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Cryptocurrencies pose a risk to financial stability – Industry roundup: 25 May

Germany, Europe's largest economy, to facilitate easier crypto investments

Countries around the world are recognizing that cryptocurrencies may be in for the long-term in the financial sector, according to recent reports. This newly discovered perception leads to increased awareness by governments of the management and legislation of taxes and profits.

Taxes are generally considered to impede economic development. As a result, businesses are encouraged to do more business when taxes are low. On the flipside, low-tax countries can also promote economic development centred on crypto and blockchain technologies where both citizens and businesses can reap benefits.

This appears to be the goal of countries like El Salvador where the economy is underdeveloped, but there are no capital gains taxes on any Bitcoin, thus stimulating the economy and attracting a new era of entrepreneurs. Western countries are said to consider cryptocurrencies as more physical assets and therefore taxable assets. However, a report indicated that one of the world's largest economies has now announced that it will adopt a similar strategy to El Salvador's.

Germany’s Ministry of Finance announced last week that they will alter their strict tax laws into a more lenient one for crypto investors. Specifically, crypto holders will not be taxed on profits unless they sell within the year. The 24-page report by the ministry was said to be one of the most comprehensive and up-to-date regulations that reflect the current crypto economy, including guidance on staking, lending and airdropping. Furthermore, the Treasury department categorized their tokens into various categories such as utilities, security, equity, debt and payment.

Given that about 9% of all Bitcoin nodes and 14% of Ethereum validators are located in Germany, reports indicate that the new legislation positions Germany as a global crypto “safe-haven”. Patrick Hensen, Financial Policy Analyst, EU, commented that Germany’s new tax position makes it enticing to investors in terms of cryptocurrencies. Additionally, the new tax laws are said to have already attracted new businesses to the region. Reports show that the largest crypto exchange, Binance, will enter Germany pending regulatory approval. Germany, Europe's largest economy, formally defining and recognizing the various sectors of the crypto economy illustrates progress towards broader adoption of cryptocurrencies.

ECB cautions that crypto markets may pose risks to overall economic stability

The European Central Bank (ECB) commented on Tuesday that cryptocurrencies pose a risk to financial stability if emerging sectors maintain the rapid growth of the past two years and if financial companies deepen their exposure. The fall of the major stablecoin TerraUSD in the crypto market prompted global financial leaders to establish a quick and comprehensive regulation of the sector.

According to reports, the crypto sector peaked at US $2.9 trillion in November 2021, up from less than $300 billion in early 2020. However, since November 2021, Bitcoin, the largest token, has fallen by more than half, pushing the value of the entire crypto market to approximately $1.2 trillion.

In its annual financial stability review, the ECB reported that capital will be at risk when banks and other financial institutions are exposed to extensive crypto, thus negatively impacting investor confidence, lending and financial markets. It further said that “systemic risk increases with the degree of interconnection between crypto assets and the traditional financial sector.” Moreover, the ECB stated that highly leveraged transactions offered by cryptocurrency exchanges have led investors to borrow funds to increase their exposure to cryptocurrencies, intensifying financial stability risks.

The industry's lack of data is also said to hinder the assessment of financial risk, and the ECB warned that publications from crypto exchanges and data aggregators need to be treated with caution. It noted that retail investors, who have long been the focus of crypto trading, are also flocking in heavily. According to a Consumer Expectations Survey conducted in six countries, 1 in 10 households in the euro area buys cryptocurrencies such as Bitcoin.

The ECB said cryptocurrencies were unsuitable for most retail investors and called on the European Union authorities to urgently approve new rules for crypto assets. The rules, first published in September 2020, have not yet been agreed on by the EU and will not be approved by 2024 at the earliest, stated the ECB.

Cross-border payments industry revolutionized by MoneySwitch and partnerships

MoneySwitch, a new platform that reportedly provides uncollateralized lending to cross-border payment service providers, has raised US $1 million in a pre-seed funding round at a $35 million valuation. At the forefront of the pre-seed investment are Frax Finance, DeeMoney, Decentralized, and PIF Labs. These strategic investors and partners are said to strengthen the ability of MoneySwitch to build liquidity and expand its reach within the cross-border payments ecosystem. MoneySwitch reportedly aims to become a leading liquidity provider to help cross-border payment providers (CPPs) achieve cross-border payment services more efficiently and seamlessly by providing them short-term liquidity at fixed interest rates.

After the borrower goes through a rigorous approval process, the CPP should be able to access immediate liquidity from MoneySwitch's liquidity pools, powered by stablecoins and built on the Ethereum blockchain. Additionally, permissionless transactions are completed without the lender and borrower negotiating collateral, interest rates and terms. It was noted that earned interest is shared among lenders who provide the liquidity, and the use of blockchain technology ensures transparency, as all transactions are unalterably recorded in a shared public ledger.

The cross-border payments industry has grown significantly over the past few decades, driven by supply chain globalization, economic activity, e-commerce, migration and the proliferation of the internet and smartphones, with a global estimate of US $155.9 trillion transaction volume in 2022. Notwithstanding the market size, reports indicate that the industry is hindered by outdated systems that suffer from delays, high costs and low transparency.

Traditional payment systems’ pre-funding models tie up CPPs working capital, and “red days”, weekends, holidays and off-hours on SWIFT create delays, further strain their working capital, and increase costs and risks. Khibar Rassul, co-founder, MoneySwitch, commented that their protocols should ensure that CPPs do not suffer these downtime issues. Rassul believes their pre-seed investors are at the forefront of the cross-border payment revolution.

Bank of England urges banks to take action on climate change now or face slumps in earnings

The Bank of England (BoE) stated on Tuesday that banks and insurers that cannot manage climate risk as a top priority issue may face 10-15% penalties against their annual profits and higher capital requirements.

In the first comprehensive stress test on how the UK financial system will address climate change and the transition to a net zero carbon economy by 2050, the BoE stated that organizations need to act now to reduce future costs.

Sam Woods, Deputy Governor, BOE, commented that the first important lesson to be learned from this exercise is that climate risk will sustainably reduce the profitability of banks and insurers over time, especially if they are not managed effectively. Woods also added that while depending on the type of company and the scenario, the overall loss rate shows that the average annual revenue decline is approximately 10-15%.

Reports indicate that the Bank of France was the first central bank to conduct a climate stress test on banks and insurers, but global credit ratings and research firm Fitch stated that the BoE test was the most difficult one performed by a central bank. The European Central Bank plans to test this year, but the Federal Reserve has not yet begun such an exercise.

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