Crypto currency economic shock

Significant informational and data shortcomings persist, hindering the proper assessment of financial stability risks. These shortcomings include not only quantitative issues but also the reliability and consistency of data, and the fact that a significant proportion of activities take place outside the regulatory perimeter. Most publications from crypto-asset service providers including platforms, exchanges and data aggregators are not verifiable and should be treated with caution, while the limited regulatory data currently available e.

As long as there continue to be no official statistics on crypto-assets or reporting of underlying data to a supervisory or oversight authority, the reliability of the metrics from the above sources and the full extent of possible contagion channels with the traditional financial system cannot be fully ascertained.

Products such as leveraged tokens,[ 13 ] futures contracts and options can allow investors to synthetically increase their exposure to crypto-asset returns and risk. Some crypto exchanges offer ways to increase exposures by as much as times the initial investment Table B. However, the total volumes of leveraged contracts in crypto-asset markets and the extent to which leverage is actually used on these trading platforms are generally not reported. Furthermore, some investors use borrowed funds to purchase their exposure margin trading , thus increasing the risks to financial stability.

Table B. Estimates suggest there has been a slight increase in crypto-asset leverage in recent years. The rise in leverage in the Ethereum blockchain could be related to the growth of DeFi and associated activities where funds borrowed in one transaction can be reused as collateral in others.

Even if leverage is currently limited at an aggregate level for the main unbacked crypto-assets, any concentration of high leverage in a few key market participants could still prompt stress. Another useful dimension to consider when analysing leverage in crypto-asset markets is the volume of long and short liquidations.

In the face of adverse price movements in the underlying there can be significant spikes in the volume of liquidations, which could cause further price declines. Drops in Bitcoin prices have been exacerbated by the increasing liquidation volumes associated with long positions in Bitcoin futures Chart B. This provides confirmation that leverage is contributing to the volatility observed in crypto-asset markets.

The result shows how much leverage traders are using on average. A higher ratio indicates that more investors are taking higher leverage risks. Investors can earn interest on their digital asset holdings, usually at a higher rate than they can obtain from a bank Chart B.

Crypto lending may fall under existing financial regulation and has come under increased regulatory scrutiny. Although such cases are still unknown in the EU, these developments show that regulation is, in principle, technology-neutral. DeFi platforms that mimic traditional financial services would do well to ensure they comply with existing EU financial regulation before offering their services to EU clients to avoid the risk of any legal action.

Notes: Panel a: total value locked might be overestimated due to reuse of tokens. Panel b: crypto lending rates are calculated as the average of the day average offered interest rate in 13 DeFi and CeFi centralised platforms. Not all platforms offer lending for all of the selected crypto-assets. The deposit rate is the average interest rate offered by monetary financial institutions MFIs in the euro area to households and non-profit organisations.

Rehypothecation where collateral for a loan can be re-pledged in order to obtain another loan [ 19 ] increases the chances of a breach of LTV limits and could cause liquidity to vanish very quickly in the case of a big shock. The high volatility of crypto-assets means that LTV limits may be exceeded in a market downturn and that more collateral needs to be posted by borrowers, who could potentially lose that collateral. In addition, if borrowers are not able to pay back their loans, investors may seek to withdraw their funds in a panic, potentially leading to an investor run.

The likelihood of such a run could be exacerbated by the high degree of concentration in liquidity provision in decentralised protocols. As they are outside the regulatory perimeter, there is no guarantee in such instances that investors would get their money back or borrowers their collateral as they would in the case of a bank deposit, given the existence of deposit guarantee schemes.

This reflects the lack, in many cases, of investor protection regulation, the highly technical and fast-moving nature of the market segment, and the use of different tokens in terms of assets purchased, collateral posted or interest paid. Although the risks are currently small, they could rise significantly if platforms started to offer services to the real economy, instead of remaining confined to the crypto universe.

While interconnectedness between unbacked crypto-assets and the traditional financial sector has grown considerably, interconnections and other contagion channels have so far remained sufficiently small. However, at this rate, a point will be reached where unbacked crypto-assets represent a risk to financial stability.

