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World | Jan 12, 2022

IMF warning of crypto-currency link to financial markets

/ Our Today

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Representations of the Bitcoin cryptocurrency are seen in this illustration picture taken June 7, 2021. (Photo: REUTERS/Edgar Su/Illustration/File)

The International Monetary Fund (IMF) has issued a stern warning about the growing connection between crypto-currency and financial markets, which it argues poses risks to the financial system.

In a report on the matter, the Washington-based multinational funding agency argues that digital assets are no longer on the “fringe” of the financial system, particularly given their high volatility.

The IMF contends that the rising correlation between crypto-currencies and stocks could soon pose risks to financial stability— especially in countries that have adopted digital units.

According to the IMF, “The correlation of crypto assets with traditional holdings like stocks has increased significantly, which limits their perceived risk diversification benefits and raises the risk of contagion across financial markets. Crypto assets such as Bitcoin (BTC-USD) have matured from an obscure asset class with few users to an integral part of the digital asset revolution, raising financial stability concerns.”

Before the pandemic, crypto-currencies – including Bitcoin and Ethereum – showed little correlation with major stock indices but since the pandemic, crypto and stocks have traded largely in tandem with digital coins trading like other risk-sensitive assets such as investment grade bonds and major (fiat) currencies.

Volatility with Bitcoins led to S&P 500 market variability

Bitcoin has experienced severe volatility in recent time. According to the IMF, “Bitcoins explained about a sixth of S&P 500 volatility during the pandemic and about one-tenth of the variation in S&P 500 returns.

The IMF in its report said, “a sharp decline in Bitcoin prices can increase investor risk aversion and lead to a fall in investment in stock markets. IMF analysis showed how spillover activity between crypto and stocks tend to increase during financial market volatility – including periods of sustained market turmoil like developments in the COVID-19 pandemic, or during sharp swings in Bitcoin prices.

As an asset class, crypto-currencies soared to nearly $3 trillion last year, but a massive selloff has driven its total market value to around $2 trillion since hitting those highs. Bitcoin and Ethereum (ETH-USD) are both in bear markets since hitting all-time highs in the fall.

A representation of the virtual cryptocurrency Ethereum is seen among representations of other cryptocurrencies in this picture illustration taken June 14, 2021. (Photo: REUTERS/Edgar Su/Illustration/File)

Global regulatory framework needed to mitigate crypto-currency risk

The IMF has argued that it’s time to adopt a comprehensive, coordinated global regulatory framework to guide national regulation to mitigate the financial stability risks from crypto. It said that those regulations should establish clear requirements for banks to disclose exposure to crypto.

The Biden administration has issued recommendations for how to regulate stable coins, but Congress has yet to act. Senator Cynthia Lummis, one of bitcoin’s most vocal advocates on Capitol Hill, is expected to introduce a bill on regulating crypto that aims to fully integrate digital assets into the financial system.

This bill proposes the creation of a new crypto regulatory agency under the joint jurisdiction of the US Commodity Futures Trading Commission (CFTC) and the US Securities and Exchange Commission (SEC). It would also give guidance on which assets belong in which asset class and offer up new rules on taxing crypto and protecting consumers.

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