Bundesbank deputy president: Do crypto assets pose a threat to financial stability?

Author: Claudia Buch, Vice President of Deutsche Bundesbank; Compiler: TaxDAO

Original article published on April 25, 2023

So far, the crypto market is small, with a market capitalization of about 0.2% of global financial assets. However, if we have learned anything from the past, it is that even seemingly trivial difficulties can trigger financial crises. Cryptoassets promise to provide financial services in innovative ways, much like the securitization of financial assets did in the 1990s. Securitization is considered an innovation aimed at improving the distribution of risk in the financial system. It also started small in the 1980s and only grew in 2007 to annual issuances of about half of outstanding mortgages and consumer loans. Likewise, the U.S. mortgage market is considered to be of relatively minor importance—it only caused a shock to the global financial system in 2007-2008.

Therefore, early assessment of risks to financial stability is important. In short, financial stability means ensuring that its services are available to the real economy even in times of stress and structural change. Currently, the world of crypto assets is not closely connected to the traditional financial system or the real economy. This may be good news. Failures and stress in these markets may not threaten financial stability. But it could also mean the opposite: Perhaps cryptoassets and their underlying technologies have little real value-add, while at the same time, high leverage in a largely unregulated market could lead to instability in the core financial system?

Before answering these questions and setting out the need for regulatory action, let's outline how we assess financial stability. In part two, I will apply these concepts to the crypto asset market.

1. What is critical for financial stability?

Different indicators are used to capture the systemic importance of financial institutions. Banks are classified as important or less important institutions based on their degree of regulatory and supervisory impact. Banks are classified using indicators including size, interconnectedness, common risk exposure, complexity and substitutability. Before comparing the core financial system with the cryptoasset system based on these indicators, it is important to emphasize that the quality of the information is completely different. For the core financial system, especially banks, the information quality is high. Banks are highly regulated and required to provide relevant reports. These reporting systems were significantly upgraded in the wake of the global financial crisis, at a heavy cost to both banks and government authorities. These efforts are paying off: we now know much more about the linkages, risk exposures and risk concentrations in the financial system. The information is not perfect, but it does a pretty good job of filling in the gaps identified during the financial crisis, and work continues.

In the world of cryptoassets, it’s a very different story. Cryptoasset markets are not yet fully regulated, which means there are hardly any reliable reporting systems. Some may think this is unnecessary. After all, one of the promises of cryptoassets is transparency. All information should be public and accessible to everyone. But public transaction data is insufficient to monitor and assess risks in the cryptoasset market. For example, transactions cannot be tied to a specific individual, and many cryptoassets are traded “off-chain.”

Unless appropriate reporting standards are adopted, we may only rely on information provided voluntarily. Such information is difficult to verify and may be manipulated. This risk is especially high for self-reported content from unregulated exchanges. There is indeed growing evidence of price manipulation, which occurs more frequently in illiquid markets. Most of the data I use below on crypto assets comes from public sources. It has been tested for plausibility, including comparisons with data from other sources, but should still be treated with caution.

Let us first look at indicators of systemic risk in the banking system.

1.1 Scale

The larger the bank, the larger its system footprint. Generally speaking, the banking system is dominated by a very small number of very large players. Therefore, idiosyncratic shocks affecting these institutions can have consequences for the entire financial system. The German banking industry is no exception, with the top 1% of banks accounting for 51% of the market in terms of total assets. A large number of small banks - more than 1,300 savings banks or cooperatives - together account for 41% of the market

The systemic footprint of large banks cannot be directly observed. However, statistical indicators can be used to indirectly assess this impact. For example, a related question is how the potential capital shortfall of a large bank under stress is related to the capital shortfall of the financial system as a whole. This is what the Co method measures (below). This indicator of the German financial system has recently shown that the level of systemic risk has declined. However, current levels are still higher than before the global financial crisis.

In the aftermath of the 2007-2008 global financial crisis, the G20 initiated financial sector reforms to reduce "too big to fail" problems. Banks have become so large that their disorderly collapse would cause significant disruption to the broader financial system and economic activity.

In times of distress, systemically important banks are often bailed out by governments. They benefit from an implicit guarantee that becomes especially explicit in times of crisis. This changes incentives: If the risk is ultimately borne by taxpayers, financing costs may not fully reflect the risk, creating incentives for excessive risk-taking, balance sheet growth, and management compensation. To mitigate these risks, stricter capital requirements and supervision of systemically important banks will need to be imposed. The Financial Stability Board, an international body that oversees the global financial system, assesses the effectiveness of these reforms.

1.2 Interconnectivity

Size alone is not a sufficient indicator of system importance. Smaller banks may also be systemically important if the financial system is highly interconnected and banks face the same types of risks (such as interest rate risk).

One channel for interconnection is the interbank market. During the global financial crisis, liquidity provided through the interbank market suddenly dried up. Banks cut each other's credit lines as uncertainty over counterparty credit risks grew. As a result, interbank assets and liabilities fell from 19% to 8% of total German bank loans from 2008 to 2022, while at the same time the liquidity provided by the central bank increased.

