A sharp shift has recently occurred in regulatory attitudes to cryptocurrencies and the crypto ecosystems of financial assets and services that originate from them. Whereas only a few years ago many regulators, especially in advanced economies, viewed cryptocurrencies as a symbol of technological advancement and embraced the ‘do no harm’ approach, it has become apparent today that the concerns are mounting over the growing risks. Not only is there talk of operational risks, exposure to cyber-attacks and fraud, and the wide use of crypto to fund a wide range of illegal activities and terrorism, but also of rising macroeconomic risks and systemic risks to financial stability.
If cryptocurrencies and financial instruments based on them are compared with cars, we can clearly see a change in consumer attitudes from admiration of their technological capabilities to the realisation that traffic and safety rules should be urgently developed and that monitoring and control systems should be rolled out to ensure that such rules work. These risks are particularly high in emerging market economies. This is why there is a need for a balance between the benefits of technological innovation and the risks of the financial innovation based on technological ones.
The coronavirus pandemic, or rather the accomodative monetary policy that has come with it, has spurred growth in global crypto capitalisation. By November 2021, crypto capitalisation had surpassed $2.6 trillion, an increase of 650% in the course of the year. The most recent IMF Global Financial Stability Report discusses the entire crypto ecosystem, including stablecoins, blockchains based on smart contracts, and decentralised finance (DeFi). Crypto ecosystems are increasingly turning to the use of borrowed funds for investment, pushing up the volatility of assets.
Importantly, the crypto ecosystem and regulated financial markets are becoming increasingly interrelated. For example, we have seen the emergence of exchange-traded funds (ETFs) of crypto assets, which enable investors to profit from the latter without direct interaction with crypto ecosystems. The interest of institutional investors in cryptocurrencies is also growing, as shown by a recent survey of 100 hedge funds in Europe, Great Britain, North America and Asia constituting about 12% of global hedge fund assets, according to the global monitoring of non-bank financial intermediation conducted by the Financial Stability Board. These hedge funds intend to increase their crypto investments to an average of 7% of their portfolios.
This explosive growth has increased the importance of the problem of risks. Some of these problems have drawn attention already, such as the operational risks, the growing risks of outright fraud (such as the crypto token inspired by Squid Game), the use of cryptocurrencies for money laundering and the financing of terrorism, the risks related to the lack of data, anonymity and the cross-border nature of operations. Focus has recently turned to the risks of regulatory arbitrage.
Despite their cutting-edge nature, the assets in question, although based on a new technological platform, are intended for standard or near-standard economic and financial purposes. For instance, many stablecoins are essentially nothing more than investment funds. Money and bond markets transactions may be conducted to shore up the stability of stablecoins, that is, there is an interdependence between asset-backed stablecoins and financial markets. Decentralised finance may in turn be a process for issuing debt instruments. Regulators are therefore concerned over the operation of such instruments in an unregulated environment.
The situation in advanced economies is increasingly resembling the shadow financial system, which was much discussed following the 2007–2009 crisis. Consequently, there has been stronger focus on regulation and supervision in this area in developed countries. In a recently published joint statement, US regulators voice their concerns over the risks crypto presents to banking institutions, their customers, and the overall financial system. Jon Cunliffe, deputy governor of the Bank of England, warned that digital currencies could trigger a financial meltdown unless governments step forward with tough regulations.
Developing countries are meanwhile confronted with additional risks. Ultimately, crypto assets constitute another tool for the conversion of savings into a foreign currency (the ‘cryptoisation’ of savings), thereby adding to financial stability risks (including by reducing banks’ deposit base) and weakening the impact of monetary policy. Money exits the real economy, with savings in cryptocurrencies being disengaged from the investment process, and may be spent in illegal transactions. Countries that institute capital controls are confronted with manifold drops in their efficacy. In this context, the once-popular idea that developing countries could make money by crypto mining has been moved to the back burner. To cite an example, we can see the crackdown by Chinese regulators to institute order in the crypto sphere, including a ban on both crypto investments and crypto mining. Incidentally, the ban on crypto mining is also intended to minimise the environmental risks associated with crypto mining [link in Russian].
Importantly, all of the above risks are clearly in evidence today, even before Big Tech companies have made any forays into the stablecoin market. Their entry into this market is certain to increase all these risks, and it will additionally create the risk that stablecoins — essentially money surrogates — are used as means of payment for goods and services.
Many of these risks are quite high in Russia. On many cryptocurrency exchanges, Russia is among the top three or top five countries by number of users. Some estimates show that Russian users generate bitcoin transaction turnover worth hundreds of millions of rubles per week, and they are active traders (.pdf) on popular crypto exchanges.
At the moment, the extensive involvement of Russians in the crypto system does not present financial stability or monetary policy risks. However, some risks from such involvement may already be relevant today, since cryptocurrency offers a work-around to AML/CFT (anti-money laundering/combatting the financing of terrorism) systems and threatens the loss of household investments as a result of both high volatility and outright fraud.
This leads to the need for further regulatory adjustments. The Bank of Russia is finalising a consultation paper on cryptocurrencies, to be published shortly, in which we intend to present our views in detail. Digital currencies are nothing more than money surrogates, and they must not be used for payments. The infrastructure currently operating in Russia for the exchange of cryptocurrencies for rubles or other currencies, such as points of exchange, enables the spread of cryptocurrencies and their use in shadow operations. That infrastructure should be stopped. It is also important that Russian financial companies do not themselves sell or help others sell derivatives or exchange-traded funds that use crypto as the underlying asset to Russian investors – neither qualified nor unqualified – including through their affiliated overseas companies.
Undoubtedly, this does not mean an aversion to the development of financial technology or a ban on digital financial assets issued in accordance with Russian laws. We need to ensure, however, that the digital financial assets in those cases are not used as means of payment. Furthermore, global experience suggests that we must address the looming need to avoid regulatory arbitrage. That is, we need to regulate the risks associated with the issue of specific types of tokens and possible transactions with them. Such regulation will be analogous to that of financial assets issued by regular financial institutions. Decentralised blockchain-based systems are often used to bypass regulation. In economic terms, tokens in decentralised systems may be clones of common financial instruments or a combination of them, but they fall outside the purview of their regulatory restrictions. This ultimately creates financial stability risks. Therefore, as high-tech innovation moves into mainstream finance, the risks of the financial innovation it brings should be monitored and regulated.