Latest RBI Financial Stability Report Addresses Crypto Concerns

The 26th issue of the Finance Stability Report from December 2022, released by the central bank of India, noted that while the Indian economy is facing significant global challenges, strong economic foundations and healthy financial and non-financial sector balances offer a reason for cautious optimism.

The RBI has noted that despite recessionary risks in the global economy, Indian banks are doing well due to improved asset quality, return to profitability, and strong capital & liquidity buffers. This benefits the floating demand for bank credit as well as early signs of investment cycle revival.

It further goes on to say that with strong economic, financial, and political headwinds, global macro-financial risks have increased, making the current and short-term future outlook highly uncertain.

The report, which provides insights into the health of the Indian banking system, also covers cryptocurrencies in detail. According to the report, turmoil in the cryptocurrency market, along with currency volatility, monetary tightening, and debt stress, can “potentially undermine global financial stability.”

3 Options for Approaching Crypto Policy

In the report released on Thursday, the Reserve Bank of India (RBI) called for a common approach to crypto assets in order to address potential risks to financial stability while promoting responsible innovation and protecting investors.

The RBI has stated that under India's G2 presidency, one of the main priorities is to have an appropriate policy approach. According to the RBI, the most significant roadblock in developing crypto regulations is a vastly different approach to crypto regulation worldwide. This is why India's central bank is developing a framework for regulating cryptocurrency that will be acceptable on a global scale.

For those that do not know, India officially assumed the Presidency of the G20 on December 1, 2022, which will last until November 30, 2023.

The report then noted that various options are already being considered internationally in this context. One of the options recommended is that crypto assets should be subject to the same regulations as traditional financial intermediaries and exchanges. As such, much like other regulators, RBI is also calling to apply the “same-risk-same-regulatory-outcome” principle to crypto.

Another possible solution is to just ban crypto assets along with stablecoins and decentralized finance (DeFi). The Reserve Bank of India's reasoning behind this is that their real-life use cases are next to negligible. Banning them would be a challenge, however, because different countries have different legal systems and individual rights in relation to state powers, it noted.

The RBI further recommended a third option for the sector: simply let it implode and become systemically irrelevant. According to the central bank, the underlying instability and riskiness will ultimately prevent the sector from growing.

However, this option has its risks in the form of the sector possibly becoming more interconnected with mainstream finance and diverting financing away from traditional finance, with a broader effect on the real economy, it added.

It can be pretty difficult to regulate new technology and business models after they have reached a systemic level, as mentioned previously, it pointed out.

Sudden, Rapid, & Huge Losses in Crypto

The two biggest events of 2022, the collapse of TerraUSD/Luna and the most recent bankruptcy of crypto exchange FTX have highlighted the “inherent vulnerabilities” in the cryptocurrency ecosystem, RBI noted in Chapter I titled “Macrofinancial Risks” of its report. It even noted the leading crypto exchange, Binance prohibiting withdrawals of stablecoins on its platform.

In fact, the collapse of Terra in the first half of 2022 is a reminder that stablecoins that “promise to maintain a stable value relative to fiat currency is subject to classic confidence runs,” it added.

Besides these two, several other crypto firms in the sector, like crypto lenders BlockFi and Celsius and hedge fund Three Arrows Capital (3AC), have also failed during this bear market.

The failure of cryptocurrency exchanges and lenders reveals that such platforms were not only doing their business but rather carrying out different functions such as brokerage, lending, clearing, and settlement that have different risks without appropriate governance structures, it added.

The RBI said in its report that these activities exposed trading platforms to credit, liquidity, and market risks that were disproportionate to what was necessary to discharge their essential functions.

“Leverage is a constant theme across the crypto ecosystem, making failures rapid and losses huge and sudden,” it added.

Further in the report, the apex bank observed the recent turmoil in the crypto markets, noting that crypto assets remain highly volatile. The price of Bitcoin and Ethereum has fallen by 76% from their peak in November 2021. Other crypto assets have also experienced a similar drop in their prices — many altcoins have actually fallen 90% to 99% — and heightened volatility.

It then points to a BIS study that stated that rising prices of crypto are a major driver of crypto adoption, particularly among the younger generation.

The report, however, stated that, though the crypto market is volatile, so far, it has not had any impact on the formal financial system. It went on to say that accumulated experience suggests that crypto forms an unstable ecosystem. Moreover, growing evidence indicates that it is highly concentrated and interconnected.

Additionally, according to the report, crypto assets are highly correlated with equities and do not provide any hedging benefits against inflation. The report stated that crypto assets have actually lost value even as inflation has increased, contrary to the popular belief that crypto can act as an alternative source of value in times of inflation.

Increased Risk from Crypto

In the “Systemic Risk Survey” (SRS) section of the report, RBI mentions that global financial market volatility increased and stayed in the ‘high' risk area because of advanced economies' monetary policy tightening, geopolitical risks, global growth doubtfulness, and funding constraints.

The 23rd round of the Reserve Bank's SRS was conducted in November 2022 by 48 respondents, including market participants and academicians.

According to the survey, the risks associated with cryptocurrencies have increased over the past few months. In May 2022, the risk level was rated at 4.4, but it has since increased to 5.5 in November. And even though the risks are growing, they are still categorized as “medium risk.”

Going forward, the survey respondents' sees many risks to financial stability, including strengthening the US dollar; tightening of global monetary and liquidity conditions; global economic slowdown; rise in crude oil prices; lower corporate growth due to slowdown in consumption; increase in capital outflows; increased price pressures because of higher commodity prices; and geopolitical risks due to ongoing war in Ukraine.

But while confidence in the global financial system's stability has declined marginally over the last six months, the report points out that trust in the Indian financial system has only improved. 93.6% of the respondents said they remain relatively/ highly confident of the Indian financial system's stability.

In the “Regulatory Initiatives in the Financial Sector” section of the report, the RBI referenced global financial watchdog FSB's framework for international regulation of crypto assets, which was introduced in October.

The Financial Stability Board had proposed that authorities should have “appropriate powers, tools and resources to regulate, supervise, and oversee crypto assets activities and markets, both domestically and internationally” and pitched for “promoting comprehensive governance and effective risk management frameworks.”

The report then points to the Basel Committee's approach, which includes setting a global minimum prudential treatment for banks to follow when it comes to classifying their exposure to crypto assets. This is in order to mitigate the risk associated with cryptocurrencies, as noted in the report.

As part of the new standard, banks are required to classify crypto assets into two groups on an ongoing basis: tokenized traditional assets and unbacked crypto assets, stablecoins, and any tokenized traditional assets that fail certain classification conditions.

Those in the latter group will be subjected to newly prescribed conservative capital treatment, effective from January 1, 2025. By doing this, it is believed that banks will be able to provide better protection for their customers and investors.

CBDC: Digital Rupee

The report also covered the central bank digital currency (CBDC), which will provide an additional form of money to be used by the public. The Reserve Bank of India began a pilot program for the digital version of its Indian rupee on December 1 for retail (e`-R) use, precisely a month after the pilot was released for wholesale (e`-W) use.

The e`-R pilot will provide the public with a risk-free medium of exchange, adding that the pilot will test the robustness of the digital rupee creation, distribution, and usage in real-time.

A week before this report's release, the head of India's central bank, Shaktikanta Das, said that CBDCs could accelerate international money transfers while reducing the need for logistics like printing notes.

Last week at an event, he also warned that the next financial crisis would be caused by private cryptocurrencies such as Bitcoin if they're allowed to grow because they are only “speculative.”

“Cryptocurrencies have… huge inherent risks for our macroeconomic and financial stability,” said Das, Governor of the Reserve Bank of India.