## CHAPTER 2 THE CRYPTO ECOSYSTEM AND FINANCIAL STABILITY CHALLENGES

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### Overview and key messages
- The crypto ecosystem has grown rapidly, offering cheaper, faster, and more accessible payments and financial services and enabling quick cross-border flows.
- Crypto asset technologies can transform bank deposits into stablecoins that allow instant access to financial products and instant currency conversion.
- Decentralized finance (DeFi) can provide innovative, inclusive, and transparent financial services.
- Rapid growth and increasing adoption present financial stability challenges, including operational, market integrity, and macro-financial risks—especially for emerging market and developing economies where cryptoization (asset and currency substitution) can be significant.
- The chapter concludes with a set of eight actionable policy recommendations (listed in the chapter but not reproduced here).

### Market developments and key metrics
- Market capitalization and performance:
  - Grew almost threefold in early 2021 to an all-time high of $2.5 trillion.
  - Fell by 40 percent in May 2021 amid environmental concerns and regulatory scrutiny.
  - Subsequently rose to more than $2 trillion—a 170 percent increase year to date at the time of writing.
- Risk-adjusted returns:
  - Risk-adjusted returns of Bitcoin over the past year are similar to broader technology equities or the S&P 500 (Sharpe ratios calculated on a rolling 12-month basis and annualized).
- Stablecoins:
  - Market capitalization quadrupled in 2021 to more than $120 billion.
  - Tether is the largest stablecoin, though its market share has declined as centralized exchanges introduced USD Coin and Binance USD.
  - Stablecoin trading volumes outpace those of all other crypto assets and show improving price stability (declining deviations from 1:1 pegs).
- Smart contract blockchains and Ether:
  - Bitcoin’s market share declined in 2021 from more than 70 percent to less than 45 percent.
  - Ether surpassed Bitcoin trading volumes earlier in 2021.
- DeFi size:
  - Grew from $15 billion at the end of 2020 to about $110 billion as of September 2021 (size measured as total value locked).
  - Growth driven by decentralized exchanges and credit platforms operating (usually) without customer identification requirements and largely built on Ethereum.
- Leverage and liquidations:
  - Exchanges offered leverage as high as 125 times the initial investment.
- Token listings:
  - More than 16,000 tokens have been listed over time; around 9,000 exist today.
- Mining and energy:
  - By some estimates, mining in the Bitcoin network consumes about 0.36 percent of the world’s electricity.
  - Mining revenues in 2021 have exceeded $1 billion a month, on average, for each of the Bitcoin and Ethereum blockchains.

### Data, monitoring, and cross-border activity challenges
- Data limitations and heterogeneity:
  - Monitoring is complicated by limited, fragmented, and, in some cases, unreliable data; public data sharing by crypto asset providers is mostly voluntary and lacking standardization.
  - On exchange reporting ranges from minimal information to full real-time order books; self-reported data create incentives to manipulate reported volumes.
  - On-chain analytics are at an early stage and have focused on illicit activity detection rather than producing macro-relevant metrics.
- FATF survey on P2P Bitcoin transactions shows large variation across data providers:
  - One company estimated that 80 percent of the dollar value of Bitcoin transactions in 2020 occurred without a crypto asset provider.
  - Another company estimated it at 3 percent.
- Cross-border and jurisdictional issues:
  - Crypto exchanges and service providers often operate through entities in offshore financial centers, complicating regulation and supervision.
  - Cross-border access and regulatory gaps allow users to access global exchanges or wallets without domestic banking relationships.
  - Examples: Malaysia, Nigeria, and Turkey have recently imposed restrictions on payments and/or transactions through global exchanges such as Binance; such actions cannot prevent on-chain P2P transfers or decentralized exchanges.

