ESMA warns crypto industry about crypto-crashes

Key highlights from ESMA’s report on crypto-assets and risks for financial stability 

As we were preparing a summary of the latest European Securities and Markets Authority (ESMA) report, ironically entitled ‘Crypto-assets and their risks for financial stability’, we were, as was the rest of the crypto world, spell-bound by the events that unfolded relating to the collapse of FTX.  As our Director of Intelligence Nick Smart said, “It was a watershed moment”. 

The events also underlined more so than ever the need for improved oversight, improved regulatory measures, better risk management and assessment, and due diligence.  

On October 4, 2022, just weeks before of the FTX drama unfolded,  the European Securities and Markets Authority (ESMA) published Crypto-assets and their risks for financial stability  warning investors that crypto-assets are highly risky and may bring financial instability in the future.  

In it, ESMA highlighted how the rapid growth of crypto-assets and the interest in their implications on the traditional financial system and financial stability have led to increasing attention from the authorities on the risks for consumer protection. 

Key highlights of the ESMA Report 

The report illustrated the most recent evidence on the risks and channels of transmission of cryptocurrencies to the financial markets, highlighting that while some sources of risk are well-known from traditional markets, others are new and linked to the design of the product, technological development or complex infrastructures built around crypto assets. 

The document identified the risks in the cryptocurrency market, which could serve as sources of financial instability and analyzes the interconnections with traditional markets.  

The report contains:  

• An overview of recent market developments; 
• The analysis of specific sources of risk;   
• Potential transmission channels to traditional financial markets;  
• ESMA’s approach to monitoring risks in the market;  
• A brief overview of regulatory responses on the subject; 

Risks native to crypto assets 

Crypto assets carry several risks because of their volatile price movements. There are several crypto-specific risks associated with them:  

• The anonymity of the crypto market makes it impossible to assess the credibility or aggregate exposures of participants; 
• Using Distributed Ledger Technologies (DLTs) on which crypto assets are based, attacks on DLTs can expose entire blockchains to risk 

• Crypto markets could influence the pattern of traditional financial markets, such as price manipulation and mis-sell. Huobi Global, Bitmex and Bybit are some of those crypto exchanges that allow risky investments via leverage of over 100 times; 
• Other emerging risks, such as manipulation of consensus mechanisms, large pseudonymous orders distorting prices, hacks, and congestion,  remain to be addressed 

If applicable regulatory measures are not applied, these risks may affect the stability of the traditional financial system in the future. 

Continuous monitoring of the cryptocurrency market is necessary 

Crypto  assets are still small, and their interconnections with traditional markets are limited. In the future, this situation may change, as market growth can happen suddenly, and the transmission of risk is possible through various channels.  Therefore, continuous monitoring of the cryptocurrency market and its interconnection with the financial system is necessary to assess the new emerging threats promptly.  

Regulatory proposals should be implemented quickly to mitigate the risks associated with the crypto market. This document offers a first view of how ESMA defines the risks in the crypto market, as they prepare to take on new duties under the European Union’s Markets in Crypto Assets Regulation, (MiCA).  

So far, the turbulence in the cryptocurrency market (attributable primarily to the inherent vulnerabilities of the market structure and underlying technology) has not been reflected in traditional financial markets or the real economy.  

However, ESMA concludes, relapses could occur, depending on how the current risks are managed to contain and how the interconnections between the two systems develop. While these threats have not yet surfaced, understanding their causes is an essential first step in defining an appropriate regulatory response and mitigating future fallout from market downturns.   

Crystal’s Regulatory & Compliance experts are helping you transform regulations into adequate risk management. Stay ahead of the change and the coming regulatory frameworks and sanctions with the help of our compliance team. For any compliance-related questions, please get in touch with us at: [email protected]