Systemic Risk in the Age of Digital Assets: Implications for Financial Stability and Regulatory Frameworks

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Abstract

The rapid evolution of the global financial landscape, particularly marked by the emergence and increasing integration of digital assets, necessitates a profound re-evaluation of systemic risk. This comprehensive report delves into the intricate concept of systemic risk, moving beyond its traditional understanding to encompass the novel and amplified vulnerabilities introduced by cryptocurrencies, and more specifically, stablecoins. It meticulously dissects the foundational causes of financial instability, leveraging insights from historical crises to establish a robust baseline. Subsequently, the report explores how the unique characteristics of digital assets – such as decentralization, borderless transactions, and programmability – can exacerbate existing systemic frailties or forge entirely new pathways for financial contagion. Through an in-depth analysis of landmark financial crises, the intricacies of established regulatory frameworks like Basel III and Dodd-Frank, and the burgeoning interplay between conventional and nascent digital financial ecosystems, this report aims to furnish a granular and actionable understanding of systemic risk in the digital age. It emphasizes the critical need for adaptive, proactive, and internationally coordinated regulatory responses to safeguard global financial stability.

Many thanks to our sponsor Panxora who helped us prepare this research report.

1. Introduction

Systemic risk, at its core, denotes the potential for a localized disturbance within a financial system – whether originating from a firm, a specific market segment, or a critical infrastructure component – to propagate uncontrollably, ultimately threatening the stability or even precipitating the collapse of the entire financial system. This risk is not merely the sum of individual failures but rather a consequence of the complex web of interdependencies that characterize modern finance. The past decade has witnessed the prodigious rise of digital assets, a diverse category encompassing cryptocurrencies, non-fungible tokens (NFTs), and central bank digital currencies (CBDCs). Among these, stablecoins have garnered particular attention from policymakers and regulators due to their distinctive design aimed at maintaining a stable value, typically pegged to fiat currencies like the US dollar, commodities, or a basket of assets. While stablecoins ostensibly offer compelling advantages such as enhanced transactional efficiency, reduced costs for cross-border payments, and expanded financial inclusion, their escalating market capitalization and burgeoning integration into the broader financial system have simultaneously ignited significant apprehension regarding their capacity to amplify systemic risk. Their rapid adoption challenges the efficacy of traditional risk management paradigms, demanding a rethinking of regulatory perimeters and supervisory tools.

Historically, financial crises have underscored the profound importance of identifying and mitigating systemic risks. From the Great Depression to the 2008 Global Financial Crisis, each episode has revealed new facets of interconnectedness and vulnerability. The advent of digital assets introduces unprecedented layers of complexity. Unlike traditional assets, many digital assets operate on distributed ledger technologies (DLTs), often decentralized, pseudonymous, and global in reach. This unique architecture, while offering innovation, also presents formidable challenges for conventional regulatory oversight, consumer protection, and financial stability. This report seeks to comprehensively address these challenges, exploring the mechanisms through which digital assets, particularly stablecoins, might introduce or heighten systemic risk, and evaluating the ongoing efforts by global regulatory bodies to forge a robust and adaptable framework for this burgeoning sector.

Many thanks to our sponsor Panxora who helped us prepare this research report.

2. Understanding Systemic Risk

2.1 Definition and Characteristics

Systemic risk is fundamentally defined as the risk of a widespread breakdown in the provision of financial services that could have severe adverse consequences for the real economy. It transcends the failure of a single entity, focusing instead on the potential for a cascading failure that engulfs a substantial portion of the financial system, if not its entirety. The Bank for International Settlements (BIS) has frequently emphasized that systemic risk is not merely about individual institutional failures, but rather about the collective failure of the system to perform its critical functions, such as allocating capital, facilitating payments, and managing risk (Bank for International Settlements, 2023a). This often occurs through a chain reaction where the distress or failure of one participant, market, or infrastructure causes distress or failure to others.

