Full text of speech by ECB Executive Board member on crypto risks and regulation

170 years ago, Americans crossed the border and pushed westward, seeking fortune in the Gold Rush. Greed and lawlessness turned the promised land into the Wild West, where a few exploited the dreams of the many.

Fast forward a century and a half, and against the backdrop of the global financial crisis, growing distrust of banks, combined with technological innovation, gave rise to a new dream - a digital gold rush beyond national control.

Satoshi Nakamoto—or more precisely, the software developer who uses that pseudonym—created the source code for what they believed would become a decentralized digital currency. Their 2008 white paper showed a great fascination with technology, especially cryptography, but not necessarily a deep understanding of payment and monetary issues. They aspired to an anarchist utopia of a stable currency that was beyond public scrutiny.

Almost 15 years later, crypto assets are on everyone’s lips. Cryptocurrency enthusiasts were amazed by the rise of the crypto market, and many felt they should take a gamble on cryptocurrencies. An ecosystem has emerged, from miners to intermediaries, all seeking to expand into the digital financial sector. Cryptocurrency evangelists promised a paradise on earth, using the illusory narrative of rising crypto asset prices to sustain capital inflows, fueling the momentum of the cryptocurrency bubble.

But appearances are deceptive. Satoshi Nakamoto's dream of creating a trustworthy currency remains just that. Crypto asset transfers can take hours to process. Their prices fluctuate wildly. So-called anonymous transactions leave an immutable trail that can be tracked. Most cryptocurrency holders rely on intermediaries, contrary to the avowed philosophy of decentralized finance. For example, in El Salvador, the first country to adopt Bitcoin as legal tender, payments are made through a traditional, centrally managed wallet.

Crypto assets bring instability and insecurity — the exact opposite of what they promised. They are creating a new Wild West. To quote Game of Thrones, “Chaos is a ladder.” This character’s story does not end well. However, it only takes a few people to climb high on the ladder — even if their gains are only temporary — to convince many others that they are missing out. In fact, the cryptocurrency market is now larger than the subprime mortgage market — worth $1.3 trillion, which triggered the global financial crisis.

It shows strikingly similar dynamics. In the absence of adequate controls, crypto assets drive speculation by promising quick and high returns and exploiting regulatory loopholes that leave investors unprotected. Limited understanding of the risks, fear of missing out, and intensive lobbying by lawmakers have driven up risk exposure while slowing regulation.

We cannot make the same mistake again and wait for the bubble to burst before realizing how pervasive crypto risks have become in the financial system. While some may hope to be smarter and get out, many will be trapped.

It is time to ensure that crypto assets can only be used within clear, regulated boundaries and for purposes that add value to society. It is time for policymakers to respond to the growing demand for digital assets and digital currencies and adapt sovereign currencies to the digital age.

Today I will argue that crypto assets are not only speculative and high-risk investments at this time, but they also raise public policy and financial stability concerns. I will then discuss some elements of the public policy response that are necessary to protect investors and preserve financial stability without stifling innovation.

The rise of crypto assets

Let me start with the underlying drivers of crypto assets.

Fundamentally, crypto assets are the result of advances in cryptographic methods and distributed ledger technology. Innovations made it possible to create an asset without any underlying claims. In the initial setup of what we call "unbacked crypto assets" today, no one was responsible, and these assets were not backed by any collateral or managed by a trusted operator. This made them purely speculative in nature and therefore very volatile.

To address the risks of unbacked cryptocurrencies, “stablecoins” have emerged whose value is pegged to one or more low-risk assets. However, without regulation, they are stable in name only.

In fact, they can be low-risk, but not risk-free, and there is no guarantee that they can be redeemed at par at any time.

They do not benefit from deposit insurance or have access to central bank standing facilities. As a result, they are vulnerable to runs.

They are often purely speculative assets that are subject to high financial and operational risks: research has found that a third of stablecoins launched in recent years have not survived. Despite these weaknesses, the number of crypto assets has expanded significantly, with around 10,000 currently available on the market.

Driving this growth is a complex and opaque crypto ecosystem consisting of cryptocurrency miners and service providers (such as exchanges or wallets) that are largely unregulated and lack adequate supervision or oversight.

