While the impact of FTX’s collapse were largely restricted to the digital asset industry, with the exchange’s investors and users naturally taking the biggest hit, one effect the dramatic crisis did have outside of the space was to put the concept of systemic risk back onto the agenda.
Despite the U.S. Federal Reserve declaring that FTX doesn’t threaten the stability of the broader financial sector, several recent regulatory and legislative initiatives have focused on attempting to rain in the ‘wild west’ of the digital asset space and, in the process, mitigate the potential for a future FTX style crisis infecting ‘traditional markets.’
However, both the level of the threat posed by the industry and the best way to deal with it are matters of differing interpretation.
The Federal Reserve in the U.S. and the European Securities and Markets Authority (ESMA) both consider digital currency markets do not pose a systemic risk to the broader global economy, while the Bank of England, the U.S. Financial Stability Oversight Council (FSOC), and the Reserve Bank of India (RBI) broadly agree that digital assets don’t currently pose a risk, they all voiced concern about the industry’s potential for risk.
In order to unpick what systemic risk the digital asset industry does or does not pose, it’s necessary to examine the concept itself and how it may be assessed, as well as what regulatory bodies around the world are saying on the topic.
Defining systemic risk
Steven Schwarcz, professor of law and business at Duke Law, attempted to define systemic risk in his 2008 paper on the subject:
‘the risk that (i) an economic shock such as market or institutional failure triggers (through panic or otherwise) either (X) the failure of a chain of markets or institutions or (Y) a chain of significant losses to financial institutions, (ii) resulting in increases in the cost of capital or decreases in its availability, often evidenced by substantial financial-market price volatility.’
This chain of economic consequences that characterize systemic risk spreads through linkages and interconnected markets and institutions, eventually leading to, potentially, the collapse of an entire financial system.
The classic example of this in action is a ‘bank run,’ in which the inability of a bank to satisfy withdrawal demands causes its failure, in turn causing other banks or their creditors to fail—the Great Recession of 2008-09 saw several bank runs that exacerbated the crisis.
The picture gets complicated when the term ‘systemic risk’ is overused and attributed to areas that would not cause this cascade of consequences leading to a complete collapse of the system.
“It isn’t helpful in the discussion to call something that is just ‘market disruption’ systemic, when it doesn’t meet the bar for seriousness and would never have caused an economic recession,” explains Dr. Jon Danielsson, reader in Finance at LSE and Director of the ‘Systemic Risk Centre,’ speaking with CoinGeek.
“What the discussion tends to get wrong is that there’s a tendency to ascribe a cause of the systemic crisis that doesn’t meet this high threshold.”
Danielsson suggests that this high bar for the root ’cause’ of a systemic crisis, in the context of the financial world, is whether the consequences of the event would reach the general public, negatively impacting ordinary people’s lives.
Whether digital assets or the entire digital asset market poses enough of a risk to traditional finance systems that could eventually impact ordinary (non-digital asset investor) people, revolves around three key questions: How large and influential, in comparison to the economy as a whole, is the digital asset market? How stable is it? And how interconnected is it to the traditional financial system and the broader economy?
Of these three key questions, the first two are more straightforward to address.
A leaky boat in a vast ocean
As of January 1, 2023, the total market capitalization of the digital asset space was less than $1 trillion, $840 billion, to be more precise, whereas global bank assets alone stand at over $180 trillion.
So, while the size of the digital asset market is large, it still represents less than 1% of the global financial economy. This, in theory, means it doesn’t represent a substantial enough percentage of global finance to pose a systemic risk if it were to collapse.
“The discussion should be about public concern, not individual i.e. investors,” Danielsson explains.
“Within the banking space we have the concept of systemically important financial institutions – HSBC, JP Morgan, Citibank and the like – in comparison, nothing that happens in the crypto world could materially affect these institutions.”
The size disparity between the types of banking and finance institutions that Danielsson names, and even the top digital assets, decentralized autonomous organizations (DOAs), and exchanges, are vast. As U.S. Treasury Secretary Janet Yellen recently acknowledged, even at its height of $3 trillion in November 2021, a collapse in the industry would not have posed a systemic risk.
The fact that investors and markets have been able to handle the €1.3 trillion ($1.4 billion) fall in the capitalization of digital assets since November 2021 without any broader financial stability risks being incurred is more evidence of the digital asset industry’s relative influence.
