Weakness in crypto ecosystem is potential risk to financial stability worldwide

The downturn began when the US Securities and Exchange Commission announced it would begin to impose regulations on crypto firms, setting the stage for a broad sell-off.

Ovais Subhani

Ovais Subhani

The Straits Times

yaohui-pixgeneric-5845_3.webp

MAS concluded that regulating crypto firms will play a key role in mitigating the vulnerabilities of the crypto ecosystem. PHOTO: ST FILE

November 28, 2022

SINGAPORE – Vulnerabilities in the crypto ecosystem could pose material risks to financial stability worldwide, including in Singapore, if its linkages with the traditional financial system increase in time, said Singapore’s central bank on Friday.

Thus, cryptocurrencies, digital assets and the technologies that underpin them warrant heightened surveillance, the Monetary Authority of Singapore (MAS) said in its Financial Stability Review (FSR) 2022.

This is not the first time MAS has raised the red flag on crypto. It telegraphed its concerns in FSR 2021 and has taken several steps since then to avoid any potential financial disruption and protect local investors.

Some of those concerns were borne out this year with the meltdown of the global crypto market.

By October 2022, the market capitalisation of crypto firms fell to around US$900 billion (S$1.2 trillion), from a peak of US$2.8 trillion in November 2021.

The downturn began in April this year when the United States Securities and Exchange Commission announced that it would begin to impose regulations on crypto firms, setting the stage for a broad sell-off.

In July, crypto hedge fund Three Arrows Capital declared bankruptcy, followed by a number of similar insolvencies, with FTX being the latest to go bust.

“Recent events, including the collapse of crypto exchanges, have also highlighted how the failure of a key crypto entity can lead to contagion within the crypto-asset ecosystem,” MAS said in its latest FSR.

While these developments have not significantly affected the broader global financial system due to its limited linkages to crypto assets, they have demonstrated some of the fragilities in the crypto-asset ecosystem.

“Given the crypto-asset ecosystem’s potential for rapid growth, its associated vulnerabilities and their implications for financial stability warrant continued close monitoring and commensurate regulation,” the central bank stressed.

MAS has long held the stance that financial innovation has the potential to improve the process of financial intermediation and the operation of the financial system more generally.

“Digital assets and the technologies that underpin them, including crypto assets and DeFi (decentralised finance), may prove to increase financial system efficiencies that benefit market participants and other agents in the real economy,” it said.

For instance, MAS said, the tokenisation of assets and their deployment on blockchain networks may reduce settlement times and costs for cross-border payments, trade finance, and in capital markets.

However, crypto assets and DeFi present an array of vulnerabilities, some of which are inherent to the crypto-asset ecosystem.

MAS said crypto assets and their markets are susceptible to price corrections, like other risk assets during times of financial stress.

“More broadly, the absence of a fundamental value implies that much trading is speculative in nature and highly sentiment-driven, leaving crypto-asset markets more susceptible to large swings in prices than more conventional types of assets.”

Another vulnerability of crypto-asset markets is the concentration of multiple financial services in the same entities, MAS said.

Crypto exchanges serve as critical infrastructure for trading, just like traditional stock exchanges. However, crypto exchanges also provide a greater range of services than traditional stock exchanges, such as custody and margin trading services. Some exchanges also perform additional payment functions by issuing stablecoins.

“The concentration of services in crypto exchanges not only exposes them to a wider range of operational and financial risk, but also creates critical nodes of failure,” MAS said.

Recent events, including those associated with crypto exchanges, have highlighted the importance of adequate risk management practices and sound governance to manage liquidity, credit and market risks by crypto intermediaries.

MAS concluded that as with other risks to financial stability, regulating crypto firms will play an important role in mitigating the vulnerabilities of the crypto ecosystem. Meanwhile, the role of international standard setting bodies and other organisations in coordinating and achieving globally consistent outcomes will be key.

“Even as digital assets and their underlying technologies are explored for their merits, it will be important to continually assess the risk that they pose,” said MAS.

scroll to top