### Stablecoins — classifications, reserves, disclosure, and run risks
- Stablecoin classifications:
  - Cash-based: Fully backed by cash or liquid and safe assets (for example, bank deposits and US government bills); redeemable by issuer at face value; reserves normally maintained by regulated entities.
  - Asset-based: Fully backed by noncash equivalent assets (for example, corporate bonds, commercial paper, or commodities) and cash; akin to pre-reform money market funds; issuers may defer redemption, offer in-kind redemption, or impose higher redemption fees in stress.
  - Crypto-asset-based: Backed by other crypto assets (for example, DAI backed by Ether, Bitcoin, and USD Coin); includes algorithmic (noncollateralized) stablecoins that maintain pegs via supply adjustments.
- Regulation categories:
  - Comprehensively regulated: Currently, no stablecoin arrangement fully meets this status.
  - Partially regulated by existing regimes: Elements (for example, reserve managers) may be regulated for conduct, prudential purposes, or limited purposes (for example, AML/CFT).
  - Nonregulated: No prudential or conduct regulation; many stablecoins currently fall in this category; some US dollar stablecoin issuers headquartered offshore operate through offshore banks and are nonregulated.
- Reserve composition and disclosure (panel data timing):
  - Reserves of top stablecoins shown as: $6 bn $12 bn $27 bn $63 bn.
  - Panel reserve data timing: Tether as of June 2021; USD Coin as of August 2021; Binance USD as of July 2021; DAI as of August 2021.
  - DAI collateralization was more than 200 percent at the time.
  - USD Coin consolidates cash and cash equivalents in its disclosure, accounting for about 60 percent of reserves; cash equivalents defined as securities with an original maturity less than or equal to 90 days.
  - Circle announced that, as of September 2021, 100 percent of USD Coin reserves would be moved to cash and cash equivalents.
  - Binance USD is issued in collaboration with Paxos, with 4 percent of its reserves in Pax Dollar (USDP), a separate native stablecoin of Paxos with under $1 billion in outstanding supply.
- Liquidity mismatch and disclosure gaps:
  - Tether disclosures are not yet audited by independent accountants; missing details include domicile, denomination of currencies, and sector of commercial paper holdings.
  - Tether shows a higher degree of liquidity mismatch than other major stablecoins: only one-third of its reserves are backed by cash and Treasury bills; about half is invested in commercial paper.
- Run and contagion risks:
  - Example: In June 2021 a small algorithmic stablecoin (IRON) experienced a run after one-quarter of its reserves were backed by another token (TITAN) whose market value went to zero; TITAN’s price collapsed to 0.
  - Run risks could trigger fire sales of commercial paper; in many jurisdictions, including the United States, the liquidity of commercial paper is worse than that of government bills during market stress.
  - Contagion risk is higher when reserve assets are concentrated in particular issuers or sectors; concentrated ownership by market makers could trigger wider contagion.
  - Financial stability implications exist for large banks from potential fire sales of assets backing stablecoins and cross-border spillovers via global exchanges.

### Financial stability implications and transmission channels
- Expansion of potential systemic channels since 2018:
  - Market capitalization has increased by a factor of 10 and is now comparable to some established asset classes (for example US high-yield bonds), though still small relative to government bond and stock markets in major advanced economies.
  - Confidence effects from large crypto asset valuation fluctuations and provider failures have, to date, had limited spillovers to broader markets, but importance is rising as trading volumes in some national exchanges reach levels comparable to domestic stock exchanges.
  - Exposures in the banking system are growing from a low base; exposures are growing faster among some nonbank institutions (for example, hedge funds), potentially increasing indirect bank exposures.
  - Use of crypto assets for payments and settlements is limited but can accelerate quickly as global payment companies integrate with stablecoins.
- New sources of risk since 2018 include widely used stablecoins and DeFi services that could scale rapidly and become systemically important across multiple jurisdictions.
- Operational, cyber, governance, and market integrity risks:
  - Operational: Failures and disruptions can cause significant downtime and customer losses, often coinciding with high transaction activity (example: May 19 network congestion and exchange outages).
  - Cyber: High-profile hacking-related thefts of customer funds have occurred on centralized elements (wallets, exchanges) and can target consensus algorithms.
  - Governance: Lack of transparency around issuance and distribution has resulted in investor losses.
  - Concentration: The ecosystem relies heavily on a few entities (for example, Binance handles more than half of trading volumes; Tether has issued more than half the supply of stablecoins).
  - Consumer fraud and market integrity: DeFi products can be complex and opaque, with inadequate risk disclosures and instances of hacking (example: $0.6 billion Polychain hack in August) and scams such as rug pulls.
  - Data and anonymity: While blockchain transactions can be traced, parties may not be identifiable; privacy tokens further conceal transaction data.

