Continued exuberance makes crypto very volatile, says ECB

ECB says volatility in crypto assets has created vulnerabilities that will be exposed if higher-than-expected inflation leads to spike in interest rates

In its new financial stability review, the European Central Bank has branded cryptocurrencies as ‘exotic’ but admitted the popularity of stablecoins was growing.

Crypto-asset markets, says the ECB, remain subject to volatility, “with the growing popularity of stablecoins increasing connection between crypto-assets and traditional financial markets”.

ECB’s vice president, Luis de Guindos, wrote that the development of a crypto-based market infrastructure under the name of ‘decentralised finance’ (DeFi) has increased the complexity of these markets.

He added some crypto-asset investors use leverage, which increases the potential relevance of the segment for financial stability as “such practices can lead to large, concentrated losses and continued exuberance may leave crypto markets seriously affected with corrections”.

According to the latest ECB report, the market capitalisation of stablecoins has risen from $5bn to $120bn since 2020 and they are serving increasingly different functions in the crypto-asset ecosystem.

“For those stablecoins referring to currencies or assets, these tools include holding reserve assets against which stablecoin holdings can be redeemed,” de Guindos noted.

“The functions served by stablecoins within the ecosystem have multiplied. In addition to acting as a relatively safe ‘parking space’ for crypto volatility, stablecoins serve as a bridge between fiat currencies and crypto-assets.”

Higher yields enhance crypto demand

According to the report, investors continue to seek investment avenues that promise significantly higher yields on the back of declining interest rates and rising inflation.

This trend, the bank argued, has led to surging investment activity in market segments like crypto, junk bonds, and housing.

The ECB stated that such a situation could cause problems down the line especially if abrupt changes to global liquidity conditions were to occur.

The bank was traditionally not inclined to cryptocurrencies. Its president Christine Lagarde recently branded them as ‘suspicious’ and ‘highly speculative’.

However, both cryptocurrency and stablecoin regulations are among the issues under consideration by the European Commission in its proposed Markets in Crypto Assets (MiCA) framework.

Disclaimer: The views and opinions expressed by the author should not be considered as financial advice. We do not give advice on financial products.

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