Can cryptos trigger macroeconomic and financial stability risks?

The cryptocurrency market peaked at $2.9 trillion in November 2021
Can cryptos trigger macroeconomic and financial stability risks?

Incumbent banks and traditional financial and monetary systems have long been at odds with the advent of cryptocurrency and its decentralized appeal to many. Many rushed to warn about its usage for money laundering activities on encrypted blockchains.

But these are no longer desperate calls from financial mogul institutions trying to hang on to a glorious past. Today there are legitimate concerns about the proliferation of cryptos, especially in emerging markets.

IMF and G20 issue warning

The International Monetary Fund (IMF) and the G20’s risk regulator, the Financial Stability Board (FSB), recently issued a joint white paper.  “Comprehensive policy and regulatory response for crypto-assets is necessary to address the risks of crypto-assets to macroeconomic and financial stability,” it said.

The cryptocurrency market grew from a nascent industry to one peaking at $2.9 trillion in November 2021. Harder times followed. Crypto’s market cap dropped some 75 percent within just one year of its all-time high.

Still, the two organizations believe that widespread adoption of cryptos would damage monetary policy. They also said that giving them legal tender status presents a threat to stability. Central banks have no solutions to adjust interest rates on a foreign currency. This would undermine monetary policy effectiveness.

Add to that the fact that granting such status would subject domestic prices to highly unstable conditions. This is due to the corresponding volatility of the crypto-asset used in conjunction with regular currencies.

But even if digital currency traders quote all domestic prices in a specific crypto-asset, the prices of imported goods and services would still experience significant fluctuations. These fluctuations are based on market valuations of the crypto asset used.

crypto financial

Regulating the crypto space

The current crypto winter and costly bankruptcies like that of FTX and Terra drew more attention to the dangers of digital money.

The potential disruption posed by crypto prompted the G20 to issue up to 9 regulatory recommendations to rein in the crypto industry.

But the core question remained: how to regulate crypto firms?

In order to protect economies from potential problems, jurisdictions should “safeguard monetary sovereignty and strengthen monetary policy frameworks, guard against excessive capital flow volatility and adopt unambiguous tax treatment of crypto assets”, the paper recommends.

The FSB and IMF also pointed at risks stablecoins posed, saying their widespread use could lead to fragmentation of global payments. This stemmed from the 2022 collapse of the Luna/Terra ecosystem.

Central bank digital currencies (CBDCs) were left out of the discussion, pending more adoption by major central banks.

Read: Unveiling the top countries embracing cryptocurrencies

Risk to less developed and emerging markets

The Consultative Group of Directors of Financial Stability comprises representatives from central banks of the U.S., Argentina, Brazil, Canada, Chile, and Mexico. It argues that crypto advocates endorse digital currencies as low-cost payment solutions and substitutes for national currencies. This is true, especially in countries suffering from high inflation.

“However, crypto assets have so far not reduced but rather amplified the financial risks in less developed economies. Therefore, they should be assessed from a risk and regulatory perspective like all other assets,” it said in a 50-page report.

Of the top 20 countries that have adopted the use of crypto, 18 are emerging markets. This includes Venezuela, El Salvador, and Nigeria where inflation and depreciating national currencies are ravaging their respective economies.

Crypto assets increase financial stability risks in emerging market economies. A weaker rule of law there makes it doubly harder to legally enforce crypto contracts. This raises the prospects of high market risks.

In weaker markets, lack of financial literacy and technological knowledge can potentially create a severe catalyst for risks. It can lead to financial instability, especially with crypto assets.

A look at premier markets shows the UK’s crypto ownership doubling in 2022, according to a Financial Conduct Authority report last June.  One in 10 holdings are in some form of crypto. Also, nearly 17 percent of US citizens have invested in or traded cryptocurrency in 2022, the Pew Research Centre said.

Types of market risks

1- Speculative bubbles

The risk of falling into a speculative bubble depends on how speculative the activity is in a digital currency. Stablecoins are not immune to this. They can be volatile in cases when real assets don’t properly back them. For example when the collateral is using yet another stablecoin or an algorithmic technique.

2- Illiquidity

While cryptos are decentralized by design, liquidity is channeled via market participants, most notably, digital currency exchanges. Many top exchanges, like FTX, have faced significant challenges to meet liquidity demand at times.  These failures drove these exchanges to bankruptcy causing the value of the digital currency to quickly drop.

3- Fraud

Fraud, money laundering, price manipulation, and deceptive activity are prevalent in crypto dealings. The Financial Times estimates that cryptocurrency scams increased by more than 41 percent in England and Wales between 2021 and 2022.  Practices like “rug pulls” are common during initial coin offerings (ICOs) where rogue promoters withdraw transactions from the offering after selling it, resulting in devaluating the digital currency used for such events.

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