### Emerging market and developing economy (EMDE) implications
- Adoption patterns and drivers:
  - Blockchain analytics and web-traffic–based residency estimates indicate adoption in EMDEs is rising and has outpaced that in advanced economies.
  - Pull factors include returns from speculative investment, relative transaction costs and speed, competitive financial products, reduced AML/CFT standards, and convenience of on-chain custody.
  - Push factors include unsound domestic macro policies, FX restrictions, a vulnerable banking sector, and exclusion from other financial services.
- Cryptoization and macro-financial risks:
  - Macro-criticality of crypto assets—and particularly stablecoins—can be significantly higher for some EMDEs with rapid adoption.
  - Risks include cryptoization (asset and currency substitution), circumvention of exchange and capital controls, destabilizing capital flows, effects on monetary policy transmission, and potential bank disintermediation.
  - Examples and indicators:
    - Among a sample of 65 EMDEs that are not de jure dollarized, 2020 data showed that about one-third have foreign currency exceeding 30 percent of both total loans and deposits.
    - Korea experienced Bitcoin purchase premia as high as 50 percent in 2018 due to strong domestic demand and restrictions.
  - Country-level tracking challenges:
    - No reliable way currently to estimate stock or flow of crypto assets by country residency.
    - Proxy measures include residency estimates based on internet visits to crypto asset provider websites, on-chain value received, exchange volumes, and hashrate estimates; these are indicative but not direct measures of resident holdings or flows.
- Mining migration and capital flow implications:
  - Migration of mining activity following a crackdown in China in early 2021 moved activity to other EMDEs and to the United States.
  - Large migration of mining activity can lead to a significant rise in domestic energy use, especially in countries that subsidize energy costs.
  - Mining revenues can potentially be used to circumvent capital flow restrictions and international financial sanctions because operating costs are paid domestically in local currency while revenues are paid on-chain in crypto assets.
- Banking sector risks:
  - Competition for bank deposits from stablecoins held on crypto exchanges or private wallets may push local banks toward less stable and more expensive funding sources.
  - Additional risks include loss of net interest income and loss of customer relationships and transaction data, undermining credit risk assessment and banks’ ability to offer targeted products.

### Policy recommendations and guidance
- Policy priority areas:
  1. Regulation, supervision, and monitoring of the crypto ecosystem.
  2. Stablecoin-specific risks.
  3. Managing macro-financial risks in emerging market and developing economies.
- Standards, supervision, and data:
  - National regulators should prioritize the implementation of global standards applicable to crypto assets.
  - Regulators need to control the risks of crypto assets, especially in areas of systemic importance.
  - Coordination among national regulators is key for effective enforcement and less regulatory arbitrage.
  - Regulators should address data gaps and monitor the crypto ecosystem for better policy decisions.
  - Where standards do not yet exist, regulators should use existing tools and a flexible framework, prioritizing areas of acute risk such as wallets, exchanges, and financial institutions’ exposures.
  - Interim measures include clear consumer warnings and investor education programs.
  - Swift data standardization and an international agreement on common minimum principles for data are central for informed policy decisions.
- Stablecoin-specific guidance:
  - Apply the principle of “same business, same risk, same rules” as reflected in the Financial Stability Board’s 10 high-level recommendations covering governance, risk management, transparency, and redemption rights.
  - Ensure widely used stablecoins have effective risk management frameworks addressing credit and liquidity risks, operational risks, AML/CFT, and cyber risks.
  - Enhance disclosure requirements, independent audit of reserves, fit and proper rules for network administrators and issuers, and rules around operational and cyber resilience.
  - Where stablecoins generate systemic risk, regulatory obligations should be aligned with those applying to traditional entities that provide similar products (for example, bank deposits, digital payments, money market funds).
- Managing macro-financial risks in EMDEs:
  - Strengthen macroeconomic policies to reduce incentives for cryptoization: enhance monetary policy credibility; safeguard central bank independence; maintain a sound fiscal position; implement effective legal and regulatory measures to disincentivize foreign currency use.
  - Consider the benefits and limitations of central bank digital currencies (CBDCs); issuing a CBDC does not automatically change incentives to hold foreign currencies, but CBDCs may help reduce dollarization if they satisfy needs for better payment technologies.
  - Reconsider the design, supervision, and enforcement of capital flow restrictions in a digital world and foster cross-border collaboration and cooperation.
  - Host authorities where stablecoins are widely used should establish close coordination mechanisms with home regulators where stablecoin reserves are managed.

*Source: ch2 - Introduction and CHAPTER 2 THE CRYPTO ECOSYSTEM AND FINANCIAL STABILITY CHALLENGES (https://www.imf.org/-/media/files/publications/gfsr/2021/october/english/ch2.pdf).*

### Introduction

### ch2 - Introduction

### Overview and key messages
- The crypto ecosystem has grown rapidly, offering cheaper, faster, and more accessible payments and financial services and enabling quick cross-border flows.
- Crypto asset technologies can transform bank deposits into stablecoins that allow instant access to financial products and instant currency conversion.
- Decentralized finance (DeFi) can provide innovative, inclusive, and transparent financial services.
- Rapid growth and increasing adoption present financial stability challenges, including operational, market integrity, and macro-financial risks—especially for emerging market and developing economies where cryptoization (asset and currency substitution) can be significant.
- The chapter concludes with a set of eight actionable policy recommendations (listed in the chapter but not reproduced here).

