ECB expresses concerns over ‘interconnectedness’ of crypto with financial institutions

The European Central Bank warned in its latest Financial Stability Review that the growing adoption of crypto assets by banks and other financial institutions could affect the region’s financial stability.

The review included a section titled:

“Decrypting financial stability risks in the crypto-asset market.”

According to the regulator, its comprehensive study on “leverage and crypto lending” shows that these activities are becoming more complex and risky.

Investors have been able to handle the €1.3tn fall in the market capitalization of unbacked crypto-assets since November 2021 without any financial stability risks being incurred. However, at this rate, a point will be reached where unbacked crypto-assets represent a risk to financial stability.

The crypto industry is undergoing intense scrutiny from regulators globally. A recent market crash wiped off close to $1 trillion from the sector in two months, and it has unnerved regulators.

The review acknowledged the growth of the crypto market, pointing out that trading volumes of crypto assets have reached or even surpassed “those of the New York Stock Exchange or euro area sovereign bond quarterly trading volumes” occasionally.

Meanwhile, crypto exchanges are also offering their customers more financial products, allowing them to increase their exposure far above their initial investment.

The report noted that the full scale of the connection between the crypto industry and traditional finance might be unknown as there are “significant informational and data shortcomings.”

Additionally, it listed the various instances of this connection between traditional financial institutions and crypto-assets. These include banks “trading and clearing derivatives,” payments networks supporting “crypto asset services,” and institutional investors “investing in bitcoin and crypto-assets more generally.”

The ECB also discussed the risks of DeFi, stating that rehypothecation, which is the practice of repledging already-pledged collateral against another loan, has increased the chances of a breach of leverage limit.

The report concluded that authorities worldwide should work to close the regulatory gaps in the space while urging the EU to approve the MiCA regulation urgently.

This report rehashes the view of ECB President Christine Lagarde. In a recent interview, she had said that:

Crypto assets are highly speculative, very risky assets.

She added that there’s a need to regulate cryptocurrencies because those who’ll lose the most are those who don’t understand the risks.

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