Occasional Paper Series Crypto-Assets Implications for financial stability, monetary policy, and payments and market infrastructures ECB Crypto-Assets Task Force No 223 / May 2019 Disclaimer This paper should not be reported as representing the views of the European Central Bank ECB. The views expressed are those of the authors and do not necessarily reflect those of the ECB. Contents Abstract 2 cutive summary 3 1 Introduction 5 2 Characterisation of crypto-assets 7 3 Recent developments and current status of the crypto-assets market 10 Box 1 ICA-TF approach to monitoring crypto-assets 10 3.1 Developments in crypto-asset markets 11 3.2 Evolution of linkages to the financial markets and the economy 15 4 Risks assessment and gap analysis 21 4.1 Potential implications for monetary policy 21 4.2 Risks to financial stability 22 4.3 Supervision and prudential treatment 23 4.4 Risks to financial market infrastructures 25 4.5 Regulatory issues 28 5 Conclusions and future directions 31 Annex 1 The case for central bank digital currency in the European Union 32 Annex 2 List of acronyms 35 References 37 ECB Occasional Paper Series No 223 / May 2019 1Abstract This paper summarises the outcomes of the analysis of the ECB Crypto-Assets Task Force. First, it proposes a characterisation of crypto-assets in the absence of a common definition and as a basis for the consistent analysis of this phenomenon. Second, it analyses recent developments in the crypto-assets market and unfolding links with financial markets and the economy. Finally, it assesses the potential impact of crypto-assets on monetary policy, payments and market infrastructures, and financial stability. The analysis shows that, in the current market, crypto-assets’ risks or potential implications are limited and/or manageable on the basis of the existing regulatory and oversight frameworks. However, this assessment is subject to change and should not prevent the ECB from continuing to monitor crypto-assets, raise awareness and develop preparedness. Keywords crypto-assets, characterisation, monitoring, crypto-assets risks JEL codes E42, G21, G23, O33 ECB Occasional Paper Series No 223 / May 2019 2cutive summary For the purposes of this paper, a crypto-asset is defined as a new type of asset recorded in digital and enabled by the use of cryptography that is not and does not represent a financial claim on, or a liability of, any identifiable entity. Crypto-assets derive their novelty and specific risk profile, particularly their inherent high volatility, from the absence of an underlying fundamental value. Crypto-assets are highly speculative and could expose investors to large losses 1 .This paper’s conclusions are to be interpreted in relation to crypto-assets as defined herein. The ECB monitors crypto-assets and analyses potential implications for monetary policy and the risks they may entail for the smooth functioning of market infrastructures and payments, as well as for the stability of the financial system. To this end, the ECB established the Internal Crypto-Assets Task Force ICA-TF. The ICA-TF analysis shows that crypto-assets do not currently 2pose an immediate threat to the financial stability of the euro area. Their combined value is small relative to the financial system, and their linkages with the financial sector are still limited. There are no indications so far that banks in the EU have systemically-relevant holdings of crypto-assets. Crypto-assets do not fulfil the functions of money 3and, at the current stage, neither do they entail a tangible impact on the real economy nor have significant implications for monetary policy. The very low number of merchants that allow the purchase of goods and services with bitcoins indicates no influence of the most prominent crypto-asset on price-setting. In the current regulatory framework, crypto-assets can hardly enter EU financial market infrastructures FMIs. Crypto-assets cannot be used to conduct money settlements in systemically important FMIs. To the extent that they do not qualify as securities, central securities depositories CSDs cannot undertake settlement of crypto-assets. Even if crypto-assets-based products were to be cleared by central counterparties CCPs, these would need to be authorised and to satisfy existing regulatory requirements, albeit at additional costs and with no clear benefits to EU CCPs 4 . The sector nevertheless requires continuous careful monitoring since crypto-assets are dynamic and linkages with the wider financial sector may increase to more significant levels in the future. Exposures may increase as the crypto-assets ecosystem e.g. post-trade services develops further and more clarity 1 In February 2018, the European Supervisory Authorities ESAs for securities ESMA, banking EBA, and insurance and pensions EIOPA issued a pan-EU warning to consumers regarding the risks of buying virtual currencies. 