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Russia-Ukraine war shines spotlight on crypto risks to financial stability

Closer regulatory scrutiny of digital assets expected as international financial oversight body compares cryptos to subprime mortgages
Russia-Ukraine war shines spotlight on crypto risks to financial stability
  • Conflict has shone a light on cryptocurrencies as an alternative 
  • Bitcoin has rallied during the crisis
  • But regulation could dampen the appeal

Digital assets came to the fore in the early days of the Russian invasion of Ukraine. Ukraine received up to $55mn (£42mn) of donations in cryptocurrencies to fund its military over the last two weeks, including raising $6mn from issuing non-fungible tokens (NFTs) of the country’s flag. The world’s largest cryptocurrency Bitcoin rallied by 16 per cent in the week of the invasion, diverging sharply from equity markets, which were in freefall.

That pseudonymous, borderless assets are popular at a time when currencies are plunging in value and people are fleeing their homes is not surprising. Alexandre Birry at S&P Global Ratings told Investors' Chronicle that the war in Ukraine showed both the risks and benefits of crypto. 

“If you're a citizen trying to protect your savings against the devaluation in rouble and other assets, obviously you see a positive there," he said. "On the other hand, if you’re a foreign government trying to impose sanctions, you're more worried about whether cryptocurrencies could offer alternatives to traditional finance and therefore, make some of the sanctions lose their bite." 

The US, UK, European Union and Canada aligned to cut Russia’s banks out of international payment system Swift, as well as to stop the Russian central bank from accessing its foreign reserves, estimated to be worth $630bn. 

The doubling of Bitcoin trading activity using roubles over the week of Russia’s invasion sparked unease that cryptocurrencies could take the sting out of Western sanctions against the country. Major crypto exchanges Coinbase, Kraken, and Binance have also refused to close the accounts of Russian users who are not targeted by sanctions. 

Even before Russia-Ukraine hostilities broke out, the interest of regulators was piqued by the more than threefold-growth of the overall crypto asset market capitalisation over 2021, to an all-time high of $2.6tn, according to Coin Dance - roughly the same value as Apple (US:AAPL). 

Earlier in February, international advisory body the Financial Stability Board (FSB) warned about the growing interconnections between the worlds of digital and traditional finance, which could allow a crisis from one sphere to ripple out across the entire financial system. “As in the case of the US sub-prime mortgage crisis, a small amount of known exposure does not necessarily mean a small amount of risk, particularly if there exists a lack of transparency and insufficient regulatory coverage,” wrote the FSB. 

“As in the case of the US subprime mortgage crisis, a small amount of known exposure does not necessarily mean a small amount of risk, particularly if there exists a lack of transparency and insufficient regulatory coverage,” wrote the FSB, which was founded in 2009 in the wake of the global financial crisis.

“If the current trajectory of growth in scale and interconnectedness of crypto-assets to these institutions were to continue, this could have implications for global financial stability,” it said. 

 

Greater regulation looms

Dr Catherine Mulligan, co-director of the Imperial College Centre for Cryptocurrency Research, told Investors' Chronicle that digital assets have become “a lot more financialised” in recent years, with complex instruments such as NFTs being used as collateral for loans, increasing the risks of ongoing price volatility.

Regulation is important in order to protect investors from the “unintended consequences” of this complexity, but would “probably reduce the profit margins” for crypto products dramatically, she added. 

The Ukraine crisis is shining a spotlight on the world’s as-yet patchy understanding of the risks involved in the unfettered growth of digital assets. According to S&P's Birry, discussions around government-approved offerings and regulation of the cryptocurrency landscape at large are “accelerating” due to the Russia-Ukraine crisis, ranging from full adoption to outright bans. The schism began last year, with China declaring Bitcoin illegal, while El Salvador made it legal tender.

But cryptocurrencies are unlikely to be Russia’s lifeboat against sanctions. The crypto world is “still too small to offer the scale for an economy to evade sanctions”, said Birry. A central bank digital currency (CBDC) could theoretically allow Russia to trade internationally without having to convert into dollars first, but the digital rouble is still in a pilot phase.

European Central Bank (ECB) president Christine Lagarde has called on regulators to hurry through approval of its framework for crypto assets (MiCA) in order to curb Russian sanctions evasion, a sentiment echoed in the US by Democratic senators including Elizabeth Warren who urged the Treasury Department to "monitor and enforce sanctions compliance by the cryptocurrency industry". 

 

Risks ahead

The FSB identified the vulnerabilities of crypto assets as similar to those of traditional financial instruments: leverage, liquidity, technology, and contagion effects. 

Stablecoins - digital tokens that are pegged to currencies - were a key concern since they act as a bridge between the worlds of digital and fiat currency. The war in Ukraine sparked a jump in demand for the largest stablecoin Tether, which tracks the US dollar, and was trading at a hefty premium on the Ukrainian exchange Kuna at the end of February when the country’s central bank introduced limits on ATM withdrawals and suspended the foreign-exchange market. 

Stablecoins are often considered safer since they are backed by assets, and have grown from $5.7bn in late 2019 to $155.6bn in January. The FSB warned that if one were to fail, the unwinding of its real-world reserves could destabilise the entire market for those assets.

These risks fell on deaf ears in some crypto communities, who were quick to accuse the FSB of spreading 'FUD' - fear, uncertainty, and doubt, a favourite retort of cryptobulls. 

Setting international standards for crypto assets does not intend to “stifle innovation and new ideas”, said the FSB's secretary general Dietrich Domanski said in a Times Radio interview last month. “The objective here is to preserve financial stability as a global public good and create conditions for safe innovation that benefits people, economies and society overall,” he said.