In terms of the stability, or lack thereof, in the digital asset space, its volatility is notorious. Issues can stem from potential malicious actions such as cyber-attacks, the collapse of speculative or fraudulent schemes, technology-related disruptions, and governance or mismanagement issues.
2022 alone saw the unpegging from the dollar of TerraUSD in May, which led to a collapse of the so-called stablecoin as well as its sister token LUNA; the Mango Markets manipulation attack in October, where $110 million of assets were drained from the DeFi exchange; and, of course, the collapse of digital asset exchange FTX, where so far millions of dollars remain unaccounted for, with many users and investors losing all their assets.
With each crisis came a hit to the overall market value of digital assets as investors lost faith, often followed by an upturn encouraged by all-in enthusiasts doubling down—the market capitalization graph of 2022 resembles a minimalist sketch of the alps.
The volatility of the digital asset space makes it a concern for investors. Still, the relative size of the market means that the effects of these downturns are unlikely to spread to the general public or even other industries. Rocky seas are also not unique to the digital asset space. ‘Traditional’ financial and capital markets are no strangers to bull and bear cycles, but they have the added risk that comes when values reach the tens of trillions.
So, while volatility might be high, values are low enough (relatively) to mitigate systemic risk.
While agreement might differ on the potential risks the digital asset market poses to the broader economy, a consistent opinion amongst commentators and regulators alike is that systemic risk increases with the level of interconnectedness between the financial sector and the digital asset market.
Fortunately, depending on your perspective, current connections appear limited. As Danielsson points out, “the real economy doesn’t depend on crypto for anything and therefore that danger is gone. If there’s a major industry crisis and Bitcoin, Ethereum and all the others went to zero in value, it would only be a tragedy for the investors. It wouldn’t cross over and harm the ‘real economy’.”
This might currently be the case, but interconnectedness with the ‘real economy’ has been growing. Areas such as leverage and lending activity are an example, but a more important and controversial point of interconnection with traditional financial systems is the so-called stablecoins.
The FSOC, in its 2022 report, highlighted the inherent risks of stablecoins, recognizing “the importance of strong regulation of stablecoins given run risk, payment system risks, and risks of greater concentration of market power they pose.”
These are all pressing concerns regarding the go-to stablecoin that has spread its roots across huge swathes of the digital asset industry, Tether (USDT).
Used as a tool for integrating new money, managing and growing liquidity, leveraged trading, and pricing digital assets, the influential stablecoin is the largest by circulation and the third-largest digital currency by market cap.
In 2019 Tether LTD was sued, along with its sister company Bitfinex, by the New York Attorney General Leticia James, who alleged the company was printing unbacked money to cover up an $850 million loss suffered by Bitfinex. The pair eventually settled, but in the agreement, the Attorney General shows that for periods of time, Tether LTD didn’t have the reserves to back the USDT in circulation.
If such an un-pegging were to happen again, and publicly this time, the knock-on effects on a digital asset industry that’s over-reliant on the coin could be catastrophic. Yet while it poses a systemic risk to the industry ecosystem, it’s unclear whether a Tether crash would substantially impact the broader economy.
Like many stablecoin issuers, Tether backs its coins with fiat currency and a range of other traditional assets. Traditional asset markets could therefore experience dislocations if stablecoin activities were to obtain significant scale, with runs on stablecoins leading to fire sales of the conventional assets backing the stablecoins.
Again, these are currently marginal risks. The threat Tether poses at the moment is primarily to the digital asset space itself. However, were a country to tie its economy to a digital currency, then the risk Tether, or other influential digital assets, poses to the industry could become a more systemic crisis.
El Salvador made itself a case study for the potential effects of a digital asset-linked economy when in 2021, President Nayib Bukele made BTC legal tender.
This came alongside the issuing of subsidies to rural Salvadorians via hot wallets, subsidized block reward mining efforts using renewable energy, and more recently, the passing of the bill that proves the framework for a BTC-backed bond, or “Volcano Bond,” which Bukele hopes will eventually fund a planned city shaped like the BTC symbol.
Putting the various issues that came with this move aside for a moment—such as the IMF pulling out of a much-needed loan and the President subsequently having to go cap in hand to China to pay the country’s debts—El Salvador now presents a microcosm example of the systemic risk that certain digital assets could pose if it were to be more broadly spread and adopted by mainstream economic systems.