2 As of 31 January 2019 cut-off date for crypto-assets data used throughout this paper. 3 Mersch, 2018a, 2018b. 4 It is worth noting though that EU clearing members may be exposed to risks stemming from crypto-assets futures offered for clearing by third-country recognised CCPs TC-CCPs. ECB Occasional Paper Series No 223 / May 2019 3regarding application of standards may create a more conducive environment for investments. Depending on how they will be regulated in the future, crypto-assets may more easily enter the FMI environment, and deteriorate the FMI risk profile. If FMI participants were assessed to pose heightened risks to the FMIs’ safety in light of their crypto-assets business, FMI operators would have the authority to impose more stringent restrictions on participation, without prejudice to fair and open access. Particularly the Eurosystem could, if need be, require the segregation of crypto-assets business for participation in TARGET2 and could also terminate participation on grounds of prudence. CCPs could voluntarily pursue segregation via separate default funds for crypto-assets clearing services, although they would still be exposed to loss in own capital at the end of the default “waterfall” 5 . From a prudential view, crypto-assets should be deducted from CET1 as part of a conservative prudential treatment. In fact, the regulation on capital requirements for credit institutions and investment firms CRR is not tailored to crypto-assets in light of their high volatility. Without prejudice to the ongoing work at the Basel Committee on Banking Supervision BCBS, a possible way forward for this conservative prudential treatment is the Pillar 1 deduction from CET1 similarly to other assets classified as “intangible assets” under the accounting framework. Independently of the stipulated prudential treatment, financial institutions undertaking exposures in crypto-assets are expected to put in place an appropriate risk management framework commensurate to the risks posed by the unique characteristics of these activities. Furthermore, any outstanding risks not adequately covered under Pillar 1 could be addressed via supervisory action under a proportional approach. Disjointed regulatory initiatives at the national level could trigger regulatory arbitrage and, ultimately, hamper the resilience of the financial system to crypto-asset market based shocks. Without prejudice to further work to be undertaken by the European Parliament, the Council and the Commission, the ICA-TF analysis suggests that a broader approach to regulation of crypto-assets could be pursued at the intersection with the financial system, where risks arise from unregulated so-called “gatekeepers” that provide an entry point for retail investors and regulated entities. Any regulation should also be balanced to avoid incentivising risky crypto-assets business. At present, crypto-assets’ implications for and/or risks to the financial stability of the euro area, monetary policy, and payments and market infrastructures are limited or manageable. This assessment should not be extended to other areas outside of the scope of this report e.g. money laundering, consumer protection where risks may have already materialised, and should not preclude continuous monitoring or the analysis of future implications of crypto-assets for the stability and efficiency of the EU financial systems and FMIs. 5Prefunded financial resources used to cover losses caused by participant defaults are commonly referred to as a “waterfall” and may include the defaulter’s initial margin, the defaulter’s contribution to a prefunded default arrangement, a specified portion of the CCP’s own funds and other participants’ contributions to a prefunded default arrangement. See CPMI-IOSCO 2017. ECB Occasional Paper Series No 223 / May 2019 41 Introduction Crypto-assets have been the subject of intense policy debate. In particular, crypto-assets have raised concerns with regard to money laundering, market integrity and consumer protection – among other things – as well as possible implications for financial stability. Financial sector authorities in Europe and worldwide undertake various activities on crypto-assets within their mandates. International fora such as the G7, the G20, the Financial Stability Board FSB, and standard setting bodies SSBs conduct work on crypto-assets aimed at monitoring crypto-assets’ implications for global financial stability and coordinating policy responses. The ECB has been studying this phenomenon since its inception, and published its first report on virtual currency schemes in 2012, followed by further analysis in 2015 6 . The ECB Internal Crypto-Assets Task Force ICA-TF was established in March 2018 with the mandate to deepen the analysis around virtual currencies and crypto-assets. To fulfil this mandate, the ICA-TF has structured its work in three pillars i characterising crypto-assets and related activities; ii monitoring crypto-assets and related