31.05.2022
Crypto-assets: a financial authority's view
Masters in Finance Closing of the Speakers Series, ESADE
Pablo Hernández de Cos
Governor
Good afternoon.
I am delighted to be here today to address an audience of recent Masters graduates. Not
only as recognition of the growing importance of furthering our education in such a
changeable world, but also because it affords me the opportunity to talk about cutting-edge
themes with those who will play a leading role in the future of our society.
Among the many topical issues I could have selected for my address, I believe crypto-assets
are the most suitable choice. Among other reasons, because young high-earners who study
or work and live in big cities are precisely those who best fit the typical crypto-asset investor
profile in Spain.1
Despite being a somewhat misleading term, so-called "virtual currencies" have already been
part of our lives for over a decade now. However, only in recent times a series of factors
have emerged that seem to be underscoring their ultimate potential to end up playing a
significant role in the financial system.
Beyond their likely contribution to, e.g., making payments more efficient or to driving
innovation in financial markets, crypto-assets pose a number of important risks for the
financial stability which could, eventually, become a material source of concern for relevant
authorities if not accompanied by effective mitigation measures, as emphasised in the G20
communiqué of 18 February.2
I will begin my speech by describing the defining characteristics of the phenomenon and
recent developments, before turning to the specific risks to financial stability that they may
pose. I will end by highlighting some of the main elements shaping the current response of
regulators and supervisors and the challenges that lie ahead.
The complex universe of crypto-assets
The term crypto-asset is oftentimes used to refer to a wide range of highly heterogeneous
assets whose common trait is that they are a digital representation of value or a set of
contractual rights. In contrast with other digital assets already in circulation, they rely on
distributed ledger technology (DLT) to be transferred, traded and stored. In addition, unlike
central bank digital currencies (CBDCs), they are not backed by a central bank or any other
public authority.
To simplify somewhat, they can be said to share certain standard technical features, such
as (i) a decentralised ledger, (ii) the use of encryption techniques to secure communications
over open networks, and (iii) the deployment of protocols that allow to automatically execute
different types of transactions.
However, the commonalities end there. With over 16,000 existing tokens3 (around ten new
crypto-assets are estimated to be launched every day on average) the digital asset space
exhibits sheer amplitude and a gigantic functional and operational disparity.
When analysing crypto-assets, one practical approach is to classify them in accordance
with what apparently is their declared main purpose. As a result, broadly speaking, three
different groups may be distinguished.
The first one comprises those assets whose primary objective is to serve as a medium of
payment or exchange. These are loosely labelled as "virtual currencies", and they
frequently fall outside the prevailing regulatory framework, except where specifically
referenced in new or existing provisions, such as the case of Germany or France.4
The second group covers instruments designed to help raise capital from investors. Specific
procedures are organised to this end, known as Initial Coin Offerings.5 Investors receive
tokens substantiating their legal claim to participate in any potential increase in the future
value of, or returns on, businesses or specific projects. Alternatively, these may be
structured to confer rights equivalent to those of other financial instruments. As they largely
overlap with marketable securities, usually sectoral regulations which are already in place
apply.
The third cluster encompasses so-called utility tokens, which act as electronic coupons
that can be exchanged for future services, products or benefits marketed through the
issuer's own platform. The very capital raised from the sale of these tokens will then be used
to fund the development of the forthcoming products or services. In principle, provided their
amount remains limited, these will be subject to regulations on consumer protection, online
trading, data protection and business operations, but not financial ones.
Another classification criteria of the crypto-asset ecosystem has to do with the primary
nature of each token. Tokens are understood to be a specific unit of digital value, as
assembled by an issuing organization, which further enables interactions between those
agents that operate in the virtual space.6 In some cases these are dubbed native tokens
since they are created from scratch with no underlying asset. They are further linked to a
specific ledger. This is the case of bitcoin and its blockchain network. Given their
singularities, the value of these tokens stems essentially from their users' expectations as
to how they may be used in future transactions, rather than, for example, as result of a
potential cash flow or their issuer's fundamentals.
In other cases, these tokens are connected to actual real-world assets, be they financial
or of another kind. This, for instance, allows real estate assets to be broken down into
fractions which, in turn, can bear ownership rights and ultimately render such properties
more liquid.