Systemic risk increases in line with the level of interconnectedness between the financial sector and the crypto-asset market, the use of leverage and lending activity. Based on the developments observed to date, crypto-asset markets currently show all the signs of an emerging financial stability risk. It is therefore key for regulators and supervisors to monitor developments attentively and close regulatory gaps or arbitrage possibilities.

As this is a global market and therefore a global issue, global coordination of regulatory measures is necessary. It is important to close regulatory and data gaps in the crypto-asset ecosystem. In the EU, the MiCA Regulation should be approved by the co-legislators as a matter of urgency to ensure it is applied sooner rather than later.

However, MiCA is only a first step. The sectoral regulations will need to be reviewed to ensure financial stability risks posed by crypto-assets are mitigated. Any further steps that allow the traditional financial sector to increase its interconnectedness with the crypto-asset market space should be carefully weighed up, and priority should be given to avoiding financial stability risks. This holds in particular when considering interconnections with parts of the financial system that are strictly regulated and benefit from a public safety net.

Data gaps should be closed. The challenges faced in monitoring financial stability risks from crypto-assets developments and interconnectedness with the traditional financial sector will persist as long as there are no standardised reporting or disclosure requirements.

See also Tara, I. See Fletcher, L. A recent survey of hedge fund CFOs by fund administrator Intertrust Group found that they expected to allocate, on average, 7. See the warning issued by the EU financial regulators on 17 March Leveraged tokens allow their holder to take a leveraged position on a crypto derivative e.

One popular indicator used to estimate crypto-asset leverage is calculated as the open interest of derivatives on a specific crypto-asset relative to the amount of crypto-assets held in reserve by the exchanges offering those derivatives. The open interest conveys a measure of the total crypto assets, while the reserves held by exchanges may be seen as the equity. In this way, the ratio used to measure leverage in crypto-assets recalls the standard leverage ratio: assets over equity.

Although it seems rather counterintuitive, users facing unforeseen funding needs may prefer not to sell their holdings, as they expect the crypto-asset to increase in value in the future. Another advantage of borrowing is potentially avoiding or delaying the payment of capital gains taxes.

Lastly, individuals can use funds borrowed via such platforms to increase their leverage on certain trading positions. Total value locked represents the sum of all assets deposited in DeFi protocols earning rewards, interest, new coins and tokens, fixed income, etc. As an example, borrowers can pledge crypto to obtain a stablecoin loan. This loan can be used as collateral in another liquidity pool in exchange for liquidity pool tokens, which are, in effect, a form of derivative. Therefore, our approach will allow us to ascertain whether demand-side shocks and risk shocks play a major role during the pandemic.

Furthermore, accounting for the nature of oil price shocks enables to uncover potential interconnections between cryptocurrencies and crude oil otherwise masked when considering the effect of oil price shocks at the aggregated level. Third, most of the papers devoted to the study of the relationship between the cryptocurrency and alternative financial markets focus solely on Bitcoin, with only a few studies including other leading cryptocurrencies Conlon et al.

Thus, we employ eleven relevant cryptocurrencies based on market capitalization along the sample period to explore the presence of heterogeneous sensitivities of cryptocurrencies to oil price shocks and, therefore, whether different cryptocurrencies may play alternative roles in investment strategies. Fourth, the present study differs from most closely related studies Bouri et al. On the one hand, Bouri et al. Thus, unlike Bouri et al. On the other hand, Das et al. Overall, our study extends the two previous works by considering other popular cryptocurrencies in addition to Bitcoin and by investigating whether diversification benefits can be obtained by combining cryptocurrencies along with oil-related products during episodes of financial turmoil, such as the one triggered by the COVID pandemic.

Two noteworthy findings arise from the empirical analysis of this paper. First, we find that over the investigated period there exists consistent evidence of a significant positive negative correlation between demand-side crude oil shocks risk shocks and cryptocurrencies.