activities, and the evolution of channels for the possible transmission of risks to the financial sector and the economy; and iii identifying potential control measures to mitigate such risks. The ICA-TF analysis is focused on assessing and helping to contain any adverse impact of crypto-assets on the use of the euro, the monetary policy and the safety and efficiency of market infrastructures, as well as on the stability of the financial system. This analysis serves as a basis for ECB contributions to policy discussions at the European System of Central Banks ESCB, European Union EU, and international level, and with the relevant regulatory authorities. The ECB acknowledges that crypto-assets currently pose risks mostly with regard to money laundering/terrorism financing and consumer protection. On these aspects, as well as on the broader assessment of the EU regulatory framework in light of crypto-assets, the ECB defers the analysis to the relevant authorities, and supports their efforts as appropriate. In particular, the European Banking Authority EBA and the European Securities and Markets Authority ESMA in line with the European Commission’s 2018 FinTech Action Plan, have recently published their advices to the European Union Institutions on crypto-assets 7 . As far as this paper is concerned, selected regulatory issues are covered as part of the risks assessment and gap analysis. This paper summarises the main outcomes of ICA-TF analysis. In particular, it provides an assessment of selected crypto-assets risks and the extent to which the current regulatory and oversight frameworks allow the propagation of these risks to the financial system and the economy to be contained. 6See the 2012 and 2015 reports on virtual currency schemes. 7On 9 January 2019, the European Securities and Markets Authority ESMA and the European Banking Authority EBA released their reports with advice to the European Union Institutions on crypto-assets. ECB Occasional Paper Series No 223 / May 2019 5From a ological perspective, this paper is premised on a characterisation of crypto-assets as a new asset type with a unique risk profile. Within the crypto-assets phenomenon, the ECB clearly distinguishes between the infrastructure layer, where distributed ledger technology DLT underpins crypto-assets as one of many possible use cases, and the asset layer, which is the sole focus of this analysis. Nonetheless, the ECB acknowledges that DLT and other innovative technologies have potential to increase the efficiency of financial intermediation and the financial system as a whole, and is active in monitoring their developments and exploring their application 8 . This paper is structured in five sections Section 2 discusses the ICA-TF characterisation of crypto-assets; Section 3 presents an overview of crypto-assets market trends and the evolution of links with the financial system; Section 4 provides a risk assessment and gap analysis based on the current regulatory and oversight frameworks; Section 5 offers conclusions and the next steps in the analysis of crypto-assets. 8The ECB and Bank of Japan are jointly exploring the potential of Distributed Ledger Technologies in the field of market infrastructures in the context of their joint project Stella. To date, two reports have been published “Payment systems liquidity saving mechanisms in a distributed ledger environment September 2017; “Securities settlement systems delivery-versus-payment in a distributed ledger environment” March 2018. ECB Occasional Paper Series No 223 / May 2019 62 Characterisation of crypto-assets There is currently no international agreement on how crypto-assets should be defined. Given the lack of an agreed definition of crypto-assets, this paper’s characterisation of this phenomenon may not necessarily coincide with the approach taken by other authorities or in the relevant international fora 9 . At the same time, the approach taken in this paper is not inconsistent with the EU regulator’s definition of virtual currencies 10 , which represent a broader set of assets compared to crypto-assets as defined in this paper. Within the scope of its mandate, the ECB works to facilitate a common understanding of this phenomenon so as to avoid a proliferation of definitions at a sectoral and jurisdictional level hampering international coordination efforts. In this paper, the term “crypto-asset” denotes any asset recorded in digital that is not and does not represent either a financial claim on, or a financial liability of, any natural or legal person, and which does not embody a proprietary right against an entity. Yet, a crypto-asset is considered valuable by its users an asset as an investment and/or means of exchange, whereby controls to supply and the agreement over validity of transfers in crypto-assets are not enforced by an accountable party but are induced by the use of cryptographic tools. The emergence of crypto-assets has been