Within this market, there is a rapidly growing decentralized finance sector, which uses smart contracts to support trading, lending, and investing in crypto assets - without relying on intermediaries. This supply of crypto assets has met strong demand from professional investors and the general public. By 2021, approximately 16% of Americans and 10% of Europeans have invested in crypto assets.

This strong appeal of crypto assets, especially unbacked assets, is worrisome given the lack of fundamentals, the number of recent scandals, their use in illicit activities, and high price volatility, all of which suggest that the underlying market dynamics are not sound.

First, the market is highly concentrated: retail investors holding fewer than 10 bitcoins, for example, hold a tenth of the bitcoin supply, while professional investors and high-net-worth individuals hold nearly two-thirds.

The vested interests of large investors will naturally lead to an increase in lobbying activities. In the United States, for example, crypto companies spent about $5 million lobbying the Senate in the first nine months of 2021 alone.

A flood of news stories and investment advice on social media highlighting past price increases, as well as features such as artificial scarcity to create fear of missing out, drive up prices. As a result, many people invest without a clear understanding of what they are buying. Like a Ponzi scheme, this dynamic will continue as long as more and more investors believe that prices will continue to rise and that there can be fiat value without any income or security streams to back it up. Until the enthusiasm dies down and the bubble bursts.

Cryptoassets and public policy issues

Meanwhile, cryptocurrency enthusiasts will argue that crypto assets are different and regulating them would stifle innovation. We’ve heard it all before. But can crypto assets actually create value for the payment system?

Unbacked crypto assets cannot achieve their original goal of facilitating payments. Currencies are too volatile to fulfill their three functions: medium of exchange, store of value, and unit of account. For example, between November 2021 and January 2022, Bitcoin prices fell from about $68,000 to about $38,000. Their three-month volatility is 60%, nearly five times that of gold and four times that of the U.S. stock market.

Such high volatility also means that households cannot rely on crypto assets as a store of value to smooth their consumption. Similarly, businesses cannot rely on crypto assets as a unit of account for calculating prices or balance sheets.

The same is true for stablecoins, which, in the absence of proper regulation and oversight, have poor consumer protection and are prone to panic selling. If adequately regulated and overseen, stablecoins are nothing more than an electronic money arrangement. This is what we have known for years.

Cryptoassets, especially unbacked ones, are therefore not useful as money. But do they at least perform other valuable social or economic functions, such as financing consumption or investment, or helping to combat climate change? There is reason to believe that they do just the opposite.

Crypto assets are widely used in criminal and terrorist activities. It is estimated that the amount of crypto assets exchanged for criminal purposes is huge, exceeding $24 billion in 2021. Studies show that $72 billion (about 23%) of transactions are related to criminal activities each year. Ransomware attackers often demand crypto payments.

Crypto assets may also be used to evade taxes or circumvent sanctions. For example, North Korea has actively tried to recruit cryptocurrency experts over the past few years. Recently, there has been an increase in crypto asset transactions using the ruble following sanctions on Russia. While we cannot be sure whether crypto assets are used by sanctioned individuals or businesses, this suggests that they offer a potential means of circumventing sanctions.

Crypto assets based on proof-of-work (PoW) blockchains also cause huge pollution and damage to the environment. They are created in a decentralized mining process that consumes a lot of energy and computing hardware. It is estimated that mining on the Bitcoin network consumes about 0.36% of the world's electricity, equivalent to the energy consumption of Belgium or Chile. Worse, efforts to reduce energy demand may be futile. The network's demand for energy is potentially unlimited because the verification process encourages miners to constantly upgrade their computing power to ensure the security of the system. Even if crypto mining uses clean energy or less energy-intensive technologies, this energy cannot be used for other purposes, thereby increasing the consumption of fossil fuels and hindering the fight against climate change.

Crypto assets are therefore speculative assets that can cause significant damage to society. Currently, their value comes mainly from greed, they rely on the greed of others and hope that the plan will work out. Until this house of cards collapses and people are buried under their losses.

Crypto-assets and financial stability risks

Let me now turn to the risks that crypto assets pose to financial stability.

