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The already volatile world of crypto has once again been turned upside down by the collapse of one of its largest platforms, which has highlighted the risks of crypto assets lacking basic safeguards.

The losses punctuated an already perilous period for the crypto, which lost billions of dollars in market value. Bitcoin, the biggest, is down nearly two-thirds from its late-2021 peak, and around three-quarters of investors have lost money on it, according to new analysis from the Bank for International Settlements

in November.

During times of stress, we have seen market failures in stablecoins, crypto-focused hedge funds, and crypto exchanges, raising serious concerns about market integrity and user protection. And with growing and deepening ties to the core financial system, there could also be concerns about systemic risk and financial stability in the near future.

Many of these concerns can be addressed by strengthening financial regulation and supervision and developing global standards that can be consistently implemented by national regulatory authorities.

Two recent IMF reports on the regulation of the crypto ecosystem are particularly timely amid the severe turmoil and disruption in many parts of the crypto market and the repeated boom and bust cycles of the ecosystem around these digital assets.

Our reports address the above issues at two levels. First, we take a broad approach, looking at the key entities that perform essential functions within the industry, and therefore our findings and recommendations apply to the entire crypto asset ecosystem.

Second, we focus more closely on

and their facilities. These are crypto assets that aim to maintain a stable value against a specified asset or pool of assets.

New challenges

Crypto assets, including stablecoins, do not yet pose risks to the global financial system, but some emerging markets and developing economies are already significantly affected. Some of these countries are seeing large retail holdings and currency substitution through crypto assets, primarily dollar-denominated stablecoins. Some are familiar with crypto, when these assets substitute for currency and domestic assets and circumvent foreign exchange restrictions and capital controls.

Such substitution has the potential to cause capital outflows, loss of monetary sovereignty and threats to financial stability, creating new challenges for policymakers. Authorities must address the root causes of crypto by improving confidence in their national economic policies, currencies, and banking systems.

Advanced economies are also susceptible to crypto-related financial stability risks, as institutional investors have increased their holdings of stablecoins, attracted by higher rates of return in a previously low interest rate environment. Therefore, we believe it is important for regulators to address crypto risk quickly, without stifling innovation.

Specifically, we make five key recommendations in two Fintech Notes,

Regulating the crypto ecosystem: the case of unbacked crypto assets

Regulating the crypto ecosystem: the case of stablecoins and arrangements
both published in September.

1. Crypto-asset service providers must be licensed, registered and authorized. This includes those providing storage, transfer, exchange, settlement and custody services, with rules like those governing service providers in the traditional financial sector. It is particularly important that client assets are segregated from the company’s own assets and isolated from other functions. The criteria for granting licenses and authorizations must be well defined and the responsible authorities clearly designated.

2. Entities performing multiple functions should be subject to additional prudential requirements. In cases where performing more than one function could generate conflicts of interest, authorities should consider whether to prohibit entities from doing so. Where companies are allowed to perform multiple functions, and do so, they should be subject to strict transparency and disclosure requirements so that authorities can identify key dependencies.

3. Stablecoin issuers should be subject to strict prudential requirements. Some of these instruments are beginning to gain acceptance beyond crypto users and are being used as a store of value. If not properly regulated, stablecoins could undermine monetary and financial stability. Depending on the model and size of the stablecoin arrangement, strict banking-like regulation might be required.

4. There should be clear requirements for regulated financial institutions regarding their exposure and engagement with crypto. If they provide custodial services, the requirements should be clarified to address the risks arising from these functions. The recent Basel Committee on Banking Supervision standard on the prudential treatment of exposures to banks’ crypto assets is recently welcome in this regard.

5. Ultimately, we need robust, comprehensive, and globally consistent crypto regulation and oversight. The cross-industry and cross-border nature of crypto limits the effectiveness of uncoordinated national approaches. For a holistic approach to work, it must also be able to adapt to a changing landscape and risk perspective.

Control user risks will be difficult for authorities around the world given the rapid evolution of crypto, and some countries are taking even more drastic measures. For example, in Sub-Saharan Africa, the smallest but fastest growing region for crypto trading, almost a fifth of countries have

bans enacted
of some kind to help reduce risk.

While blanket bans may be disproportionate, we believe targeted restrictions offer better policy outcomes provided there is sufficient regulatory capacity. For example, we may restrict the use of certain crypto derivatives, as shown in Japan and the UK. We may also restrict crypto promotions, as Spain and Singapore have done.

Yet, although developing global standards takes time, the Financial Stability Board has done a great job providing recommendations for crypto assets and stablecoins. Our Fintech Notes draw many of the same conclusions, reflecting our close collaboration and shared insights into the market. For its part, the IMF will continue to work with global bodies and member countries to help key policymakers working on this topic best serve individual users as well as the global financial system.

—This blog reflects the research contributions of Parma Bains, Fabiana Melo, and Arif Ismail

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