If BTC, or the USDT that it’s so reliant on, tanks, one of El Salvador‘s national currencies will be worth nothing, and the infrastructure that Bukele has forced onto the country will be a useless waste of precious funds—even more than it is already.
As Danielsson explains: “If there’s one country in the world, where crypto might pose a systemic risk it is El Salvador, recent drops in the price of Bitcoin are already causing problems in the country.”
These problems include the $107 million of public money that Bukele spent on BTC, currently worth a little over $40 million.
However, Danielsson reiterates that despite the country’s precarious situation, “it is a tiny part of the global economy, digital assets are systemic there, but it’s the only country in the world so far where that’s the case. Of course, if the U.K. or the U.S. decided to go down the same road, digital assets will become more important.”
If companies in the U.K., the U.S., and elsewhere started using digital assets as part of day-to-day business operations; if you could get paid in digital assets; if you went about your economic life using them and companies used them in their critical operations, that changes everything. But currently, that is just a thought experiment “that is not crypto today,” as Danielsson says, “that’s how crypto enthusiasts see the future and if it succeeds then it becomes pertinent, but it is certainly not relevant in the year 2023”.
A status quo of limited risk
It appears then that the institutional consensus is right. Digital currency does not pose a substantial systemic risk at this time. So why all the talk around the possible infection of the digital asset space could pass to traditional finance?
Danielsson suggests that some of the overuse of the term might be tactical as there is a certain weight, in terms of vigilance and scrutiny, that comes with being labeled a ‘systemic risk,’ a weight that doesn’t follow if something is just a risk to a few unlucky investors.
“It is often political, if you want to attack digital assets it’s an easier tack to say ‘systemic’, which I don’t think is true,” he says.
So, it might benefit the arguments of those who favor stronger regulation, or perhaps those that are fundamentally against the digital asset industry, to over-state the risk the sector poses to the broader economy in order to heighten the scrutiny of it—the finance equivalent of shouting “fire” in a crowded room, “systemic risk” gets a bigger reaction than “market disruption.”
Either way, the cry worked, and regulatory bodies worldwide have been increasingly assessing the risk the industry poses in light of the dramatic FTX collapse.
Regulatory opinions across the globe
In its October 2022 report on “Crypto-assets and their risks for financial stability,” the European Securities and Markets Authority (ESMA) concluded that: “Until now, turmoil in the market for crypto-assets (much of which can be attributed to the inherent vulnerabilities in the market structure and underlying technology) has not spilled over into traditional financial markets or the real economy.”
The ESMA attributed this lack of spillover to the relatively small size of the industry and the fact that “interlinkages to traditional markets are limited.” However, it did note that the transmission risk would become heightened if the market grew.
The report recommended continued vigilance and monitoring, as well as the swift implementation of the Markets in Crypto-Assets (MiCA) regulation, which is likely to come into force in 2024. MiCA will bring classifications of different digital assets and regulatory regimes adapted to different assets, which should further mitigate any emerging systemic risks.
Just a short ferry or Eurostar ride away, the Bank of England published its financial stability report in July 2022, which noted how digital assets valuations had fallen sharply, exposing some “vulnerabilities” within markets.
The report suggests that, while these events did not pose risks to financial stability overall, “unless addressed, systemic risks would emerge if cryptoasset activity, and its interconnectedness with the wider financial system, continued to develop.”
It underscored the need for “enhanced regulatory and law enforcement frameworks” to address developments in the digital asset space.
Some of these frameworks are incoming, and the U.K. Financial Conduct Authority (FCA) had a busy 2022 drafting regulation to bring digital assets more into the enforcement fold, including digital asset financial promotions being brought into the same regulatory regime used for other types of financial promotion; and stablecoins used as a form of payment being brought into the U.K. payments regime.
Across the Atlantic, the Federal Reserve (U.S.) has been assessing the risks that the FTX collapse poses to the broader economy.
In a December 2022 policy-setting meeting of the Federal Open Market Committee and the Board of Governors of the Federal Reserve System, it was determined that the FTX collapse did not pose a risk to financial markets outside of the digital asset space, stating “while the spillovers from this situation had been significant among other crypto lenders and exchanges, the collapse was not seen as posing broader market risks to the financial system.”