An alternative taxonomy distinguishes between traditional crypto-assets and
"stablecoins". In an attempt to reduce their volatility, the latter are usually backed by other
real or virtual assets as a means of collateral. For example, some stablecoins are pegged to
legal tender, while others are anchored to commodities, bonds or even other digital assets.
In some cases, even the overall wealth of the issuer can serve as collateral.7
Algorithmic stablecoins are another, albeit less common, category; here, formal
collateralisation is replaced by a series of automatic supply adjustment mechanisms. In
comparison to other stablecoins, the latter are subject to greater price fluctuations and arise
more doubts as to their potential use as a means of payment. A prime example of this just
happened a few weeks ago with Terra: a stablecoin which, despite remaining relatively firm
around the US dollar for a long time, suddenly lost that nexus and caused significant losses
to investors.
The functionalities or operating characteristics of crypto-assets also vary notably.
Perhaps the most visible example of this is the consensus mechanism that is used to
approve crypto-asset transactions. These mechanisms can take various forms, but all seek
to offer sufficient certainty to system participants as to the correct status of the transaction
ledger at any moment in time.
One of the most well-known tools is the so-called proof-of-work or PoW, which requires
complex and costly - primarily in energy consumption - computational calculations. It is
precisely this latter aspect which is expected to deter irregular behaviour on the part of
validators. However, the price of electricity, concerns about the environmental impact, the
limited access to the specialised hardware required and scalability problems are some of
the factors that are encouraging gradual migration to other types of solutions.8
Proof-of-stake or PoS is one such alternative. Its main characteristic is that validators are
selected according to their direct economic stake in the network; in other words, depending
on the amount of crypto-assets they own and must block to ensure that the operation is
validated correctly. As they have a direct interest in preserving the value of the crypto-asset,
in principle, this mechanism creates incentives to behave honestly. Moreover, as the
possibility of their being assigned operations is generally connected with the volume of
crypto-assets blocked, the network is less decentralised than under the other mechanisms.
Although there are more options, where blockchain networks are set up as closed circuits
(permissioned networks), a third mechanism, dubbed proof-of-authority or PoA, is
generally prominent. In this case, the potential validators disclose their identity to the entire
ecosystem, and they are entrusted this role according to their reputation rather than their
economic interest. Not only is this mechanism more efficient and more agile, but it is
particularly useful in situations with a low number of participants and where potential
validators already enjoy trust.
The environment in which crypto-assets operate is also characterised by the presence of a
wide range of players9 whose services are essential to provide structure and contribute to
the proper functioning of the system. Thus, in addition to crypto-asset issuers, there are
platforms that help dematerialise pre-existing assets, infrastructures that facilitate the
trading and exchange of crypto-assets, institutions that receive, transfer and/or execute
third-party orders, as well as market-makers, code developers, providers of custody, wallet
and consultancy services and a long list of others. It is, therefore, a highly complex universe,
and this complexity is heightened by the fact that these players are based on a broad range
of jurisdictions.
In this regard, we should also bear in mind the world of decentralised finance (DeFi), which
aims to replicate the dynamics of the provision of financial products and services, but in a
decentralised and fully automated environment, thus removing the need for intermediaries.
The growing importance of crypto-assets
With such a wealth of initiatives, the significant developments experienced by
cryptoasset markets in recent times may come as no surprise. In particular, total capitalisation
grew very markedly until reaching a peak of $3 trillion in November 2021, three times higher
than the previous all-time high of 2017. The market is dominated by traditional
cryptoassets; indeed, bitcoin and ethereum account for more than two-thirds of total
capitalisation. In Spain, their transaction volume on some estimates amounted to around
€60 billion in 2021.10
Yet they are also much less mature than is generally believed, and still, in aggregated terms
this market only represents around 1% of the global financial system. At the same time, we
should not overlook the fact that this market is already bigger than the subprime mortgage
market was in the run-up to the global financial crisis. And the fact that trading volumes for
some of the most representative assets types (including bitcoin, ether and tether) came,
occasionally, close to those of the New York Stock Exchange (somewhere in between 70%
and 95%).
