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In the context of the Bank Resolution Academy the Florence School of Banking and Finance organised a tailored live class for a group of participants  of the South African Reserve Bank to discuss resolution...

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Past May, the third largest so-called stablecoin TerraUSD and its sister token Luna imploded, obliterating a combined market value once estimated at USD 60 billion. The crash of this algorithmic stablecoin -not backed by fiat money or other assets- due to an investor run hugely impacted the crypto sphere, wiping out more than USD 300 billion in market capitalization[1].

More recently, the collapse of the centralized cryptocurrency exchange FTX shook once more the trust in the overall crypto market. FTX was one of the world’s largest exchanges, with more than one million users trading nearly a billion dollars daily, according to CoinMarketCap. This bankruptcy was a textbook case of poor governance, opacity, weak risk management, and brazen fraud.

Regulators worldwide have learned many lessons from these tail events[2]: they have shown a high level of interconnectedness within the crypto asset ecosystem, as sharp price drops often lead to cascades of liquidations, contributing to the propagation and risk amplification. For instance, stablecoins are used as collateral to facilitate trading, lending, and borrowing of other more volatile crypto assets in a process similar to rehypothecation. This practice reinforced procyclicality due to a lack of shock absorption capacity. These shock propagation effects look very similar to those in the traditional financial system, even though decentralised finance promised to be different!

Another relevant lesson is the confirmation that the connections between crypto-assets, financial institutions (FI), and traditional financial markets are still curbed. After the fire sale in the crypto asset market, it was observed that losses were self-contained in retail investors and “whales” (large holders of cryptocurrencies) investing in these assets for speculative purposes, with no significant effects on financial stability.

However, the effect on consumers has been devastating. According to the WSJ, more than USD 16 billion of customer assets were lost only in the FTX case. Many of the impacted were retail investors lured by high returns through a narrative of ever-rising prices. Irrational enthusiasm boosted the crypto asset bubble, exploiting social media, news reports, and the fear of missing out – FOMO.

Traditional FIs in some jurisdictions were also partially responsible for this consumer detriment by providing trading and lending platforms that allow their clients to engage in complex and high-risk activities without appropriate safeguards. Moreover, some FIs even funded new crypto-asset projects on behalf of clients, mounting retail investors’ exposure[3].

How much regulation could have prevented adverse effects on consumers? According to the European regulators, the upcoming landmark new legislation, the Markets in Crypto Assets Regulation (MiCA) addresses the core problem by introducing guidelines for investors and market participants through a common EU regime[4]. Nevertheless, there are concerns about potential regulatory loopholes, for instance, in the cases of reverse solicitation, given that service providers outside the EU play a dominant role in this market[5]. A more radical proposal is to treat crypto as gambling and regulate it as such; since providing a legal framework to crypto operations might provide legitimacy to a financial sector segment that has shown limited net benefit for society, according to the advocates of this approach[6].

The final lesson from these unfortunate events is that regulation arrives after many consumers are affected. Highly dynamic markets fueled by irrational enthusiasm are a challenge for policymakers that must be addressed before the new meme asset arrives.

References

This blog post has been produced in the framework of the EU Supervisory Digital Finance Academy (EU-SDFA).

The EU Supervisory Digital Finance Academy (EU-SDFA) is a TSI flagship initiative aimed at supporting financial supervisory authorities in coping with the risks and opportunities associated to the use of advanced technologies in the financial sector. The European Commission – DG Reform has established the Academy in cooperation with the three European Supervisory Authorities (EBA – ESMA – EIOPA) and the Florence School of Banking and Finance part of the Robert Schuman Centre of the European University Institute (FBF-EUI).