Moreover, our results confirm that the cryptocurrency market is more severely affected by demand and risk shocks to crude oil prices during the COVID period, which is consistent with previous findings showing a greater interconnection among financial markets in times of financial instability Adekoya and Oliyide, ; Bouri et al.

On the one hand, our results show that Tether co-moves negatively positively with demand shocks risk shocks to crude oil prices both along the whole sample period and the COVID sub-period. On the other hand, we find that Tether is the cryptocurrency least connected to the three components of oil price shocks, even during the pandemic period, which seems to point out towards potential benefits of including Tether in oil-related portfolios for risk diversification purposes.

This finding extends previous results of studies in the field documenting safe haven properties of Tether with respect to equities during the COVID turmoil Conlon et al. The present research has been divided into different sections, structured as follows. The second section contains a broad review of the financial literature on the cryptocurrency market.

The third section describes the data and the methodology applied; specifically, it specifies the variables selected, the sample period and a brief development of the approach used, as well as the analysis of the main descriptive statistics of the variables. First, the complete sample period is analysed and, subsequently, to confirm the robustness of the results, the sample period is divided into two sub-periods: the pre-COVID sub-period, and the COVID sub-period, which incorporates the current health crisis.

Finally, the fifth section compiles the most relevant conclusions of this analysis. Literature review The financial literature has seen a growing number of empirical studies in recent years devoted to a detailed analysis of cryptocurrencies. Thus, Corbet et al. In turn, Kyriazis summarises the most relevant results of previous works on the presence of return and volatility spillovers in the cryptocurrency market.

The empirical evidence on the role of cryptocurrencies as either a diversifier, a hedge or a safe haven 2 reported by financial studies yields mixed results depending on the considered cryptocurrencies, the period under investigation and the asset s against which the properties of cryptocurrencies for risk management are examined. Thus, Selmi et al. Klein et al. In the same line, Guesmi et al. Canh et al. Bouri et al. Kurka find a weak correlation between Bitcoin and other asset traditional asset classes, with the sole exception of gold.

Contrarily, Smales argues that there is no connection between Bitcoin returns and other asset classes and that until the cryptocurrency market is consolidated, cryptocurrencies should not be considered a safe haven. Das et al. Symitsi and Chalvatzis find statistically significant diversification benefits from the inclusion of Bitcoin in portfolios in bullish and bearish market conditions.

Charfeddine et al. Shahzad et al. Finally, Rehman and Vo find that copper provides maximum diversification opportunities for investors with all cryptocurrencies in the short-run, while, for medium- and long-run investment periods, precious metals under extreme positive return distributions are not integrated with the extreme negative cryptocurrency returns, thereby implying diversification opportunities for investors.

Since cryptocurrencies are currently considered a relevant asset class, in general, and as a hedging and diversification tool, in particular, it is important to know how cryptocurrencies perform in periods of extreme stress and uncertainty when the majority of asset prices tend to move in the same direction , such as the one triggered by the COVID pandemic.

Thus, although cryptocurrencies manifest the ability to control the risk of well-diversified portfolios, not all of them manage to do so in the sample period. In addition, despite stability properties attributed to gold, it was not able to control risk in the unfolding of the COVID financial crisis.

Finally, investors should consider altcoins to achieve more effective diversification despite their lower returns. Yousaf and Ali analyse the return and volatility transmission among the three most popular cryptocurrencies during the pre-COVID and the COVID period and find that volatility transmission is not significant among cryptocurrencies during the pre-COVID period, and thus investors can obtain maximum diversification benefits. Finally, they point out that have important implications for investors regarding portfolio diversification, hedging, forecasting, and risk management.

Along these lines, Iqbal et al. Furthermore, they find that most cryptocurrencies had the ability to absorb the negative impacts of COVID and act as a hedging instrument during the period of economic turbulence, including Bitcoin.

Yarovaya et al. However, Corbet et al. As at the time of writing this article, the COVID pandemic is still ongoing, we next briefly summarize the main findings of three papers which cover not only what has been called the first wave of the coronavirus crisis mainly from March to May , but also the consecutive months where successive waves have been identified.

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