The International Monetary Fund is warning there is a growing connection between cryptocurrency and financial markets, which poses risks to the financial system.
In a report, the international body says digital assets are no longer on the “fringe” of the financial system. Given their high volatility, the rising correlation between cryptocurrencies and stocks could soon pose risks to financial stability— especially in countries that have adopted digital units.
“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,” the IMF wrote.
“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,” it added.
Before the pandemic, cryptocurrencies – including Bitcoin and Ethereum – showed little correlation with major stock indices. Crypto has been perceived as diversifying against risk and a hedge against swings in other asset classes.
Ye since the onset of the pandemic, crypto and stocks have traded largely in tandem, with digital coins trading like other risk-sensitive assets like investment-grade bonds and major (fiat) currencies.
Bitcoin volatility explains about a sixth of S&P 500 volatility during the pandemic, according to the IMF, and about one-tenth of the variation in S&P 500 returns. “A sharp decline in Bitcoin prices can increase investor risk aversion and lead to a fall in investment in stock markets,” the fund wrote.
IMF analysis showed how spillover activity between crypto and stocks tends 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, cryptocurrencies 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. Still, crypto’s market cap is up almost four-fold, from $620 billion, since 2017.
The IMF 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. The body states 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 (R-WY), 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.
Her bill proposes the creation of a new crypto regulatory agency under the joint jurisdiction of the CFTC and 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.
Senate Banking Committee Chairman Sherrod Brown (D-OH) and his staff are currently considering proposing legislation on stable coins in the New Year and consulting with regulators.