Stronger links between crypto industry and traditional finance pose key risks to financial stability: MAS

SINGAPORE — The central bank here on Friday (Nov 25) published a report identifying two key threats to financial stability posed by the global rise of crypto assets.

Firstly, any shocks to the crypto ecosystem may spread to the traditional financial system, given that the two have become more strongly interconnected, the Monetary Authority of Singapore (MAS) warned.

Secondly, financial activity using technology in the crypto world such as blockchain may be able to bypass regulations designed to ensure market functioning, integrity and resilience, MAS added.

The warnings were contained in MAS' annual stability review.

The central bank said that the adoption of crypto assets and their underlying technology by financial institutions and systems means the stability of business models, banks and other regulated financial institutions could be disrupted.

MAS noted that there are "several forms" in which linkages between the traditional financial systems and the global crypto ecosystem can occur. 

One is that crypto players could hold traditional financial assets, which connect their balance sheets to traditional asset markets. At the same time, financial institutions could also have exposures to crypto-assets and crypto players that link them to the crypto ecosystem. 

Earlier this month, Singapore state investor Temasek Holdings said it would write down its full investment of US$275 million (S$376.7 million) in cryptocurrency exchange FTX, which went bankrupt in spectacular fashion.

In doing so, Temasek acknowledges that its belief in FTX's former chief executive officer Sam Bankman-Fried “would appear to have been misplaced”.

The collapse of FTX is the latest and most serious blow to the crypto world, with billions of dollars wiped off the value of assets such as bitcoin, which is now trading around levels last seen in late 2020.

On Thursday, The Straits Times reported that Singapore sovereign wealth fund GIC, an investor in the Digital Currency Group, which has ties to troubled cryptocurrency broker Genesis Trading, is expecting volatility in investments to stay high in the short term. 

MAS highlighted that there are several vulnerabilities in the global crypto ecosystem, as it is subject to "exogenous shocks" that the traditional financial system is also vulnerable to. 

"While some of these vulnerabilities are similar to those in the traditional financial system, others stem from the use of new technologies, novel structures of organisation, or modes of financial intermediation that hew to the hallmarks of the crypto ecosystem," said MAS. 

VULNERABILITIES AND IMPLICATIONS 

MAS had considered three sub-categories in the crypto-asset space: Stablecoins, decentralised finance (DeFi) and other crypto assets. 

Stablecoins are crypto-assets that aim to maintain a stable value relative to a specified currency and are the de facto medium of exchange in the crypto ecosystem. 

DeFi is defined by MAS as a set of financial applications that operate using crypto-assets and smart contracts, with limited or no involvement of centralised intermediaries. 

Other crypto-assets are held by individuals or other financial entities to pay blockchain utilisation fees and more generally for portfolio diversification or speculative purposes. A blockchain is a decentralised, distributed and public digital ledger that is used to record transactions. 

Vulnerabilities in investing in the global crypto ecosystem identified by MAS include: 

• TECHNOLOGY, CYBER AND OPERATIONAL RISK

The proper functioning of the crypto ecosystem depends on the robustness of the underlying blockchain infrastructure.

Should blockchain networks encounter operational disruptions, crypto transactions cannot be recorded and completed, and the use of stablecoins as mediums of payment and trading on crypto-asset markets will be disrupted at the same time.

DeFi applications that run on blockchain networks and financial intermediation facilitated by their protocols, likewise, cannot proceed.

"While traditional finance is also subject to cyber risks, these are a relatively greater threat to the crypto ecosystem because of its comparatively higher level of technological intensity," said MAS. 

The open source nature of the technologies used in the crypto ecosystem also makes it more likely to be exploited than the technologies used in traditional finance.

• RISKS SPECIFIC TO CRYPTO-ASSETS 

The absence of a fundamental value for these crypto-assets implies that much trading is "speculative in nature and highly sentiment-driven", and this leaves crypto-asset markets more susceptible to large swings in prices than more conventional types of assets.

The use of debt to fund crypto trading also increases the market's susceptibility to price corrections in crypto-asset trading.

• RISKS SPECIFIC TO DEFI

Cyberattacks, such as hacks or exploits of coding vulnerabilities, can severely disrupt DeFi application operations, and the decentralised governance of DeFi applications also increases the likelihood that such operational disruptions are not being resolved in a timely manner. 

MAS said that the implications of risks is not only on the likelihood of "impact shocks" within the crypto ecosystem, but also that they could "become systemically disruptive if propagated to the wider financial sector". 

Another implication to financial stability arises from the changes to the structure of the financial system caused by the adoption of crypto-assets and the underlying technology.

"The changes could take the form of new modes of financial intermediation, a displacement of incumbent mediums of exchange and other financial services providers, which could accentuate the volatility of cross-border capital flows," said MAS. 

Thus, there is the potential of disruption to the stability of the business models of banks and other regulated financial institutions, as well as "non-trivial implications on the monetary and external stability of economies". 

HOW TO MITIGATE THE RISKS 

MAS said that financial innovation has the potential to improve the financial processes and the operation of the financial system more generally.

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

However, due to the risks to financial stability involved, regulations at the business level will play an important role in "mitigating the vulnerabilities presented by crypto-assets and DeFi at source".

These regulations include:

• Regulatory frameworks that specifically target stablecoins and their risks, which are in progress
• Growing initiatives by global regulators to mitigate risks posed by crypto-asset markets, including money laundering and terrorist financing. MAS has proposed a set of regulatory measures in October to address concerns on the use of digital payment token services, including stipulations that businesses ensure their consumers pass a test on the risks of buying cryptocurrencies before they are allowed to do so
• Limiting banks’ crypto-asset exposures by enhancing the resilience of banks to shocks from crypto-markets