### Chapter 2 at a Glance — concise findings
- The crypto ecosystem continues rapid growth, presenting both opportunities and challenges, with emphasis on implications for emerging market and developing economies.
- Crypto assets serve varying needs: speculative investment, store of value, currency conversion, and payments. DeFi is gaining momentum by offering new services.
- Financial stability risks are not yet systemic globally, but should be closely monitored given global implications and inadequate operational and regulatory frameworks in most jurisdictions.
- Key challenges: operational and financial integrity risks from crypto asset providers; investor protection risks for crypto assets and DeFi; inadequate reserves and disclosure for some stablecoins.
- In emerging markets, crypto assets can accelerate cryptoization and circumvent exchange and capital control restrictions, with increased trading risking destabilizing capital flows.
- Policy priorities: implement global standards for crypto assets; address data gaps to improve monitoring; ensure stablecoin regulations correspond to risks and economic functions; emerging markets facing cryptoization should strengthen macroeconomic policies and consider central bank digital currencies (CBDCs).

### Market developments and metrics
- Market capitalization:
  - Grew almost threefold in early 2021 to an all-time high of $2.5 trillion.
  - Fell by 40 percent in May 2021 amid environmental concerns and regulatory scrutiny.
  - Subsequently rose to more than $2 trillion—a 170 percent increase year to date at the time of writing.
- Risk-adjusted returns:
  - Risk-adjusted returns of Bitcoin over the past year are similar to broader technology equities or the S&P 500 (Sharpe ratios calculated on a rolling 12-month basis and annualized).
- Stablecoins:
  - Market capitalization quadrupled in 2021 to more than $120 billion.
  - Tether is the largest stablecoin, though its market share has declined as centralized exchanges introduced USD Coin and Binance USD.
  - Stablecoin trading volumes outpace those of all other crypto assets and show improving price stability (declining deviations from 1:1 pegs).
- Smart contract blockchains and Ether:
  - Bitcoin’s market share declined in 2021 from more than 70 percent to less than 45 percent.
  - Ether surpassed Bitcoin trading volumes earlier in 2021.
- DeFi size:
  - Grew from $15 billion at the end of 2020 to about $110 billion as of September 2021 (size measured as total value locked).
  - Growth driven by decentralized exchanges and credit platforms operating (usually) without customer identification requirements and largely built on Ethereum.
- Leverage and liquidations:
  - High use of leverage exacerbated declines; exchanges offered leverage as high as 125 times the initial investment.
  - Automatic liquidations of margin and futures positions contributed to sharp price movements and exchange outages during peak liquidation events.
- Token listings:
  - More than 16,000 tokens have been listed over time; around 9,000 exist today.

### Financial stability implications and transmission channels
- Since 2018, several channels of potential systemic risk have grown or emerged:
  - Market capitalization has increased by a factor of 10 and is now comparable to some established asset classes (for example US high-yield bonds), though still small relative to government bond and stock markets in major advanced economies.
  - Confidence effects from large crypto asset valuation fluctuations and provider failures have, to date, had limited spillovers to broader markets, but importance is rising as trading volumes in some national exchanges reach levels comparable to domestic stock exchanges.
  - Exposures in the banking system are growing from a low base; exposures are growing faster among some nonbank institutions (for example, hedge funds), potentially increasing indirect bank exposures.
  - Use of crypto assets for payments and settlements is limited but can accelerate quickly as global payment companies integrate with stablecoins.
- New sources of risk since 2018 include widely used stablecoins and DeFi services that could scale rapidly and become systemically important across multiple jurisdictions.