The fact that the collapse of a prominent exchange causes such little concern, warranting only two sentences in the committee minutes, speaks for itself with regard to how the broader economic risk of the digital asset industry is perceived by traditional financial institutions in the U.S.
The FSOC agreed that the digital asset market doesn’t currently pose a substantial threat, but in its report on digital asset financial stability risks and regulation, the organization was keen to point out that if interconnections were to grow without being paired with appropriate regulation, including enforcement of the existing regulatory structure, it could begin to pose a risk.
When it comes to appropriate regulation, the Digital Commodities Consumer Protection Act (DCCPA) of 2022 will be a major change once put into force and aims to provide clarity over enforcement jurisdictions, giving the Commodities Futures Trading Commission (CFTC) exclusive jurisdiction over digital commodities trading including, crucially, BTC and Ether.
Turning to the world’s fifth largest economy by GDP, last year, the Reserve Bank of India (RBI) went further than most in its warnings by highlighting digital assets among the major contributors to a rise in the global financial market and general risks, in a systemic risk survey as part of its December 29 Financial Stability Report.
The report also pointed to the collapse of FTX, hedge fund Three Arrows Capital (3AC), and stablecoin Terra/Luna, among examples of interconnected weaknesses in the sector.
While these stronger warnings contradict other global financial institutions that deemed the risks of such collapses industry-wide but not economy-wide, the RBI report did admit that the volatility of digital assets hasn’t yet spilled over into the formal financial system.
The solution to systemic risk?
Despite broad agreement that the status quo of the digital asset industry doesn’t currently pose a threat, there is enough concern about future growth in value and increased interconnectedness with traditional markets that it’s worth considering what the possible solution is to systemic risk and how they might apply to digital assets.
In his 2008 paper on System Risk, Steven Schwarcz concluded that a regulation establishing a “liquidity-provider of last resort” would be the most effective approach to minimizing systemic risk.
This public liquidity provider of last resort would provide liquidity to help prevent “critical financial intermediaries” from defaulting and/or failing. This approach seems a logical way to save the ‘too-big-to-fail’ financial institutions whose failure could cause a chain reaction that leads to a general economic crisis, but would essentially amount to a bailout—an unpopular concept at the best of times.
Bailouts with public money, ‘for the greater good of the economy,’ might make sense but are often hard to sell to the average consumer who sees no connection between themselves and the fraudulent or mismanaged organization being bailed out with their tax money.
There are possible alternative solutions that don’t rely on quasi-bailouts.
Danielsson suggests that systemic risk in the finance sector is higher now than it was before 2008 and not because of any specific event but due to the misguided way we regulate banks. He believes that regulators and institutions, such as the Bank of England, are forcing banks to measure risk and react to risk in the same way, “which makes the industry in aggregate act as a herd, as one entity, and in times of stress they all have to buy and sell at the same time.”
This means that if a sufficiently bad shock happens, Russia’s invasion of Ukraine, for example, the banks are forced to handle the shocks in the same way, then there’s a real danger that the financial system ends up as a “shock amplifier instead of a shock absorber.”
Therefore, what is needed is actually a more nuanced approach to banking regulation, not a one-solution or one-reaction fits all approach.
If an ability to act individually is beneficial in times of crisis, then the position of certain digital assets outside the restrictions of traditional finance regulation and banking governance could have been seen as a benefit, if a systemic shock came along. However, as numerous court cases, prosecutions, and regulatory changes worldwide have shown, digital assets increasingly no longer live outside of the ‘system.’
“Something I think that a lot of enthusiasts and users of digital assets are reluctantly coming to terms with is that they cannot exist outside of the domain of the financial regulators,” Danielsson says.
“I think what we learned the past couple of years is that if digital assets become successful, the authorities have the power to bend them to its will.”
The larger an industry becomes, the more attention it receives from regulators. Despite the digital asset industry’s decentralized and open access philosophy, the industry has found it difficult to operate outside of regulatory umbrellas—for the security of investors and users, and the avoidance of criminal activity, it has rightly been pulled in line with other industries, particularly finance.
So, paradoxically, it seems that whilst these efforts to bring digital assets into the regulatory fold make them safer for investors and users, it could be simultaneously increasing the potential for greater systemic risk as another infection-prone animal is brought into the herd.
Watch: The Future World with Blockchain
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