RBI Financial Stability Report: Crypto tokens failed to prove inflation-hedging benefits

Reserve Bank of India. (File image)

Contrary to its claims of inflation-hedging benefits, the value of crypto tokens continued to fall as inflation rose, the Reserve Bank of India’s (RBI) Financial Stability report released on December 29 said, coming just days after Governor Shaktikanta Das noted that allowing growth of private crypto could lead to the next financial crisis.

The report highlighted that the volatility of such tokens and possible risks of spillovers into the formal financial system require a common regulatory approach, especially at an international level.

“In addition, crypto assets also exhibit high correlations with equities. Furthermore, contrary to claims that they are an alternative source of value due to inflation hedging benefits, crypto assets value has fallen even as inflation rose,” the report said.

According to the report, the ongoing turmoil in the crypto industry with the collapse and bankruptcy of crypto exchange FTX and “subsequent sell-off in crypto assets market have highlighted the inherent vulnerabilities in the crypto ecosystem”.

“Recently, Binance, the largest crypto exchange has also prohibited withdrawals of stablecoins on its platform. The implosion of FTX was preceded by failure of TerraUSD/Luna, an algorithmic stablecoin, a run on Celsius, a crypto lender, and bankruptcy of Three Arrows Capital, a cryptocurrency hedge fund,” the report noted.

More risks than rewards

Stable coins like TerraUSD and Luna which failed show that their promise to maintain a stable value relative to fiat currency is subject to classic confidence runs, the report said. The failure of FTX and Celsius further added to the fact that crypto exchanges and trading platforms were offering features such as lending, brokerage, clearing and settlement that have different risks without appropriate governance structures.

“This exposed them to credit, market and liquidity risks disproportionate to what was necessary to discharge their essential functions. Leverage is a constant theme across the crypto ecosystem, making failures rapid and losses huge and sudden,” the report said.

Mitigating crypto risks

Despite the current volatility, there is yet to be seen its spillovers into the stability of the formal financial system. But crypto still continues to remain a risk forming an unstable ecosystem and there is growing evidence that they remain highly concentrated and interconnected, according to the report.

The report suggested some solutions to address potential future financial stability risks and to protect consumers and investors. One of them is to come at a common approach to crypto assets such as the options being contemplated internationally. The report also mentions prohibiting crypto assets entirely since their real-life use cases are next to negligible as of now. However, the challenge remains that different countries have different legal systems and individual rights vis-à-vis state powers.

The report added, “One option is to apply the same risk-same-regulatory-outcome principle and subject them to the same regulation applicable to traditional financial intermediaries and exchanges.”

“Other option is to let it implode and make it systemically irrelevant as the underlying instability and riskiness will ultimately prevent the sector from growing. This, however, is fraught with risks as the sector may become more interconnected with mainstream finance and divert financing away from traditional finance with broader effect on the real economy,” it said.

Regulating new technology and business models after they have grown to systemic level is challenging. To promote responsible innovation and to mitigate financial stability risks in the crypto ecosystem, it is vital for policymakers to design an appropriate policy approach, according to the report.

Under India’s G20 presidency, working on a global crypto regulatory framework will remain one of the priorities, including the possibility of prohibition, of unbacked crypto assets, stablecoins and DeFi.