### Operational, cyber, governance, and market integrity risks
- Operational risks:
  - Failures and disruptions can cause significant downtime and customer losses, often coinciding with high transaction activity (example: May 19 network congestion and exchange outages).
- Cyber risks:
  - High-profile hacking-related thefts of customer funds have occurred on centralized elements (wallets, exchanges) and can target consensus algorithms.
- Governance risks:
  - Lack of transparency around issuance and distribution has resulted in investor losses.
- Concentration risks and market structure:
  - The ecosystem relies heavily on a few entities (for example, Binance handles more than half of trading volumes; Tether has issued more than half the supply of stablecoins).
- Consumer fraud and market integrity:
  - Many crypto assets are volatile and speculative; “meme tokens” exemplify speculation driven by social media.
  - DeFi products can be complex and opaque, with inadequate risk disclosures and instances of hacking (example: $0.6 billion Polychain hack in August) and scams such as rug pulls.
- Data and anonymity challenges:
  - While blockchain transactions can be traced, parties may not be identifiable; privacy tokens further conceal transaction data.
  - Limited global standards and anonymity create significant data gaps for regulators.

### Special focus: emerging market and developing economy implications
- Macro-criticality of crypto assets—and particularly stablecoins—can be significantly higher for some emerging market and developing economies with rapid adoption.
- Risks include cryptoization (asset and currency substitution), circumvention of exchange and capital controls, destabilizing capital flows, effects on monetary policy transmission, and potential bank disintermediation.
- Policymakers in these economies should:
  - Strengthen macroeconomic policies.
  - Consider the benefits of issuing central bank digital currencies.

*Source: ch2 - Introduction (https://www.imf.org/-/media/files/publications/gfsr/2021/october/english/ch2.pdf).*

### 1. Market Capitalization and Realized Volatility

### ch2 - 1. Market Capitalization and Realized Volatility

### Crypto ecosystem challenges: data, monitoring, and cross-border activity
- Monitoring is complicated by limited, fragmented, and, in some cases, unreliable data; public data sharing by crypto asset providers is mostly voluntary and lacking standardization.
- On exchange reporting ranges from minimal information to full real-time order books; self-reported data create incentives to manipulate reported volumes.
- On-chain analytics are at an early stage and have focused on illicit activity detection rather than producing macro-relevant metrics.
- FATF survey on P2P Bitcoin transactions shows large variation across data providers:
  - One company estimated that 80 percent of the dollar value of Bitcoin transactions in 2020 occurred without a crypto asset provider.
  - Another company estimated it at 3 percent.
- Crypto exchanges and service providers often operate through entities in offshore financial centers, complicating regulation and supervision.
- Cross-border access and regulatory gaps allow users to access global exchanges or wallets without domestic banking relationships; use of sovereign currencies can occur through third-party payment processors exploiting regulatory loopholes.
- Examples of jurisdictional measures: Malaysia, Nigeria, and Turkey have recently imposed restrictions on payments and/or transactions through global exchanges such as Binance; such actions cannot prevent on-chain P2P transfers or decentralized exchanges.

### Stablecoins: classifications, reserve composition, disclosure, and run risks
- Stablecoin classifications described:
  - Cash-based: Fully backed by cash or liquid and safe assets (for example, bank deposits and US government bills); redeemable by issuer at face value; reserves normally maintained by regulated entities.
  - Asset-based: Fully backed by noncash equivalent assets (for example, corporate bonds, commercial paper, or commodities) and cash; akin to pre-reform money market funds; issuers may defer redemption, offer in-kind redemption, or impose higher redemption fees in stress.
  - Crypto-asset-based: Backed by other crypto assets (for example, DAI backed by Ether, Bitcoin, and USD Coin); includes algorithmic (noncollateralized) stablecoins that maintain pegs via supply adjustments.
- Regulation categories for stablecoins:
  - Comprehensively regulated: Currently, no stablecoin arrangement fully meets this status.
  - Partially regulated by existing regimes: Elements (for example, reserve managers) may be regulated for conduct, prudential purposes, or limited purposes (for example, AML/CFT).
  - Nonregulated: No prudential or conduct regulation; many stablecoins currently fall in this category; some US dollar stablecoin issuers headquartered offshore operate through offshore banks and are nonregulated.
- Reserve and disclosure observations (panel data notes):
  - Reserves of top stablecoins shown as: $6 bn $12 bn $27 bn $63 bn.
  - Panel reserve data timing: Tether as of June 2021; USD Coin as of August 2021; Binance USD as of July 2021; DAI as of August 2021.
  - DAI collateralization was more than 200 percent at the time.
  - USD Coin consolidates cash and cash equivalents in its disclosure, accounting for about 60 percent of reserves; cash equivalents defined as securities with an original maturity less than or equal to 90 days.
  - Circle announced that, as of September 2021, 100 percent of USD Coin reserves would be moved to cash and cash equivalents.
  - Binance USD is issued in collaboration with Paxos, with 4 percent of its reserves in Pax Dollar (USDP), a separate native stablecoin of Paxos with under $1 billion in outstanding supply.
- Disclosure and liquidity mismatch concerns:
  - Tether has disclosed reserve composition but disclosures are not yet audited by independent accountants; missing details include domicile, denomination of currencies, and sector of commercial paper holdings.
  - Tether shows a higher degree of liquidity mismatch than other major stablecoins: only one-third of its reserves are backed by cash and Treasury bills; about half is invested in commercial paper.
- Run and contagion risks:
  - Stablecoins can be subject to runs if doubts arise about redeemability at a 1:1 peg or the speed at which reserves can be liquidated.
  - Example: In June 2021 a small algorithmic stablecoin (IRON) experienced a run after one-quarter of its reserves were backed by another token (TITAN) whose market value went to zero; TITAN’s price collapsed to 0.
  - Run risks could trigger fire sales of commercial paper; in many jurisdictions, including the United States, the liquidity of commercial paper is worse than that of government bills during market stress.
  - Contagion risk is higher when reserve assets are concentrated in particular issuers or sectors; concentrated ownership by market makers could trigger wider contagion.
  - Even if stablecoins are not yet “systemic,” there are financial stability implications for large banks in the event of fire sales of assets backing stablecoins and potential cross-border spillovers via global exchanges.