Crypto assets still only make up a small portion of total global financial assets (about 1%). But, as I mentioned, they already have a larger market than subprime mortgages did before the start of the global financial crisis. We can’t ignore them.

In fact, the popularity of crypto assets is spreading beyond their core supporters.

The launch of the first U.S. bitcoin exchange-traded fund in October marked a rise in institutional activity in these assets, largely in response to client demand. The retail sector is also growing, with retail investors often lured by misleading advertising that fails to clearly explain the risks of these products.

Large payment networks have stepped up their support for crypto assets, and retail holdings by intermediaries have also increased significantly. For example, Coinbase, the largest cryptocurrency exchange in the United States, currently has 56 million users, an increase of 65% since March 2020.

Crypto-assets pose financial stability risks through three main channels.

First, stress in cryptoasset markets could spread to participants in the broader financial system through direct holdings of assets or ownership of service providers. One measure of this connection is the correlation between changes in cryptoasset prices and changes in stock prices, which has been positive since 2020.

Second, a decline in the value of crypto assets could have an impact on investors’ wealth and have a knock-on effect on the financial system.

A loss of confidence in the value of crypto assets, due to operational failures, fraud, price manipulation or cybercrime, could lead to a sharp deterioration in investor confidence. This could spread to broader financial markets.

Connections through these three channels are still limited. But they could increase rapidly if crypto assets are widely adopted by institutional or retail investors. Such a scenario is not far-fetched. For example, high-net-worth investors, financial advisors, and family offices are now leading investments in crypto assets. What’s more, big tech companies could launch global stablecoins for retail use. We’ve already seen the example of Meta’s cryptocurrency project Diem, where big tech companies could significantly strengthen the connection between the crypto asset ecosystem and the broader financial system by leveraging their large customer base and bundling payments and other financial services together.

In stress situations, a sudden surge in redemptions by stablecoin holders could lead to instability in various market segments. For example, Tether, one of the most popular stablecoins, promises “stability” by investing in low-risk assets such as commercial paper and holds a large portion of the stock of these circulating instruments. Large-scale sales of these assets in response to a sudden increase in redemptions could bring instability to the entire commercial paper market. This phenomenon could spread to other stablecoins and related industries, and ultimately to banks holding stablecoin liquidity.

Such extreme conditions may not occur immediately. But the longer we wait, the greater the risk exposure and the more vested interests there are. The harder it will be for policymakers to act.

Regulation of crypto assets

This brings me to the question of regulation.

Policymakers should not allow crypto assets and their associated risks to proliferate without limit. We must decide how to regulate them, following a strict risk-based approach for different instruments. Currently, regulatory approaches vary from country to country. Some countries have completely banned crypto assets, while others have restricted their use.

This situation is clearly unsatisfactory, as crypto assets are a global phenomenon and their underlying technology can play an important role, not just in the financial sector. We need globally coordinated regulatory action to address issues such as the use of crypto assets in cross-border illicit activities or their environmental footprint. Regulation should balance risks and benefits so as not to stifle innovation that could spur payment efficiency and wider adoption of these technologies.

Progress is being made in Europe and around the world, but not fast enough to meet emerging challenges. We need to see faster progress on many fronts. Four are particularly relevant.

First, we need to hold crypto assets to the same standards as the rest of the financial system. This means swiftly implementing all rules to prevent the use of crypto assets for money laundering and terrorist financing, in accordance with the standards set by the Financial Action Task Force (FATF), and effectively enforcing those rules. These efforts should also aim to bring peer-to-peer crypto asset transfers within the scope of Anti-Money Laundering (AML) and Combating the Financing of Terrorism (CFT) standards.

Second, we should consider how to adequately tax crypto assets. Currently, the tax treatment of crypto assets is very poor: we know very little about who actually owns them and how big they are. By its very nature, the crypto asset market makes it very difficult to identify tax-relevant activity because it relies less on traditional financial intermediaries, which typically provide information for tax purposes.