While the interbank market is the channel for direct effects of the financial system, shared exposure to the same shock can lead to indirect effects. This risk is particularly acute at this critical moment. Higher interest rates and higher risks to the growth outlook expose vulnerabilities that have built up over time in the financial system. Maturity transformation exposes banks to interest rate risk. Adverse shocks to the real economy may increase banks' credit risks to a considerable extent.

1.3 Complexity

A highly complex entity may be systemically important. Complexity can have different dimensions, such as derivatives volume, large number of (international) affiliates or operational complexity. The more complex a bank is, the more costly and time-consuming it will be to resolve the problems it faces. Cross-border resolution of such entities requires coordination between authorities in multiple jurisdictions. A vivid example of the resolution of a complex entity was the bankruptcy of Lehman Brothers, which took 14 years to resolve.

1.4 Substitutability

Very specialized financial services providers may be systemically important even if they are small or less sophisticated. Infrastructure providers such as payment system services are one example. If such an institution becomes troubled or even fails, other services will be disrupted and liquidity may dry up. The more specialized an agency is, the more expensive it is to replace its services.

1.5 Leverage

Leverage in the financial system has caused financial crises time and time again. High leverage makes borrowers vulnerable to adverse shocks such as rising interest rates or reduced income. This increases credit risk and results in losses for financial institutions. Undercapitalized (i.e., highly “leveraged”) financial institutions responded by cutting back on the provision of financial services and credit, which had a negative impact on the real economy. The reform agenda over the past decade has therefore been focused on reducing the leverage of the financial system. Banks are indeed better capitalized than in the past, while private and public sector leverage continues to rise.

2. Are cryptoassets related to financial stability?

There is no simple metric for measuring "financial stability." Rather, financial stability is formed by the complex interplay between the financial products on offer, market structure, the leverage and governance of financial institutions, regulation, and the motivations and objectives of those who provide these financial services. An important difference between traditional financial services providers (such as banks) and crypto asset providers is technology. Otherwise, many characteristics are similar – including potential risks to financial stability. So, let’s discuss these characteristics in turn, starting with what cryptoassets actually are.

2.1 What are crypto assets?

Currently, there is no unified definition of crypto-assets internationally. According to the Financial Stability Board (FSB), a cryptoasset is a “digital asset issued by the private sector that relies primarily on cryptography and distributed ledgers or similar technologies.”

Traditional financial systems use traditional IT infrastructure. Securities transactions and holdings are recorded in a central database (the "ledger") by a central securities depository. In contrast, cryptoassets are issued and recorded on a shared, distributed digital ledger (the “blockchain”). The most popular crypto-asset blockchains are public and permissionless. "Public" means that all transactions are visible to everyone, but are conducted in a pseudonymous manner: participants within the network interact through identification codes, but the actual identity of the participants is usually unknown. “Permissionless” means that anyone (a “miner” or a “validator”) can add new information by meeting the technical requirements using a computerized process for validating transactions (the “consensus mechanism”). Depending on the underlying consensus mechanism, the mining and verification of certain cryptoassets requires a large amount of computing power, making the process very energy-consuming. For example, the energy consumption of crypto-assets like Bitcoin is comparable to that of a mid-sized country like Spain. Despite these technical differences, crypto-assets share common characteristics with the traditional financial system: being traded on markets and exchanges, providing payment services, lending or using collateral in financial transactions.

There are two types of crypto assets that are related:

The first crypto-assets were “native” tokens. These assets are not backed by any physical or financial assets and are therefore labeled as “unsecured” cryptoassets. This distinguishes them from traditional financial instruments or currencies. Unsecured cryptoassets have no fundamental value, are not backed by any cash flow, and their prices are driven entirely by emotion. The two most famous native coins are Bitcoin and Ethereum. Native tokens are an integral part of permissionless blockchains as they reward miners or validators for solving transactions by adding new blocks to the chain.

The second crypto asset is stablecoins. Most of these currencies are pegged to central bank currencies such as the US dollar. Stablecoins were developed primarily to overcome the inefficiencies of traditional payment systems and reduce costs. Despite being called “stable,” the market valuations of stablecoins are actually quite volatile. Additionally, some stablecoins are not fully audited and only disclose their reserves on a voluntary basis. Therefore, the existence and composition of reserves cannot always be verified.

2.2 Scale and Market Structure

In 2021, the total market capitalization of all cryptoassets traded on exchanges reached an all-time high of approximately $3 trillion (chart below). In the first half of 2022, crypto asset prices plummeted. In addition to changes in the macroeconomic environment, price declines reflect the widespread use of leverage. Many crypto-asset intermediaries became insolvent, and the market value fell to $1 trillion in early 2023, accounting for only 0.2% of total global financial assets.

And the market is highly concentrated. The top six coins account for more than 70% of the market capitalization. As for stablecoin issuers, 90% of the market capitalization is concentrated in the three largest entities (chart below). A large portion of crypto asset trading occurs on a few platforms. Centralized crypto-asset service providers and crypto-asset groups simultaneously offer many different services, such as brokerage, trading, clearing, custody, and clearing and settlement. However, this concentration of activity may lead to conflicts of interest and excessive risk-taking.