### Cryptoization risks and emerging market exposures
- Crypto adoption has outpaced that of advanced economies in some emerging market and developing economies (EMDEs); surveys indicate top adopters are EMDEs while lowest adopters are generally advanced economies.
- Country-level tracking challenges:
  - No reliable way currently to estimate stock or flow of crypto assets by country residency.
  - Proxy measures include residency estimates based on internet visits to crypto asset provider websites, which confirm higher interest from EMDE residents but cannot measure actual use.
- Indicators and patterns (panel summaries):
  - Value received on-chain among 50 EMDEs is presented as percent of GDP (figure series referenced).
  - Volumes of EMDE FX on crypto exchanges are shown as share of interbank FX volumes (figure series referenced).
  - Bitcoin premiums in local currency markets calculated as (Bitcoin/LCL × LCL/USD) / (Bitcoin/USD) − 1; for Nigeria and Argentina a parallel FX-rate estimate is used.
  - Bitcoin mining activity by country measured as share of global hashrate; migration of mining can lead to higher electricity usage and on-chain revenues in EMDEs.
- Local market segmentation and volatility:
  - Demand and supply imbalances and capital flow management measures can lead to large market segmentation.
  - Off-chain trading volumes against some EMDE FX pairs showed large volatility in 2021.
  - Volumes in EMDE registered crypto exchanges have grown rapidly and in some cases are comparable to some equity markets.
- Data limitations and interpretation cautions:
  - Samples for EMDE panels often comprise 10 countries; measures rely on multiple data sources including internet visits, exchange volumes, and hashrate estimates.
  - Metrics such as geographic breakdown of internet visitors, volumes of EMDE registered exchanges (percent share of local equity exchange volumes), and on-chain value received are indicative but not direct measures of resident holdings or flows.

*Source: https://www.imf.org/-/media/files/publications/gfsr/2021/october/english/ch2.pdf*

### CHAPTER 2 THE CRYPTO ECOSYSTEM AND FINANCIAL STABILITY CHALLENGES

### CHAPTER 2 THE CRYPTO ECOSYSTEM AND FINANCIAL STABILITY CHALLENGES

### Adoption Patterns and Drivers
- Reported traded volume in 2021 rose sharply on exchanges that operate only in specific countries; in some cases volumes have become comparable to the activity on the local stock exchange.
- Blockchain analytics and web-traffic–based residency estimates indicate adoption in emerging market and developing economies is rising and has outpaced that in advanced economies, though interpretation is challenging.
- Pull and push factors (Table 2.2):
  - Pull Factors:
    - Returns from speculative investment
    - Relative transaction costs and speed
    - Competitive financial products
    - Reduced AML/CFT standards
    - Convenience of “on-chain” custody
  - Push Factors:
    - Unsound domestic macro policies
    - FX restrictions
    - Vulnerable banking sector
    - Exclusion from other financial services
- Examples and empirical notes:
  - Among a sample of 65 emerging market and developing economies that are not de jure dollarized, 2020 data showed that about one-third have foreign currency exceeding 30 percent of both total loans and deposits.
  - Korea experienced Bitcoin purchase premia as high as 50 percent in 2018 due to strong domestic demand and restrictions.