Key characteristics of systemic risk include:

Interconnectedness: The intricate web of financial relationships, including credit exposures, common asset holdings, and participation in shared payment or clearing systems, creates pathways for contagion. A shock to one institution can rapidly transmit to others, akin to a domino effect.
Leverage: The extensive use of borrowed capital, both on-balance sheet and through off-balance sheet arrangements, amplifies both gains and losses. Excessive leverage can lead to rapid deleveraging cycles, where institutions are forced to sell assets, driving down prices and further exacerbating losses across the system (European Central Bank, 2023a).
Liquidity Mismatches: Financial institutions often engage in maturity transformation, funding long-term, illiquid assets with short-term, liquid liabilities (e.g., bank deposits). A sudden loss of confidence or tightening of short-term funding markets can trigger severe liquidity crises, leading to fire sales of assets that further depress market prices.
Concentration Risk: The reliance on a small number of large institutions, critical market infrastructures (e.g., central counterparties – CCPs), or specific asset classes can create vulnerabilities. The failure or disruption of a highly concentrated entity or market segment can have disproportionate systemic implications.
Procyclicality: Financial systems often exhibit procyclical behavior, meaning that positive feedback loops amplify economic booms and busts. During expansions, lax lending standards and rising asset prices encourage further risk-taking, while during downturns, deleveraging and tighter credit conditions exacerbate economic contraction. This amplifies systemic risk by reinforcing rather than dampening shocks.
Information Asymmetries and Confidence Channels: Lack of transparent information can lead to ‘runs’ on institutions as market participants lose confidence. Rumors or uncertainty can rapidly erode trust, triggering widespread withdrawals of funds or collateral, regardless of an institution’s underlying solvency.
Moral Hazard: The perception that certain institutions are ‘too big to fail’ can incentivize excessive risk-taking, as these institutions may anticipate government intervention or bailouts in times of crisis. This undermines market discipline and can increase the likelihood and severity of systemic events.

Systemic risk can propagate through various channels, including direct credit exposures between institutions, common exposures to specific assets or markets (e.g., housing bubbles), and confidence channels where distress in one area triggers panic selling or withdrawals elsewhere (Bank for International Settlements, 2023b).

2.2 Common Causes of Systemic Risk

Beyond the intrinsic characteristics, several operational and behavioral factors recurrently contribute to systemic risk:

Excessive Interconnectedness: Modern financial systems are dense networks of institutions connected via lending, borrowing, derivatives, and payment systems. The failure of a single large, interconnected institution (often termed a Systemically Important Financial Institution, or SIFI) can trigger a chain reaction, as its failure imposes losses on its creditors, counterparties, and even impacts broader market liquidity. This interconnectedness extends beyond banks to shadow banking entities, hedge funds, and critical market infrastructures like clearinghouses (en.wikipedia.org, 2025a).
High Leverage and Speculative Bubbles: Periods of excessive credit expansion often fuel asset bubbles. When these bubbles burst, the high leverage employed by financial institutions, corporations, and households amplifies losses, leading to widespread defaults and forced asset sales. This deleveraging process can severely contract credit availability, deepening economic downturns.
Funding Liquidity and Market Liquidity Mismatches: Financial institutions often rely on short-term wholesale funding markets to finance longer-term, less liquid assets. A sudden reluctance by lenders to provide short-term funding (a ‘liquidity crunch’) can force institutions into fire sales, driving down asset prices and leading to market illiquidity. This market illiquidity can then feed back into funding liquidity problems, creating a vicious cycle.
Regulatory Gaps and Arbitrage: Gaps in regulatory oversight, particularly in rapidly evolving sectors or across national borders, can allow risks to accumulate unnoticed. Financial institutions may engage in ‘regulatory arbitrage,’ structuring their activities to fall outside existing prudential rules, thereby shifting risk to less regulated parts of the system or to jurisdictions with weaker oversight.
Information Opacity and Complexity: The increasing complexity of financial products (e.g., structured finance products) and the opacity of inter-firm exposures can make it challenging for market participants and regulators to accurately assess and price risk. This information asymmetry can lead to sudden, sharp losses of confidence when underlying issues are revealed.
Weak Governance and Risk Management: Deficiencies in internal governance, risk culture, and risk management practices within individual institutions can lead to excessive risk-taking, insufficient capital buffers, and inadequate liquidity planning, making them vulnerable to shocks and potentially transmitting those vulnerabilities to the broader system.