Given the global nature of the cryptocurrency market, we should align the taxation of crypto assets with that of other instruments, with the goal of achieving uniformity across jurisdictions. The Organization for Economic Cooperation and Development (OECD) recently proposed reporting obligations for transactions above certain thresholds, which would increase transparency and combat tax evasion, and also have the potential to impose higher taxes on certain crypto assets (such as PoW-based assets) than other financial instruments. Negative externalities that lead to sunk costs for society, such as high pollution, could be included in appropriate taxes levied on cryptocurrency market participants (issuers, investors, and service providers).

Strengthen public disclosure and regulatory reporting. The practices currently observed in the crypto industry—for example, the disclosure of reserve assets backing stablecoins—are highly problematic. They are insufficient, vary between products, and can even mislead investors and policymakers. Mandatory disclosure requirements for financial institutions are necessary to identify where risks from crypto assets are concentrated. At the same time, public institutions (central banks, regulators, and anti-money laundering agencies) need to further improve their data capabilities to detect illicit transactions and new threats to financial stability.

Fourth, given that key issues such as operational risk, volatility and liquidity have not yet been resolved, regulators should introduce strict transparency requirements and establish standards of conduct that professional operators should follow to protect inexperienced retail crypto-asset investors.

Europe is leading the way in bringing crypto assets under regulatory purview. The finalization of the Regulation on Markets in Crypto-Assets (MiCA) will harmonize regulatory approaches across the European Union (EU). Similarly, the European Commission’s legislative proposal to create an EU single rulebook on AML/CFT will bring all crypto-asset service providers within the scope of the relevant EU framework, which will also provide the basis for a unified European approach to regulating them.

In addition, the proposed Regulation on Information Transfers of Funds and Certain Crypto-Assets (FCTR) will aim to ensure that crypto-asset transfers involving at least one crypto-asset service provider can be tracked and suspicious transactions can be blocked. Given the rapid growth of the cryptocurrency market, expeditious negotiations by the European Commission, the European Parliament and the Council of the European Union, as well as thorough enforcement by the competent national authorities are necessary.

Regulatory measures in Europe need to go further. We need to focus more on unsecured crypto-asset activities that take place without a service provider. Furthermore, we cannot leave on-chain peer-to-peer payments unregulated, as they can be used to circumvent any regulation. Finally, if we really want to significantly harmonize regulation across all EU member states, the new European Anti-Money Laundering Authority should regulate the riskiest crypto-asset providers.

But our measures will only be effective if they match the ambitious measures implemented by our international counterparts.

The United States is taking action in this regard, while the Financial Stability Board (FSB) has made progress in advancing the global agenda for work on crypto assets, working with other international bodies such as the Committee on Payments and Market Infrastructures, the Basel Committee on Banking Supervision, and the Financial Action Task Force.

We should build on this momentum and not wait until a crisis occurs to create a dedicated global policy forum that brings together the key players needed to address crypto-asset risks.

in conclusion

Let me summarize.

The westward expansion of the United States in the second half of the 19th century roughly coincided with the passage of free banking laws in some states, which eased the conditions for opening a bank and facilitated the emergence of so-called "wildcat banks." These banks, often located in remote areas where wildcats were active, were able to issue their own notes to the public, secured by questionable assets, with no intention of honoring them. Many banks defaulted, undermining public confidence in banks.

We should not allow this to happen again in the digital realm of crypto assets.

We need a coordinated effort at the global level to bring crypto-assets under the regulatory umbrella. We need to ensure that they are subject to standards consistent with those that apply to the financial system. In doing so, we must navigate complex trade-offs, balancing the goals of promoting innovation, maintaining financial stability, and ensuring consumer protection. If we want to ensure that crypto-assets do not spark a wave of lawless risk-taking, we should make faster progress.

But this is not enough. The growth of the cryptoasset market shows that society has a growing demand for digital assets and instant payments. If the official sector - public authorities and intermediaries - cannot meet this demand, others will step in.

Central banks must become more involved in digital innovation by upgrading financial infrastructure, operating fast retail payment systems, and preparing for the issuance of central bank digital currencies.

In all these areas, the ECB is at the forefront. We are focusing on a digital euro, allowing citizens to use sovereign currency for payments anywhere in the euro area, while protecting its role as the anchor of the payments and monetary system.