In any event, their high volatility is striking, as borne out by a cumulative loss of value of
close to 40% in recent months. These fluctuations are often greater than those of other
financial instruments and can also reach much more extreme values. Some studies have
flagged the highly changeable nature of the factors underpinning crypto-asset prices and
how these factors can be difficult to anticipate given the immaturity of the market.11 This
volatility is much more pronounced in the case of unbacked crypto-assets, but it also
impacts others.
Moreover, interconnections with the rest of the financial system have increased
substantially. One such example is the sudden rise in the number of crypto-asset investors
(both institutional and retail). In addition, the range of sophisticated products around
cryptoassets has expanded, with a growing portfolio of exchange-traded funds (ETFs),12
investment funds and futures contracts referenced to crypto-assets. The latter was key to
attracting new investor cohorts to the digital assets' space.13
What's more, some large private firms did publicly announce their interest in using
cryptoassets for cash management purposes, while others were campaigning in favour of their
wide acceptance as a means of payment.14 Some major financial players, such as global
banks and international card service providers, have enlarged the selection of ancillary
services around digital assets (including custody and trading services) which they offer or
have allowed them to be used directly as a medium of exchange in their proprietary
networks.
Turning to decentralised finance, while still in its early stages, this market segment has
proven stamina as it quadrupled its size in just one year.15 What's more, other parts of the
crypto-asset ecosystem echoed this movement. For instance, the need for collateral tailored
to this environment spurred demand for certain types of digital assets. The same could be
said about certain investment strategies, known as yield farming, which support the
automated lending or borrowing of crypto-assets in order to underpin DeFi's markets
liquidity.16 The vulnerability and interconnection on this segment has been illustrated by the
sudden fall of Terra that caused this market to shrink by 22% in less than a month with an
ensuing snowballing effect on several DeFi protocols and major fiat-backed stablecoins.
Yet, most other stablecoins did not experience significant outflows or de-pegging, and
unbacked crypto-assets' prices seem to have surged back again.
Risks to financial stability
The above developments have caused a number of valid concerns among financial
authorities. For instance, the Financial Stability Board (FSB) recently stressed that, if not
properly regulated and supervised, these markets could quickly reach an inflection point
12
ETFs are investment instruments that function as a hybrid between funds and shares. Their defining characteristic is
that they can be traded and settled in straightforward stock exchange transactions much like shares.
13
A case in point is the Chicago Mercantile Exchange, which in October 2021 became one of the first to launch a bitcoin
ETF. It surpassed the $1 billion mark in just two days, making it the fastest growing ETF in history.
14
For instance, Expedia, Tesla and Microsoft.
15
See "Understanding digital bubbles amidst the COVID-19 pandemic: Evidence from DeFi and NFTs". Y. Maouchi, L.
Charfeddine and G.E. Montasser (2021), Finance Research Letters.
16
The idea behind this strategy is to incentivise investors to lend their crypto-assets to a pool that helps provide liquidity
to decentralised finance systems, while offering potential investors the highest possible returns at all times. To simplify
somewhat, this strategy is structured around smart contracts that select which environment each of the pooled assets
will be sent to at any given moment to optimise economic returns for their rightful holders.
where they start posing serious threats to global financial stability17. A message that we also
conveyed in our latest Financial Stability Report18.
Such risks are diverse in their origin. First, they may arise as a result of a limited
understanding by investors on the actual features and implications of these assets on the
part of investors.19 By way of example, a recent research from the UK's Financial Conduct
Authority (FCA) showed that around 20% of crypto-asset owners assumed an equivalent
level of customer protection as with traditional banking products.20 An OECD study reached
similar conclusions for the Asian market.21 In general terms, given their volatility and
complexity, crypto-assets are not appropriate for retail investors.
A second source of risk stems from the potential impact of crypto-assets on the smooth
functioning of financial markets. Broadly speaking, wild swings in their prices may sway
investor sentiment, triggering an overreaction that ends up influencing their behaviour in
other markets. Equally, the need to respond to such volatility with frequent adjustments to
the necessary collateral could precipitate sales of other asset classes. Indeed, the IMF has
recently warned of a notable increase in the positive correlation between crypto-asset and
capital markets, which has in certain cases increased by a factor of 35.22
These effects may be further aggravated in the event that alternatives such as stablecoin
scale up. Specifically, an accumulation of redemption requests resulting from, for instance,
widespread panic around such assets, could put money markets under strain and, by
extension, spread to those institutions acting as custodians of the hedging assets. These
problems can be exacerbated by certain emerging segments, for example decentralised
finance or DeFi, which are highly leveraged and encourage feedback dynamics between
unbacked cryptocurrencies and stablecoins.
