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The ECB warns that banks' ties to crypto and DeFi could jeopardize EU financial stability.

Updated: Sep 26, 2022

The ECB warned today that European banks' ties to crypto and DeFi could jeopardize financial stability.

The European Central Banks announced that they had conducted a a deep dive into cryptoasset leverage and crypto lending" and discovered evidence that it was becoming more risky, complex, and interconnected with traditional institutions.

The ECB said in a report released on Tuesday that links between eurozone banks and crypto assets "have been limited so far."

Some international and eurozone banks are "already trading and clearing regulated crypto derivatives, even if they do not hold an underlying cryptoasset inventory," according to the Frankfurt-based regulator.

Large payment networks have "stepped up their support of cryptoasset services," according to the ECB. Meanwhile, institutional investors are "now investing in bitcoin and cryptoassets more broadly."

Since last year, German institutional investment funds have been allowed to invest up to a fifth of their holdings in crypto assets, according to the bank led by President Christine Lagarde.

The availability of crypto-based derivatives and securities listed on exchanges aided such investments.

The ECB also warned about the dangers of decentralized finance, or DeFi, in which cryptocurrency-based software programs provide financial services without the use of middlemen like banks.

"Crypto credit on DeFi platforms grew by a factor of 14 in 2021," it said, "while the total value locked was hovering at around €70bn until very recently, on a par with small domestic peripheral European banks."

Leverage limits were more likely to be breached due to rehypothecation, which allows collateral for one loan to be pledged against another.

According to a recent ECB survey, one out of every ten EU households "may own cryptoassets," though most have less than €5,000 invested in the sector.

A Fed survey released on Monday found that in 2021, 13% of US adults held or used cryptocurrencies.

"Investors have been able to handle the €1.3tn fall in the market capitalisation of unbacked cryptoassets since November 2021 without any financial stability risks being incurred," the ECB said.

"However, at this rate, a point will be reached where unbacked cryptoassets represent a risk to financial stability."

One commentator recently told Bloomberg tv that cryptocurrency was "a limited amount of nothing."

Since November, Bitcoin's value has halved, and it recently fell below $30,000 for the first time since last summer.

Similarly, tether, the market's most important stablecoin, lost its peg to the US dollar for a brief period, while its rival terraUSD nearly collapsed.

According to data compiled by The Block Crypto, the world's largest crypto exchanges processed nearly $700 billion in spot trading and $1.1 trillion in bitcoin futures last month.

Cryptoasset trading volumes have "at times been comparable with or even surpassed those of the New York Stock Exchange or euro area sovereign bond quarterly trading volumes," according to the ECB.

Some crypto exchanges are providing loans to customers, allowing them to increase their exposures by up to 125 times their initial investment, according to the bank.

"Significant informational and data shortcomings persist," implying that "the full extent of possible contagion channels with the traditional financial system cannot be fully ascertained."

A crypto token is "worth nothing, it is based on nothing, there is no underlying asset to act as an anchor of safety," ECB President Christine Lagarde said this weekend on Dutch television.

An ECB executive, Fabio Panetta, had previously compared the industry to a "Ponzi scheme" and called for regulatory action to prevent a "lawless frenzy of risk-taking."

The ECB stated that EU legislation on crypto assets would not take effect until at least 2024.

"Given the speed of crypto developments and the increasing risks, it is important to bring cryptoassets into the regulatory perimeter and under supervision as a matter of urgency," the report stated.


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