Given that the largest stablecoins serve a critical function for crypto-asset markets’ liquidity, the failure of one of the largest stablecoins could have wide-ranging implications for crypto-asset markets and in turn contagion effects on the financial system, according to the European Central Bank (ECB).
A report released by the ECB on stablecoins and decentralized finance states a run on a single stablecoin could also prove catastrophic for the broader financial system through large-scale redemptions of reserve assets comprising traditional assets like government bonds or commercial paper.
The Central Bank also pointed out that the crash of the Terra LUNA/USD blockchain and its native token LUNA exposed the vulnerabilities of the crypto-asset ecosystem and that amid the ensuing crypto-asset market stress, the price of Tether came under pressure, with the largest stablecoin temporarily losing its peg.
The centralized stablecoin faced large outflows of more than 10% of its market capitalization, which it had to redeem by liquidating reserve assets.
Stablecoins cannot be used for payment in the real economy.
The ECB notes that to date, the transaction speed and cost of stablecoins as well as their redemption terms and conditions have proven inadequate for use in real economy payments.
In addition, European payment service providers have not been very active in stablecoin markets thus far, and activities vary considerably among the EU member states.
Urgent regulations needed
While the risk of financial instability due to the failure of major stablecoins in the euro area is currently limited, if their growth continues at the current pace, stablecoins may cause major damage, if left unchecked.
“Existing stablecoins need to be brought into the regulatory perimeter with urgency,” the ECB states.
Internationally coordinated approach to mitigate risks from DeFi
DeFi to a large extent mimics the traditional financial markets through technology-enabled innovation, however, its novel technology and method of service provision can amplify certain vulnerabilities and incur additional specific risks.
Citing the example of the TerraUSD crash, the ECB stated that the lack of traditional centralized entry points for regulation and its opaque and anonymous nature pose challenges for policymakers in terms of enforcement and effective regulation and supervision.
“As vulnerabilities start to build, an internationally coordinated approach is needed to mitigate risks from DeFi. This would entail a careful analysis to disentangle actual regulatory gaps from lack of enforcement. Where regulatory gaps are identified, relevant entry points for regulation as well as regulatory standards are needed,” the ECB states.
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