ESMA has released a new report, Crypto-assets and their risks for financial stability, focusing on identifying risks in the crypto-assets market and the interlinkages with traditional markets.

Teh regulator has been following crypto developments for years, tracking developments to the point where native tokens and stable coins now represent the largest part of the crypto market. Even if the crypto asset market is small in size compared to the traditional financial system, ESMA’s analysis is that the market still could change rapidly. And it can be very risky for investors.

“Due to their volatile growth cycles, and as long as relevant regulatory provisions do not apply, crypto-assets entail numerous risks which may in future become relevant for financial stability.”

ESMA

As most cryptos have no tangible value, and are mostly highly speculative, investing in cryptos can be a big a big risk to consumers, while the value of assets depends exclusively on supply and demand.

A good example of the market volatility came earlier this year, when the market collapsed by over 60% in just a few months.

“Due to their volatile growth cycles, and as long as relevant regulatory provisions do not apply, crypto-assets entail numerous risks which may in future become relevant for financial stability,” ESMA said in the analysis.

Growing crypto interest

The November 2021 Consumer Expectation Survey, from the European Central Bank, found that as many as 10% of European households may own crypto assets. However, most private investors have only invested small amounts – below €5,000 ($4,885). The FCA’s 2021 Consumer research on crypto-assets showed similar results, and it estimated that around 4% of British adults have invested in crypto, with a median investment of around £300 ($333). Even though the number of private investors might seem small, both surveys indicate an increasing interest to invest in crypto assets.

Besides the growing interest in crypto trading, another noticeable expanding development in the fintech market is decentralised finance, (DeFi), which allows users and businesses to make transactions without depending on intermediaries by using distributed ledger technologies (DLT).

ESMA has also observed an increasing use of crypto-assets derivatives, where people trade contracts without actually holding the asset, and either pay or get paid the price difference depending on the market values when the contract ends.  

However, the most crypto-assets derivatives transactions are made on unregulated crypto trading platforms.

New framework with MiCA

Even though crypto-asset markets and traditional financial markets are considered as two separate systems, some connections between the markets exist and are likely to grow.

Some jurisdictions are already outlined, but the biggest one is yet to come. The EU is the first major jurisdiction worldwide that will provide a comprehensive, dedicated regulatory framework for crypto assets, called the EU Markets in Crypto-Asset Regulation (MiCA). The framework is set to regulate crypto assets, including stable coins that do not fall under existing EU rules, by setting regulatory requirements for public offers and marketing of crypto assets, and the services related to them.

MiCA is expected to be published in the Official Journal of the European Union in the spring of 2023, and will be implemented between 12 and 18 months later.

Pending EU rules, France and Malta have already established dedicated national regimes for crypto-asset service providers (CASP), and Germany has some licencing and prudential requirements that also apply to CASPs providing certain types of services (for example MiFID-type or custody services).

Importance of global principles

“Given the cross-border nature of the crypto-asset market, the importance of global standard setting organisations, such as the Financial Stability Board (FSB) and the international Organization of Securities Commissions (IOSCO), cannot be understated,” says ESMA.

Both FSB and IOSCO provide essential platforms to promote regulatory standardisation across jurisdictions, and together share information and promote regulatory convergence around a common set of principles. While FSB focuses primarily on financial stability, IOSCO regulate the world’s securities and futures markets.

With MiCA, ESMA will be able to implement standards on future white papers for crypto assets. ESMA is also in the process of including crypto assets in its risk monitoring framework, and will continue to analyse material risk issues as they emerge further on.

Read the report in full here.