In the last few weeks with the ongoing saga of FTX’s sudden bankruptcy and the ripple effects on the entire crypto markets people reasonably wonder whether the shocks will extend beyond the crypto sphere, to traditional financial systems with catastrophic effects to the real economy.
Predating the bankruptcy, ESMA issued a paper titled “Crypto-assets and their risks for financial stability”, in which the risks in the market for crypto-assets are identified and the interlinkages with traditional markets were analyzed.
More specifically, ESMA recognised that financial risks facing traditional financial firms are also facing crypto-asset firms, such as the fact that crypto-assets are highly speculative, the aggressive marketing campaigns identified in the market, the complexity of crypto products, and the crypto-asset exchanges which allow investors to make inordinately large investments compared to their capital base.
In addition, ESMA recognises that crypto-asset markets include risks that are native to them due to their unique properties, such as the lack of transparency and reliable data regarding the exposures and risks for a consumer/investor. Moreover, ESMA sees that Distributed Ledger Technologies, on which crypto-assets are based, are vulnerable to manipulative attacks (such as the 51 or Sybil attacks), which can put the value on the entire blockchain at risk.
Even though crypto-asset and traditional financial markets are still considered as two separate systems, connections between both markets exist and are likely to grow, which can lead to a transmission of shocks from one system to the other. ESMA has identified stablecoins as a risk transmission channel i.e. coins that maintain a 1:1 peg with fiat currencies where the issuing coin company holds large amounts of assets (such as deposits, bonds, commercial paper etc.) to support the peg. As a second transmission channel ESMA has identified a number of derivatives, funds and structured products issued by entities with direct or indirect exposure to crypto-assets. Other channels of risk transmission were also identified by ESMA. Overall, ESMA has assessed the current risk posed by crypto-assets as medium high with a slightly negative outlook.
The recent developments involving FTX and the impact on its clients are expected to lead global authorities, including in the European Union, to bring forward the plans for regulation of crypto-assets. It should be noted that the European Union is the first major jurisdiction worldwide to propose a comprehensive, dedicated regulatory framework for crypto-assets, the EU Markets in Crypto-Asset Regulation (MiCA). The proposed framework is currently under review and consultation by the bodies of the EU and is expected to be finalised and approved in the near future.
MAP S.Platis can provide comprehensive advisory support to Crypto-Asset Service Providers.