The Financial Stability Implications of Digital Assets

Abstract

The value of assets in the digital ecosystem has grown rapidly, amid periods of high volatility. Does the digital financial system create new potential challenges to financial stability? This paper explores this question using the Federal Reserve’s framework for analyzing vulnerabilities in the traditional financial system. The digital asset ecosystem has recently proven itself highly fragile. However adverse digital asset markets shocks have had limited spillovers to the traditional financial system. Currently, the digital asset ecosystem does not provide significant financial services outside the ecosystem, and it exhibits limited interconnections with the traditional financial system. The paper describes emerging vulnerabilities that could present risks to financial stability in the future if the digital asset ecosystem becomes more systemic, including: run risks among large stablecoins, valuation pressures in crypto-assets, fragilities of DeFi platforms, growing interconnectedness, and a general lack of regulation.

Competing stakeholder narratives on crypto-assets: Miracle or mirage?

“…To date, much of the literature focuses on BTC, an exchange-token, and the first “ crypto-asset designed to work as a medium of exchange ” (Azar et al, 2022: 27). Introduced in 2009 it has drawn academic and practitioner interest on a range of topics: an empirical study on the investment opportunities of cryptocurrencies (Cunha and Murphy, 2019), determinants of exchange token rates (Li and Wang, 2017), price discovery (Alexander and Heck, 2020), pump-and-dump manipulation (Dhawan and Putnins, 2021), liquidity and transaction costs (Dyhrberg et al, 2018), asymmetric volatility (Baur and Dimpfl, 2018), users’ hidden attentions (Glaser et al, 2014), pseudonymity (Fabian et al, 2016; Yin et al, 2019), the rise of the decentralized autonomous organization (Hsieh et al, 2018), media impact on value (Mai et al, 2018), the extent to which it is untethered (Griffin and Shams, 2020), social collectives shaping markets (Briedbach and Tana, 2021), its replacement to profit maximizing firms (Huberman et al, 2021), and use as a socio-technical system (Knittel et al, 2019).…”

Central Bank Digital Currencies: a proper reaction to private digital money?

“…Given our expertise, we will not go into the technical details of the decentralized circulation of digital currencies. Innovations in payment systems that do not require the participation of banks are often seen as the novelty that will, somehow, survive the present issues with these new forms of money (the literature on these aspects include, among others, Auer et al 2021a;BIS 2021;Grasselli and Lipton 2022;Prasad 2021;Azar et al 2022;Panetta 2022;Munchau 2022).…”

Runs and Flights to Safety: Are Stablecoins the New Money Market Funds?

“…In several important ways, stablecoins closely resemble more traditional financial vehicles, particularly money-market mutual funds (MMFs). A key similarity between stablecoins and MMFs is that they both provide money-like assets to investors by engaging in liquidity transformation: They issue liabilities with a stable nominal value, but the collateral backing these claims can suddenly become illiquid.2 This liquidity transformation makes stablecoins and MMFs vulnerable to runs (Rosengren, 2021;Federal Reserve Board, 2022;Azar et al, 2022). Indeed, MMFs suffered runs during both the financial crisis in 2008 and the COVID-19 crisis in 2020 (Duygan-Bump et al, 2013;Cipriani and La Spada, 2020;Li et al, 2021).3 Furthermore, like MMFs, several stablecoins invest their reserves in short-term fixed-income instruments, and there is some evidence suggesting that stablecoin issuance exerts notable effects on traditional money market issuance volumes and interest rates (Kim, 2022;Barthélémy et al, 2023).…”