Further, these tensions could spill over into payment systems, as they would be forced to
handle a very significant rise in transaction volumes that, in certain circumstances, could
lead to delays in execution or even bring services to a standstill.
A third source of vulnerability has to do with the impact on the banking sector.
Cryptoassets represent a new competitive threat for traditional transactional services, with some
variants (such as stablecoins) also potentially compromising deposit-taking activities as
17
See "Assessment of Risks to Financial Stability from Crypto-assets". FSB (2021).
18
https://www.bde.es/f/webbde/Secciones/Publicaciones/InformesBoletinesRevistas/InformesEstabilidadFinancera/22/F
SR_2022_1_ChE.pdf
19
This extends to all matters concerning compliance with the tax obligations associated with investing in these markets.
With this in mind, Spain has announced new reporting obligations that are expected to enter into force in 2023. The
treatment of such assets for the purposes of the various different taxes has to date been resolved in the form of requests
for binding rulings from the Directorate General of Taxation.
20
See "Research Note: Cryptoasset consumer research 2021". FCA (2021).
21
Specifically, even though half were University graduates, almost two thirds of the crypto-asset owners interviewed
admitted to having limited or zero understanding of the most basic features of the associated risks and rights. See
"Cryptoassets in Asia: consumer attitudes, behaviour and experiences". OECD (2019).
22
See "Cryptic Connections: Spillovers between Crypto and Equity Markets". Iyer, T. (2022), IMF Global Financial Stability
Notes, No. 2022/01.
they intend to become a store of value. As highlighted in some recent papers, a disorderly
disintermediation in the event of an accelerated substitution of bank deposits for such digital
assets could ultimately affect the banking sector's net financing capacity and lead to credit
being rationed or becoming noticeably more expensive. It could also put collateral markets
under strain, undermine bank customer loyalty and know-your-customer standards and
potentially prompt greater risk-taking by deposit institutions.
Moreover, any rise in banks' direct and indirect exposure to crypto-assets would also
increase both their financial and reputational risks23. While currently limited, exposures
relating to the provision of ancillary services to the distribution of third-party products or as
a result of providing support to clients operating in the crypto sphere are on the rise.
Fourth, the potential consolidation of crypto-assets as an alternative payment method
threatens to create parallel value transfer systems. For as long as such assets fall out of
the scope of central bank oversight, they will be hard pressed to contain the emergence of
possible systemic risks. In certain circumstances (particularly in emerging markets), there
may be even a risk of what is known as "cryptoisation": i.e. the replacement of the national
currency and other financial assets denominated in that currency with a crypto alternative.24
Among other aspects, such circumstance can compromise a country's monetary autonomy
and undermine the ability to exercise effective control over international capital
movements.25
Fifth, we should also be mindful that some crypto-assets could increase the financial
sector's climate transition risk, given that some of the underlying consensus mechanisms
require a significantly greater amount of energy than traditional financial market
infrastructures. To put this more clearly, proof-of-work associated crypto-assets currently
account for around 80% of the total capitalisation value. In certain cases, their carbon
footprint is as large as the one of 15.5 million petrol cars in a year.26
Sixth, since crypto assets can also be used for unlawful activities, including money
laundering, financial integrity concerns follow. Such risks could be larger on account of the
fact that transactions are performed through non-standard payment systems and their
heightened degree of anonymity.
Seventh, crypto-assets' value could also become swiftly eroded on account of the
limitations and problems associated with cyber risks associated to the technologies
underpinning their operations, i.e. blockchains. This could occur due to a wide range of
possible causes, such as their technical configuration placing constraints on the scale of
operations, which would prevent growing public demand from being met. While progress is
being made in this field, these developments are still far from being mature enough. For
example, a card-based payment ecosystem can process around 65,000 transactions per
second, while blockchains such as the one underpinning bitcoin do not usually support
more than seven in their most basic configuration.27
Finally, their decentralised governance together with the realization of potential cyber
threats could give rise to instances of fraud that end up compromising agents' confidence
both in digital assets and in other areas of the ecosystem. The consequences of such a
scenario would be compounded owing to the lack of safeguards protecting customers'
interests and property rights.
