Financial System Review—2022 – Bank of Canada | Techy Kings

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Crypto asset ownership is also becoming more widespread, especially as a speculative investment rather than a payment method. In 2021, about 13% of Canadians own Bitcoin, up from 5% in 2020. The median Bitcoin holding is about $500, mostly for investment purposes. Until now, the significant volatility in the price of these unbacked crypto-assets as well as the high transaction costs have been the main obstacles to their widespread acceptance by merchants as payment methods. For example, the prices of crypto assets such as Bitcoin and Ether are typically four to five times more volatile throughout 2021 than the S&P 500 stock market index. Sharp price corrections mean that investors holding these types of crypto assets can be exposed to significant financial losses.

The interconnection between the unbacked crypto asset market and the financial system appears limited but is growing rapidly. Institutional participation in this market has grown over the past few years. However, estimating the growth of institutional investment in these assets and related infrastructure is difficult due to the lack of readily available and consistent data on the exposure of financial system participants to these markets. Discussions with industry participants suggest that portfolio exposure remains small. Cryptoassets in general have become more accessible to investors in recent years through the emergence of closed-end funds, crypto exchange-traded funds and listed companies dealing in or mining cryptoassets. Additionally, hedge funds and some large pension funds are reportedly investing more in cryptoasset platforms. Cryptoassets are also becoming more integrated into the traditional financial system (often referred to as the financialization of cryptoassets), including through the development of crypto derivatives markets and as investment assets or collateral for loans.

The Bank’s assessment that this market is not yet of systemic importance is reinforced by the fact that the major sell-off in the cryptoasset market in May 2022 is generally insignificant for the traditional financial system in Canada and abroad.

Stablecoins aim to meet the demand for more liquid and volatile crypto-assets. Stablecoins play an important role in decentralized finance, a set of alternative financial products offered in the cryptoasset market that mimic traditional financial services (eg, loans, insurance, asset management and custody). Like other cryptoassets, stablecoins can also pose a risk to financial stability if adopted on a significant scale without appropriate regulatory protections, particularly regarding issuers’ ability to honor redemptions (Box 5).

The lack of an adequate regulatory framework for crypto-assets is a major factor behind this weakness. Firms operating in the cryptoasset market often perform similar functions to traditional financial institutions. They share many risks but are not subject to the same regulatory standards. Until these regulatory gaps are addressed, investors in and end-users of unbacked cryptoassets are subject to a higher risk of financial loss from events such as fraud, cyber-attacks or the failure of a primary custodian or service provider. Additionally, a significant challenge to the regulation of crypto assets is that they are easily used for cross-border transactions. This can be positive for economic activities such as remittances, but it creates opportunities for illegal transactions such as money laundering and terrorist financing. For the regulation of these markets to be effective, countries need to coordinate closely to ensure consistency and prevent criminals from exploiting regulatory gaps.

The regulatory response is taking shape but needs to gather momentum. Regulators around the world have recognized the risks posed by a deficient regulatory framework and are working to address them. For example, in March 2022, the US administration issued a far-reaching executive order:

  • launch a strategy on digital assets
  • asked many federal government agencies to jointly examine the regulation of digital assets

In Canada, provincial securities regulators have issued guidance for the regulation of cryptoassets and cryptoasset trading platforms that meet the definition of a securities or securities market infrastructure, respectively. The federal government announced in the 2022 budget that it will undertake a legislative review of the financial sector. The first phase of this review will focus on digital currencies, including cryptoassets and stablecoins. As part of that work, the government will study:

  • regulatory approach to maintain the safety and stability of the financial system as digital currencies become more common
  • the potential need for a central bank digital currency in Canada

In addition, a Bank of Canada official currently chairs the FSB Regulatory Issues of Stablecoins working group working together to promote a globally coordinated regulatory response to stablecoins.

In general, federal and provincial authorities should move quickly to develop an integrated regulatory regime for crypto-assets, otherwise these weaknesses could continue to worsen.

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