ use in payments and settlements, amongst others.
“Issuers of collateralized stablecoins need to ensure robust reserve asset management to instill confidence, ensure the stability of the peg, and avoid a run on the coin with possible contagion to the financial sector,” the ECB noted, adding “ Given the potential risks and cross-border nature of stablecoins, a granular and robust global regulatory approach is essential.”
The researchers also outlined some of the risks inherent in the decentralized finance (DeFi) space including governance and operational risks amongst others and have buttressed the need for regulation in the industry.
The ECB report has condemned the high energy usage of PoW cryptocurrencies like bitcoin (BTC). It has also argued that a transition to renewable energy sources for PoW mining “may crowd out other uses of renewable energy, putting countries’ green transition targets at risk.”