Given its potential scope, this scenario could become a serious problem. For example, a
recent Chainalysis study shows that up to $1.3 billion was stolen from digital wallets and
platforms during the first quarter of 2022. Nearly three-quarters of said amount pertain to
DeFi activity, a rise of 72% compared with the previous year.28 Bearing in mind there are an
estimated 200-300 million crypto-asset users across the world, it is fair to call this a
nonnegligible impact.29
The regulatory response
In view of the extent of the challenges I have outlined, a number of regulatory initiatives are
taking shape. It combines public warnings on the risks of buying and/or holding virtual
currencies, and both national and international regulatory initiatives that are of the most
importance, given the global nature of crypto-assets.
Regarding the international initiatives, what started out with the regular monitoring of such
initiatives became, in 2020 and at the behest of the G20, a multilateral regulatory response
from the FSB30.
The FSB has released a report setting out high-level recommendations for the regulation
and supervision of so-called "global stablecoins" (i.e., those operating across multiple
jurisdictions and in widespread use). Flexible and proportionate to the risks, this approach
seeks to minimise the possibility of arbitration while adhering to the "same business, same
risk, same rules" principle. The FSB recommends using the existing international rules and
standards, albeit adapted in practice to the services provided and the features and risks of
global stablecoins. It highlights the importance of ensuring suitable governance and proper
transparency around these products for users and the market, including, in particular,
whether or not users enjoy redemption rights against the issuer or the reserve assets. It also
stresses that the authorities should not allow such arrangements to be launched before
confirming that all of the relevant requirements have been met.
Currently, the FSB continues to work both on identifying and resolving possible regulatory
gaps relating to global stablecoins and on regulatory approaches relating to unbacked
crypto-assets, such as Bitcoin.
Also at the global level, the Basel Committee on Banking Supervision has adopted a
proactive and forward-looking approach when it comes to the prudential regulation of
banks' exposures to crypto-assets. Work is being guided by its mandate to strengthen the
regulation, supervision and practices of banks worldwide with the purpose of enhancing
financial stability. In this regard, even though crypto assets represent only 1% of total global
financial assets and banks' direct exposures are relatively limited to date, we know that
these markets have the potential to scale up rapidly and pose risks to individual banks and
financial stability.
The approach pursued by the Basel Committee is based on key principles that seek a simple
and cautious approach at this stage, given the current level of banks' exposures and the
stage of development of these markets, while at the same time also seeking to ensure that
the prudential treatment appropriately accounts for any additional risks arising from
cryptoasset exposures relative to traditional assets.
With that in mind, the Basel Committee published a consultation paper last year proposing
a regulatory approach that differentiates among three broad types of crypto-assets:
tokenised versions of traditional assets, stablecoins and all other crypto-assets (including
unbacked ones such as Bitcoin). The proposal also includes additional supervisory
guidance to ensure that risks from crypto-assets not captured under minimum (Pillar 1)
requirements are assessed, managed and appropriately mitigated. And it also included new
disclosure requirements related to bank's exposures.
The Committee is now finalizing the process of reviewing the comments received on this
consultation and plans to issue a further consultation paper in the coming months. Let me
offer some personal reflections at this stage, which should not be understood as
preempting the outcome of this work. In particular, in deciding how best to harness the potential
benefits from these markets while mitigating their risks in a world of uncertainty, in my view,
it makes sense to err on the side of caution and prudence. In this regard, how many asset
classes market themselves as being "stable" and "currencies" while often failing on both
counts? We have witnessed some clear examples along these lines during the last few
weeks. Additionally, as mentioned earlier, banks' crypto-asset exposures are currently
limited, which means that there is currently very little activity that could even be shifted to
the non-bank sector as a result of a conservative prudential approach. Finally, if there are
unregulated areas of the financial system, including the emergence of a "shadow" crypto
financial system, then the appropriate response is to bring these areas within the relevant
regulatory perimeter, instead of diluting banking prudential regulation.