### Macro-Financial Challenges by Degree of Adoption
- Limited degree of adoption (for example, small-scale use of crypto assets for remittances):
  - Will pose some challenges (financial integrity, consumer protection) but have a marginal impact on monetary policy or capital flows.
  - Underlying crypto assets used for payment rails will likely be held only for short durations (for example, the duration of the remittance) before users exchange them for local currency.
- More extensive adoption (for example, adoption of stablecoins as means of payment and store of value):
  - Can reinforce dollarization forces, impeding central banks’ effective implementation of monetary policy.
  - Can lead to financial stability risks through currency mismatches on balance sheets of banks, firms, and households, and amplify liquidity risks because central banks cannot provide liquidity backstops in foreign units of account.
  - Could pose a threat to fiscal policy by facilitating tax evasion and reducing seigniorage revenue due to the shrinking role of central bank money.
- Adoption of non-stablecoin crypto assets as the main national currency is deemed low probability for most countries because such assets are too volatile and unrelated to the real economy to become the main unit of account; however, it could arise in countries with weak monetary and exchange rate policies.
- Increased demand for crypto assets can facilitate capital outflows and affect the foreign exchange market:
  - Crypto exchanges facilitate conversion between local currency and crypto assets; imbalances in natural demand and supply can arise over 24/7 trading periods.
  - Triangular arbitrage via institutional market makers (for example, US dollar–Bitcoin and US dollar–local currency pairs) can provide gateways for conversion of crypto asset demand into capital outflows through the exchange rate market.
  - Recent sharp rise in trading volumes of crypto assets against some emerging market and developing economy currencies may have been a source of spillovers leading to restrictions by authorities.

### Migration of Mining Activity — Energy and Capital Flow Implications
- Migration of mining activity following a crackdown in China in early 2021 moved activity to other emerging market and developing economies and to the United States.
- Energy consumption:
  - By some estimates, mining in the Bitcoin network consumes about 0.36 percent of the world’s electricity—comparable to the consumption of Belgium or Chile.
  - Large migration of mining activity can lead to a significant rise in domestic energy use, especially in countries that subsidize energy costs.
  - Future generations of Ethereum and other smart blockchains are expected to consume much less energy than Bitcoin.
- Capital flows:
  - Miners receive on-chain rewards; the value of mining revenues in 2021 has exceeded $1 billion a month, on average, for each of the Bitcoin and Ethereum blockchains.
  - Mining revenues can potentially be used to circumvent capital flow restrictions and international financial sanctions because operating costs (for example, electricity) are normally paid domestically in local currency while revenues are paid on-chain in crypto assets.

### Banking Sector Risks
- Competition for bank deposits from stablecoins held on crypto exchanges or private wallets may push local banks toward less stable and more expensive funding sources to maintain loan growth.
- Additional risks include loss of net interest income and loss of customer relationships and transaction data, which would undermine credit risk assessment and banks’ ability to offer targeted products.

### Policy Recommendations — Overview
- The chapter’s policy recommendations focus on three main areas:
  1. Regulation, supervision, and monitoring of the crypto ecosystem.
  2. Stablecoin-specific risks.
  3. Managing macro-financial risks in emerging market and developing economies.
- Summary of main policy recommendations (Table 2.3):
  - Standards, Supervision, and Data:
    - National regulators should prioritize the implementation of global standards applicable to crypto assets.
    - Regulators need to control the risks of crypto assets, especially in areas of systemic importance.
    - Coordination among national regulators is key for effective enforcement and less regulatory arbitrage.
    - Regulators should address data gaps and monitor the crypto ecosystem for better policy decisions.
  - Stablecoins:
    - Regulations should be proportionate to the risk and in line with those of global stablecoins.
    - Coordination is needed to implement recommendations in areas of acute risk; enhanced disclosure, independent audit of reserves, fit and proper rules for network administrators and issuers; and more.
  - Managing Macro-financial Risks:
    - Enact de-dollarization policies, including enhancing monetary policy credibility; a sound fiscal position; effective legal and regulatory measures; and the implementation of central bank digital currencies.
    - Capital flow restrictions need to be reconsidered with respect to their effectiveness, supervision, and enforcement.