Some cryptoasset activity has shifted toward decentralized finance (DeFi). In this model, financial intermediaries are replaced by autonomous (and self-executing) open source software protocols deployed on public blockchains. Unlike centralized crypto-asset exchanges where most transactions are initially settled outside of the blockchain network, decentralized all transactions are executed on the blockchain ("on-chain"). Modifications to software code should not be decided by a central authority, but by the "community" and a "governance token" that represents a voting power.

What sounds like a decentralized system is often highly centralized. Monitoring and governance of DeFi protocols are often in the hands of a small number of founders or developers, who gradually transfer relevant rights to the wider community. As a result, only a handful of projects operate in a truly decentralized manner.

A key metric for assessing the scale of DeFi is Total Value Locked (TVL), which reflects the sum of crypto assets that have been transferred to the underlying software code of DeFi protocols. These codes are called "smart contracts". These protocols can replicate a wide range of financial services, but currently the most important are lending and trading of crypto assets. After very strong growth in 2021, the size of the global DeFi market declined significantly in 2022, in line with the overall development of the cryptoasset market (chart below).

In the most important blockchains today, validators join the swarm. The resulting high concentration at the validator level may negatively impact the security and transparency of the blockchain.

2.3 Interconnectivity

The cryptoasset system is highly interconnected, as highlighted by the recent bankruptcies of many cryptoasset entities. Therefore, procyclical selling affects the overall volatility of the crypto asset market.

Common risk exposures in the cryptoasset system largely correspond to risk exposures in the traditional financial system. Especially since 2020, crypto asset prices have been responding to macroeconomic fundamentals such as monetary policy shocks. Prices have fallen sharply during the recent period of increased macro-financial risks, consistent with traditional asset classes such as equities (chart below).

In addition, cryptoasset systems face higher settlement and operational risks in a small number of blockchains. For example, nearly two-thirds of DeFi activity is based on the Ethereum blockchain as the settlement layer. Cryptoasset systems are also exposed to liquidity risks. Only a few stablecoins are critical to the liquidity of crypto asset trading, and they are also widely used as collateral for mortgage loans or margin trading. The liquidity of the cryptoasset system depends specifically on several stablecoins pegged to the U.S. dollar. They primarily support their tokens by investing in money market instruments. The system is therefore vulnerable to money market shocks.

At present, the crypto-asset system is not closely related to the financial system. As long as crypto-asset entities themselves do not have the necessary licenses, they rely on banks to serve as bridges between central bank money and the crypto-asset world for funding. However, as of the end of June 2022, only a handful of active international banks reported crypto-asset exposure, accounting for just 0.013% of total exposure.

2.4 Complexity

Cryptoasset providers can be very complex. Cryptoasset groups are similar to financial groups with complex risk profiles. Not only do they operate as pure exchanges, but they offer many different services within a single entity, including custody and derivatives trading.

In the traditional financial system, these activities are separated or subject to prudential requirements to prevent conflicts of interest. For example, in the case of FTX, there is no similar separation or adequate governance structure. Crypto Asset Group provides financial functions in multiple jurisdictions and operates through a global network of branches. Some companies are headquartered in unregulated offshore locations or have no known headquarters at all. Furthermore, in a decentralized system without a proper governance structure, it is difficult to enforce enforcement against specific people. This hampers efforts to regulate effectively through domestic regulators in the absence of international agreements on regulation and oversight.

2.5 Substitutability

Some blockchains and assets in crypto systems are difficult to replace in the short term. Currently, crypto systems are largely self-referential, and crypto assets are rarely used outside of crypto systems. This limits negative impacts on the broader financial system or the functioning of the real economy. However, in some developing countries the situation is different. For example, El Salvador declared Bitcoin legal tender. But even in countries that actively promote the use of cryptoassets as a means of payment, there still appear to be restrictions on cryptoassets.

2.6 Leverage

Whether in traditional finance or crypto asset markets, high leverage is a major risk to financial stability. High leverage amplifies boom and bust phases within the cryptoasset system, and it can become a conduit through which shocks to the traditional financial system propagate.

Leverage is a particular problem in the cryptoasset system, as collateral often consists of unsecured cryptoassets with no intrinsic value, and these assets tend to be highly volatile. Borrowed funds are often reused as collateral for other loans, creating a "collateral chain." In the event of a sudden price drop, assets held as collateral are automatically liquidated, amplifying the price drop and potentially causing a chain reaction.

Cryptoasset exchanges allow margin trading with increased leverage and lend cryptoassets to users, often in the form of collateral. In these margin trades, users can borrow crypto assets worth up to 20 times the value of the collateral. Some exchanges also offer leveraged derivatives, with leverage up to 100 times.

Leverage has indeed been a key transmission path during the recent market turmoil. The collapse of stablecoin TerraUSD in May 2022 resulted in significant losses for highly leveraged crypto-asset hedge funds. As a result, they were unable to meet margin calls, triggering the bankruptcy of crypto asset lending platforms. Additionally, FTX’s bankruptcy was caused by lending client funds to related entities engaged in margin trading.