The cross-border cooperation has been particularly visible in the adoption of international
standards aimed at preventing the use of virtual assets in illicit transactions. Specifically,
the Financial Action Task Force (FATF)31 has updated its Recommendations to promote the
registration or licensing of entities seeking to provide services involving virtual assets and
to extend to this field requirements already applicable to traditional financial institutions as
regards due diligence and the reporting of suspicious transactions.
The FATF has also drawn up a set of guidelines32 aimed at making it easier to analyse and
identify the associated risks and to roll out more appropriate oversight measures. Here, it
has underscored the importance of authorities adopting a risk-based supervisory approach
and having the powers and means needed to be able to carry out these responsibilities.
That said, all these mechanisms face significant limitations, not only due to the regional
asymmetries in their implementation, but also because parts of the market are not easy to
reach. Notable examples include both peer-to-peer exchanges and DeFi operations. As a
result, we have to be creative and, in turn, commit to finding alternative formulas.
For the time being, Europe has limited itself to formalising the FATF's proposals by adopting
a legislative package33 which, among other things, envisages the creation of a new authority.
Said authority will be entrusted with making anti-money laundering supervision more
efficient through the cooperation and training of the authorities concerned. This initiative is
supplemented by a series of requirements directly applicable to the provision of
cryptoasset services, such as bans on the provision and custody of anonymous wallets, greater
traceability of ownership changes and an extension of the list of obliged entities to include
all crypto-asset service providers.
At the European level, the European Regulation on Markets in Crypto-assets, or MiCA as
it is better known, is a regulatory initiative that seeks to offer a set of uniform rules and a
common supervisory architecture to provide legal certainty and appropriate legal protection
for crypto-asset users, thereby facilitating the orderly development of this ecosystem. As
such, it envisages a range of provisions applicable both to crypto-asset issuers and to
service providers.
MiCA covers multiple types of crypto-asset service providers. It not only obliges them to
obtain the necessary authorisation, but it also sets out various prudential, organisational
and transparency requirements, as well as others relating to the safekeeping of clients'
funds, conflicts of interest and outsourcing, depending on the service provider's
characteristics. In this respect, MiCA has much in common with the path followed by other
jurisdictions, although the level of requirements and granularity included in these obligations
is greater.
One of the most pioneering aspects of MiCA is its approach to stablecoins, specifically as
to the composition and management of their reserve assets and the conditions associated
with their issuance.
In this respect, matters such as restricting said activities to supervised deposit institutions,34
constraining reference assets to higher quality ones and imposing transparency measures
on the latter35 are emerging issues that could ultimately become global trends.
At the national level, in Spain there are no specific regulations on crypto-assets. The
Spanish National Securities Market Commission (CNMV) has issued a circular on advertising
of crypto-assets intended for financial investment36. The circular aims to ensure that the
advertising content is accurate, easily understandable and not misleading, and that it clearly
includes mention of the associated risks, including the possible loss of the entire investment.
As such, this regulation establishes the tools and procedures for effective supervision of
crypto-asset advertising, but it does not regulate either crypto-assets, their issuance or
crypto-asset-related services
And, since October 2021, the Banco de España37 has held a special register of providers,
although its scope is currently restricted to only a subset of players.38 Unlike other registers,
this one has a limited purpose, catering only for anti-money laundering and counter terrorist
financing needs. In other words, an entity's inclusion in the register does not imply that it
has been granted prudential authorisation, i.e. it does not guarantee that the agent is solvent
or has the technical capabilities necessary to correctly pursue its activity. Nor does the
register impose specific transparency requirements vis-à-vis the agent's clients. In sum,
initiatives such as the register of certain crypto-asset service providers are a step forward.
But they should not be interpreted as authorisation comparable to that granted to banks,
nor do they mean that the Banco de España performs any supervision of their activities.
These examples are a sample of the initiatives which are under way. In any event, beyond
the difficulties inherent to any work involving international coordination, the task at hand is,
for different reasons, particularly complex.
First, the buoyancy of this market makes it difficult to provide a regulatory response.
Second, the decentralised nature of the initiatives sometimes makes it difficult to identify a
contact to whom the measures may be addressed to or who can be designated as a
counterparty. This problem is exacerbated by the absence of a clear jurisdictional
framework. Third, given the complexity of these assets and their associated risks, i