### Standards, Supervision, and Data — Detailed Guidance
- National regulators should implement complete global standards applicable to crypto assets; existing standards include AML/CFT (FATF) and proposals on bank exposures to crypto assets (BCBS); IOSCO and CPMI/PFMI provide groundwork for regulation and supervision.
- Where standards do not yet exist, regulators should use existing tools and a flexible framework, prioritizing areas of acute risk such as wallets, exchanges, and financial institutions’ exposures.
- Interim measures include clear consumer warnings and investor education programs, especially in jurisdictions with rapid crypto adoption.
- Cross-border coordination of supervision and enforcement is essential:
  - Some authorities have banned unregulated crypto activities; bans can have direct impact but trading may move to alternative channels.
  - Jurisdictions should coordinate with relevant authorities and international standard-setting bodies to maximize enforcement effectiveness and minimize regulatory arbitrage.
- Addressing data gaps:
  - Swift data standardization and an international agreement on common minimum principles for data are central for informed policy decisions.
  - A globally consistent taxonomy can help data standardization and cooperation.
  - There is scope for international coordination on compilation and sharing of data sources from private companies for regulatory and public policy purposes.

### Stablecoin-Specific Guidance
- Apply the principle of “same business, same risk, same rules” as reflected in the Financial Stability Board’s 10 high-level recommendations covering governance, risk management, transparency, and redemption rights.
- Authorities should ensure that widely used stablecoins have effective risk management frameworks addressing credit and liquidity risks, operational risks, AML/CFT, and cyber risks.
- Regulation and supervision of stablecoins can be enhanced through cooperation agreements between country authorities that consider country-specific risks.
- Certain US dollar–linked stablecoins seek to base operations in chartered banks in the United States; meeting banking license requirements would resolve many regulatory challenges.

*Source: IMF staff; CHAPTER 2 THE CRYPTO ECOSYSTEM AND FINANCIAL STABILITY CHALLENGES (October 2021).*

### CHAPTER 2 THE CRYPTO ECOSYSTEM AND FINANCIAL STABILITY CHALLENGES

### CHAPTER 2 THE CRYPTO ECOSYSTEM AND FINANCIAL STABILITY CHALLENGES

### Areas of acute risk in stablecoin arrangements
- Various functions—reserves management, network administration and governance, custody, and exchange services—can generate risks to:
  - consumer protection,
  - financial stability,
  - market and financial integrity,
  - operational and cyber resilience.
- Suggested measures for authorities:
  - enhanced disclosure requirements,
  - independent audit of reserves,
  - fit and proper rules for network administrators and issuers,
  - rules around enhanced operational and cyber resilience to reflect increased reliance on digital platforms and various types of distributed ledger technology.
- Regulatory alignment:
  - Where stablecoins generate systemic risk, regulatory obligations should reflect that position, with rules aligned with traditional entities that provide similar products (for example, bank deposits, digital payments, money market funds, and so on).

### Managing macro-financial risks from crypto assets and stablecoins
- Crypto assets do not change the economic forces that lead to the international use of currencies or increased dollarization, but the crypto ecosystem—especially stablecoins—could reinforce incentives behind currency and asset substitution and ease adoption.
- Policy implications for countries aiming to reverse or avert dollarization:
  - strengthen monetary policy credibility,
  - safeguard the independence of central banks,
  - maintain a sound fiscal position,
  - implement effective legal and regulatory measures to disincentivize foreign currency use.
- Central bank digital currencies (CBDCs):
  - Simply issuing central bank digital currencies does not automatically change incentives to hold foreign currencies.
  - CBDCs may help reduce dollarization if they help satisfy a need for better payment technologies.
  - A number of countries have launched projects to modernize their payment systems, taking advantage of the latest developments in digital technology and using the domestic currency for instant payments.
- The tolerance for policy missteps is greatly reduced (IMF 2020a).

### Capital flow management and cross-border challenges
- Capital flow restrictions in a digital world:
  - The design of capital flow restrictions needs to be reconsidered, including via stablecoin regulations.
  - Applying established regulatory tools to manage capital flows may be more challenging when value is transmitted on new platforms that are not bound by existing capital flow management measures (IMF 2021).
- Jurisdictional and enforcement challenges:
  - Private entities may organize or relocate activities in ways that challenge the effectiveness of regulation, supervision, oversight, and enforcement of capital flow management measures at jurisdictional levels.
  - There is a need for cross-border collaboration and cooperation to address technological, legal, regulatory, and supervisory challenges (IMF 2021; IMF and BIS 2021).
  - Host authorities where stablecoins are more widely used should be encouraged to establish a close coordination mechanism with the home regulator where stablecoin reserves are managed.

*Source: CHAPTER 2 THE CRYPTO ECOSYSTEM AND FINANCIAL STABILITY CHALLENGES (October 2021).*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2021/october/english/ch2.pdf_