the year 2022 began, the crypto market started to show signs of decline after reaching all-time highs in 2021. At this time, there were two conflicting ideas about the potential risks that crypto could pose to financial stability:

The events of 2022 (TerraLuna, 3AC, FTX…) appeared to support the latter viewpoint. However, this does not mean that crypto cannot evolve into becoming a greater risk to financial stability. For crypto to reach the status of “too big to fail”, it will be necessary to regain a significant market capitalization and increase its interconnection with other capital markets.

Much research has been conducted on the growing connections between crypto and traditional finance. Let’s have a look at the main ways in which crypto crashes can become even more nightmarish:

Crypto and stablecoins as a capital flight risk

According to data analysis by World Bank researchers, there is significant evidence that Bitcoin is being used as a vehicle for international capital transfers, including capital flight.

The research, which analyzed 45 million trades on the Bitcoin network across 135 countries, challenges the commonly held belief that Bitcoin is primarily used for speculation and little used for transaction purposes. It calls for a deeper understanding of how international capital flows are impacting broader cross-country macroeconomic transmission.

Furthermore, the International Monetary Fund (IMF) has warned that cryptocurrencies such as Bitcoin have been channels for capital flight during times of currency collapse and loss of faith in a country’s banking system, leading to increased capital flow and exchange rate volatility, which can complicate domestic policy management and have negative effects on economic and financial stability.

Dollarization, de-Dollarization, and “cryptoization”

There are differing perspectives on the impact of increased crypto adoption on the dominance of the US dollar. One viewpoint, held by the IMF, is that dollar-denominated stablecoins are becoming increasingly popular in emerging markets and developing economies as a potential store of value and hedge against inflation and exchange rate volatility.

This trend could lead to dollarization and cryptoization of these economies, particularly if digital versions of well-known currencies such as the dollar become easily accessible worldwide. This viewpoint is shared by many developing world central bankers, including India’s Shaktikanta Das who has highlighted that crypto may lead to dollarization in countries such as India as the prices of crypto tokens are mostly denominated in dollars.

On the other hand, some argue that the efforts of countries like China and Russia to undermine the US dollar can be aided by the rise of crypto as a viable alternative for international payments and transfers, potentially reducing the demand for and influence of the US dollar in international trade.

Stablecoins competing with the banking system

The Federal Reserve (Fed) published a paper analyzing the potential impact of stablecoins on the banking system. They considered three different scenarios based on the composition of the reserves:

The researchers concluded that a two-tiered banking system can support both stablecoin issuance and traditional forms of credit creation. However, a narrow-bank stablecoin framework may bring more stability but at the potential cost of credit disintermediation.

The Fed Bank of New York raised concerns that using safe and liquid assets in a stablecoin arrangement means they are not available for other uses, such as helping banks to meet regulatory requirements for sufficient liquidity, which could lead to disruptive shortages of safe and liquid assets.

ECB Executive Board Member (and Digital Euro zealot) Fabio Panetta stated that, in times of difficulties, market players may turn to alternatives like commercial bank money or stablecoins. This would entail a number of risks, such as central bank money having a reduced role in settlement processes, as well as trading and liquidity becoming fragmented.

Banks’ exposure to crypto assets

The IMF has previously warned that the involvement of large financial institutions in areas such as reserve management, custody, and issuance has the potential to rapidly generate new risks. In January 2023, three U.S. bank regulators — the Federal Reserve (Fed), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) released a joint statement on the risks of crypto-assets to the banking industry.

They highlighted eight major risks that banks should be aware of, including the risk of fraud and scams, legal uncertainties, inaccurate or misleading representations or disclosures, significant volatility in the crypto market, susceptibility of stablecoins to run risks, contagion risk due to interconnectedness within crypto, weak risk management and governance in crypto, and heightened risk of public or decentralized networks.

Foreign CBDCs replacing domestic currencies

Even though digital money has existed for decades and Central Bank Digital Currencies (CBDCs) may not utilize crypto technology, it is important to mention them in the context of financial stability risks related to digital assets.

A July 2021 report by the Bank for International Settlements (BIS) stated that the emergence of CBDCs “could contribute to more widespread currency substitution through the adoption of a foreign CBDC, particularly in countries with high inflation and volatile exchange rates” which “would undermine monetary policy independence and poses risks for both the issuing and receiving countries.”

DeFi and asset tokenization

As The Boston Federal Reserve has noted, the Decentralized Finance (DeFi) ecosystem is currently relatively small compared to the overall financial system. As such, even significant disruptions in the DeFi space would have minimal implications for the financial stability of the broader financial system.

However, if current trends continue, many of the risks that have been identified may have financial stability implications for the broader non-DeFi financial system. This is because the ability to build large leveraged positions and conceal trades, combined with the novelty of the financial products that allow such leverage, have been common elements in financial crises throughout the past century.

If DeFi products become sufficiently widespread, an event that undermines confidence in the leveraged positions could potentially lead to a financial crisis.

The growing pains of becoming too big to fail

As crypto markets continue to grow and gain mainstream acceptance, it is crucial to consider the potential risks it poses to financial stability. The fact that the events of 2022 did not result in major rippled effects in the broader financial system may be misleading, as crypto still trades mostly into the void.

However, it is important to remember that where there is risk, there is also opportunity. By identifying and addressing potential risks, we can create a stronger and more stable marketplace, and — why not? — potentially come up with an idea that becomes the next crypto unicorn.

https://medium.com/market-for-ideas/what-happens-when-crypto-is-too-big-to-fail-23fad3fbcf3