2.3 Historical Examples

Examining past crises provides invaluable lessons on the nature and transmission of systemic risk:

The 2008 Global Financial Crisis (GFC): This crisis epitomized the dangers of excessive leverage and interconnectedness, particularly in the banking and shadow banking sectors. Its genesis lay in the widespread proliferation of subprime mortgage lending in the US, packaged into complex securitized products like Mortgage-Backed Securities (MBS) and Collateralized Debt Obligations (CDOs). These instruments were often poorly understood and held by a vast array of financial institutions globally. When US housing prices began to decline in 2006-2007, defaults on subprime mortgages surged, leading to massive losses on these structured products. The interconnectedness became apparent as institutions like Lehman Brothers, heavily invested in these assets and reliant on short-term funding, faced collapse. Its bankruptcy in September 2008 triggered a seismic shock across global financial markets, freezing interbank lending, impacting money market funds, and necessitating unprecedented government bailouts and interventions for institutions deemed ‘too big to fail,’ such as AIG (American International Group) and Fannie Mae and Freddie Mac. The crisis demonstrated how a localized issue (subprime mortgages) could rapidly become a global systemic event due to financial innovation, opaque markets, and deeply intertwined balance sheets.
The 1997 Asian Financial Crisis: This crisis showcased how rapid, unregulated capital flows and currency mismatches can destabilize entire economies. Many East Asian economies had experienced significant capital inflows in the preceding years, often denominated in foreign currencies (primarily USD), which were then channeled into domestic investment, including real estate. These countries typically maintained fixed or semi-fixed exchange rates, making their exports less competitive as the dollar appreciated. Speculative attacks on these currencies began in Thailand, forcing a devaluation of the Thai baht. This triggered a domino effect across the region, impacting countries like Indonesia, South Korea, Malaysia, and the Philippines. Companies and banks that had borrowed heavily in US dollars faced soaring debt burdens as their domestic currencies depreciated. The crisis highlighted the vulnerability of economies to sudden capital flight, the importance of robust financial supervision, and the dangers of currency mismatches, necessitating substantial intervention from the International Monetary Fund (IMF) to stabilize affected economies.
The European Sovereign Debt Crisis (2010s): Following the GFC, several Eurozone countries (Greece, Ireland, Portugal, Spain, Cyprus) faced severe difficulties in servicing their sovereign debt. This crisis illustrated the potent sovereign-bank nexus as a source of systemic risk. Banks in these countries held significant amounts of their national government bonds, meaning that deteriorating sovereign creditworthiness directly impaired bank balance sheets. Conversely, the potential failure of large banks placed a heavy burden on sovereign finances for potential bailouts. This created a feedback loop: concerns about sovereign debt led to rising borrowing costs for governments, which in turn weakened their banks, further exacerbating sovereign risk. The crisis exposed the structural vulnerabilities within the Eurozone’s monetary union, particularly the lack of a centralized fiscal authority and a robust banking union, and prompted significant reforms in European financial architecture (European Central Bank, 2025a).

Many thanks to our sponsor Panxora who helped us prepare this research report.

3. Regulatory Frameworks Addressing Systemic Risk

In the wake of successive financial crises, particularly the 2008 GFC, global and national regulatory bodies have significantly bolstered their frameworks to enhance financial system resilience and mitigate systemic risk. These frameworks aim to establish stricter prudential standards, improve oversight, and create mechanisms for orderly resolution of distressed institutions.

3.1 Basel III

Basel III is a comprehensive set of international banking reforms developed by the Basel Committee on Banking Supervision (BCBS) in response to the GFC. Its primary objective is to strengthen the regulation, supervision, and risk management of the banking sector to prevent future systemic crises. The framework introduced several key enhancements:

Stricter Capital Requirements: Basel III significantly raised the quality and quantity of bank capital. It mandated higher minimum Common Equity Tier 1 (CET1) capital ratios (from 2% to 4.5% of risk-weighted assets), Tier 1 capital ratios (from 4% to 6%), and total capital ratios (remaining at 8%). Crucially, it emphasized that CET1 capital should consist predominantly of common shares and retained earnings, ensuring capital truly absorbs losses. Furthermore, banks are required to hold capital buffers, including a Capital Conservation Buffer (2.5% of risk-weighted assets, designed to be drawn down during stress) and a Countercyclical Capital Buffer (CCyB) (0-2.5%, which can be increased by national authorities during periods of excessive credit growth to dampen procyclicality).
Leverage Ratio: Basel III introduced a non-risk-weighted leverage ratio (Tier 1 capital to total exposure, initially set at 3%) to serve as a backstop to risk-weighted capital requirements. This aims to constrain excessive build-up of leverage regardless of the perceived riskiness of assets, addressing a key vulnerability observed in the GFC.
Liquidity Standards: Recognizing the crucial role of liquidity in financial stability, Basel III introduced two global liquidity standards:
- Liquidity Coverage Ratio (LCR): Requires banks to hold sufficient high-quality liquid assets (HQLA) to cover net cash outflows over a 30-day stress scenario. This ensures banks can withstand short-term liquidity disruptions (Bank for International Settlements, 2023c).
- Net Stable Funding Ratio (NSFR): Requires banks to maintain a stable funding profile in relation to the liquidity characteristics of their assets and off-balance sheet activities over a one-year horizon. This aims to reduce reliance on short-term wholesale funding and mitigate maturity transformation risks.
Requirements for Systemically Important Banks (G-SIBs): Basel III introduced additional capital surcharges for global systemically important banks (G-SIBs) to reflect the greater externalities their failure would impose on the financial system. These surcharges range from 1% to 3.5% of risk-weighted assets, encouraging G-SIBs to reduce their systemic footprint.

3.2 Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)

Enacted in the US in response to the 2008 crisis, the Dodd-Frank Act was a sweeping piece of legislation designed to promote financial stability, end ‘too big to fail,’ and protect consumers. Its key provisions relevant to systemic risk include:

Financial Stability Oversight Council (FSOC): Created to monitor the financial system for emerging risks, the FSOC is empowered to identify and designate non-bank financial companies whose material distress or failure could pose a threat to US financial stability as Systemically Important Financial Institutions (SIFIs). Once designated, these non-bank SIFIs become subject to enhanced prudential supervision by the Federal Reserve.
Orderly Liquidation Authority (OLA): This new resolution authority allows the Federal Deposit Insurance Corporation (FDIC) to take over and resolve failing non-bank SIFIs (and potentially large bank holding companies) in a manner that protects financial stability, preventing disorderly bankruptcies like that of Lehman Brothers. It provides a mechanism for rapid resolution while imposing losses on shareholders and creditors, not taxpayers.
Volcker Rule: Named after former Fed Chairman Paul Volcker, this rule restricts proprietary trading by banks and financial institutions that own banks, as well as limiting their investments in and sponsorship of hedge funds and private equity funds. The aim is to reduce speculative activities that could jeopardize insured deposits and taxpayer-backed institutions.
Derivatives Reform: Dodd-Frank mandated significant reforms in the over-the-counter (OTC) derivatives market, requiring standardized OTC derivatives to be centrally cleared through clearinghouses and traded on regulated exchanges, increasing transparency and reducing counterparty risk.
Consumer Financial Protection Bureau (CFPB): Established to protect consumers in the financial marketplace, ensuring fairness, transparency, and accountability in the provision of consumer financial products and services, aiming to prevent the type of predatory lending that contributed to the subprime crisis.

3.3 European Market Infrastructure Regulation (EMIR)

EMIR (2012) is a cornerstone of the EU’s response to the GFC, specifically targeting the over-the-counter (OTC) derivatives market, which was identified as a major source of opacity and systemic risk. Its objectives are to increase transparency and reduce the counterparty and operational risks associated with derivatives. Key requirements include:

Mandatory Clearing: EMIR mandates that eligible standardized OTC derivative contracts must be centrally cleared through Central Counterparties (CCPs). CCPs act as intermediaries between counterparties, guaranteeing trades and significantly reducing counterparty credit risk through netting, collateralization, and robust risk management.
Risk Mitigation Techniques for Non-Cleared OTC Derivatives: For OTC derivatives not subject to mandatory clearing, EMIR imposes bilateral risk mitigation requirements, such as timely confirmation of trades, portfolio reconciliation, dispute resolution mechanisms, and the mandatory exchange of collateral (margining) between counterparties.
Reporting Requirements: All derivative contracts (OTC and exchange-traded) must be reported to trade repositories (TRs). This creates a comprehensive database of derivatives exposures, enhancing transparency for regulators and allowing them to monitor systemic risks more effectively. The European Securities and Markets Authority (ESMA) plays a key role in overseeing TRs and CCPs.

