Increased exposure for traditional financial entities can lead to systemic risks
Several non-collateralised cryptoassets have risen sharply in price in the past few years, but have also been highly volatile. In other words, there is an opportunity to make a great deal of money, while at the same time there is a risk of losing all or part of an investment. The turbulence on the market for cryptoassets during May 2022 is an apparent example of this. Data indicates thus far that it is primarily private individuals who are exposed to cryptoassets. This means that any drop in price that might occur will have negative consequences for the individual.
However, interest in exposure to cryptoassets among traditional financial entities, such as funds and banks, has increased in the past few years. This is because return on unbacked cryptoassets and related financial products can be high. When interconnectedness increases between these cryptoassets and the traditional financial system, there is also a heightened risk that price volatility in the cryptoassets will have implications for the financial system as a whole. If for example a fund were to have substantial exposures to a cryptoasset that loses value, this could make it difficult for the fund to meet other financial obligations. These problems can spread on to banks and impair confidence in the financial system as a whole. Thus far, however, exposure among banks and institutional investors appears to be limited. If it increases going forward, it could however cause risks to financial stability. FSB (2022), “Assessment of Risks to Financial Stability from Crypto-Assets”, February 2022, Financial Stability Board.
Potential major implications from price drops when cryptoassets are used instead of national currencies
In many developing countries, the national currency has been replaced by another currency, usually US dollars. This is commonly known as currency substitution, or dollarisation if the national currency has been replaced by dollars. It is often a result of the domestic currency having been mismanaged, for example with inflation having undermined the value of the currency. Dollarisation leads to a substantial impact on the local market from the decisions of the Federal Reserve, such as those concerning monetary policy. It also means that the national central bank only has very slim possibilities, or none at all, to implement its own monetary policy or take measures to safeguard financial stability.
Such a scenario could transpire if cryptoassets replace the local currency. This is called cryptoisation or digital dollarisation. This is considered to be a particular risk if the currency is replaced by a stablecoin issued by a bigtech firm. This is because such a stablecoin has the conditions to rapidly grow to considerable dimensions through the numerous users of the bigtech firms. However, cryptoisation can also occur with other cryptoassets, such as Bitcoin.
The probability of cryptoisation taking place is greater for developing countries than for countries like Sweden, which have an advanced financial system and high confidence in authorities. Cryptoisation can cause risks associated with cryptoassets, such as the risk of a major drop in price, to spread widely throughout the economy. At the same time, it would be difficult for the central bank to take measures when this occurs because their tools are linked to the national currency. This also means that the central bank cannot conduct monetary policy and promote financial stability.
The degree of cryptoisation in the world is currently limited. BIS Quarterly Review, March 2022, Bank for International Settlements. As mentioned previously, Bitcoin has, for example, been made legal tender in El Salvador which means that it could eventually fully or partly replace US dollars as the currency in El Salvador.
Cryptoassets as tools in criminal activities
While cryptoassets are relatively anonymous, at the same time there is a high degree of transparency in that all transactions are registered on the blockchain.
Authorities worry that cryptoassets will be used for different types of criminal activity, such as money laundering or terrorist financing. It is estimated that, for 2021, the total value of cryptoassets attributable to criminal activity is around USD 14 billion, or 0.15 per cent of the total transaction volume for cryptoassets. Chainalysis (2022), “The 2022 Crypto Crime Report”, February 2022, Chainalysis. Much of this concerns stolen cryptoassets and fraud. In relation to the total transaction volume, this is however less than before – in 2019 it was estimated that almost 3.4 per cent of the transaction volume was attributable to criminal activities.
To reduce these aspects, in the EU there is an initiative for rules aimed at improving customer due diligence for cryptoasset trading venues and preventing use of cryptoassets for illegal transactions. Regulation of the European Parliament and of the Council on the prevention of the use of financial systems for the purpose of money laundering and terrorist financing COM(2021) 420 final, July 2021. Also, authorities have some possibilities of tracing cryptoasset transactions that can be linked to criminal activities. This is primarily the case if the cryptoassets are exchanged for various national currencies, because the traditional financial system has controls to improve customer due diligence to reduce the risk of money laundering. For example, authorities in the United States managed to trace almost 120,000 Bitcoins, currently worth roughly USD 3.5 billion, that had been stolen from the Bitfinex trading venue. A. R. Chow (2022), “Inside the Chess Match That Led the Feds to $3.6 Billion in Stolen Bitcoin”, 10 February 2022, TIME.