3.4 International Coordination Efforts

Beyond national and regional frameworks, significant international efforts are underway to foster a globally coherent approach to financial stability. The Financial Stability Board (FSB), established in 2009, coordinates national financial authorities and international standard-setting bodies. It identifies vulnerabilities, develops and promotes regulatory and supervisory policies, and monitors their implementation across jurisdictions. The International Monetary Fund (IMF) conducts Financial Sector Assessment Programs (FSAPs) to evaluate the health and stability of financial systems in its member countries, providing recommendations for strengthening their resilience (International Monetary Fund, 2023). These bodies are crucial in addressing cross-border systemic risks and preventing regulatory arbitrage.

Many thanks to our sponsor Panxora who helped us prepare this research report.

4. Digital Assets and Systemic Risk

The emergence of digital assets, particularly stablecoins, introduces a new frontier for systemic risk, presenting both novel vulnerabilities and amplifying existing ones. While they offer compelling innovations, their rapid growth, unique characteristics, and increasing integration into traditional finance demand meticulous scrutiny.

4.1 Characteristics of Digital Assets

Digital assets, broadly defined as digital representations of value or rights that use distributed ledger technology (DLT) for their operation, possess distinct features that differentiate them from traditional financial instruments and are pertinent to systemic risk:

Decentralization: Many digital assets, especially cryptocurrencies like Bitcoin and Ethereum, operate on decentralized networks without a central authority or intermediary. This characteristic can reduce single points of failure but also complicates oversight, accountability, and the implementation of traditional regulatory measures. In DeFi (Decentralized Finance), smart contracts automate financial services, which can reduce operational costs but introduce new risks related to code vulnerabilities and governance without human intervention.
Borderless and Global Transactions: Digital assets facilitate instant, 24/7 cross-border transfers, bypassing traditional correspondent banking networks. While efficient, this global reach challenges the efficacy of national regulatory perimeters, anti-money laundering (AML), and countering the financing of terrorism (CFT) frameworks, and the ability of central banks to impose capital controls during crises.
Programmability (Smart Contracts): Digital assets can be ‘programmed’ via smart contracts, self-executing agreements whose terms are directly written into code. This enables automated financial services (e.g., lending, trading, insurance) within DeFi ecosystems. While powerful, bugs or exploits in smart contract code can lead to irreversible losses or systemic disruptions if widely adopted.
Pseudonymity: Transactions on many public blockchains are pseudonymous, meaning that while addresses are visible, the identities of the participants are not directly linked to those addresses. This feature, while appealing for privacy, complicates efforts to prevent illicit finance, conduct effective market surveillance, and enforce sanctions.
Volatility: Many cryptocurrencies exhibit extreme price volatility due to factors like speculative trading, nascent markets, and lack of fundamental valuation metrics. This volatility can impact institutions holding such assets and spill over into traditional markets if exposures become significant.
Novelty and Limited Track Record: The digital asset market is relatively young, lacking the extensive historical data and crisis precedents that underpin risk models in traditional finance. This makes it challenging to accurately assess and model potential systemic risks.
Frictionless Propagation of Shocks: The speed and automation inherent in digital asset markets mean that financial shocks can propagate and amplify much faster than in traditional, more manual systems, potentially leading to rapid deleveraging cascades.

4.2 Categorization of Digital Assets and their Specific Risks

To understand their systemic implications, it’s crucial to differentiate between types of digital assets:

Cryptocurrencies (e.g., Bitcoin, Ethereum): Primarily designed as mediums of exchange or stores of value, these are characterized by high price volatility due to their speculative nature, limited adoption for real-economy transactions, and lack of intrinsic value. Their systemic risk stems primarily from their potential to destabilize financial institutions with significant direct or indirect exposures, or from confidence shocks if widely adopted for investment.
Stablecoins: These are digital assets designed to maintain a stable value relative to a specified asset, often a fiat currency like the US dollar. Their stability is crucial for their intended use in payments and as a bridge between volatile cryptocurrencies and traditional finance. However, their stability mechanisms vary, giving rise to different risk profiles:
- Fiat-backed Stablecoins (e.g., USDT, USDC): These are collateralized by reserve assets, typically held by a centralized issuer, in amounts theoretically equal to or greater than the stablecoins in circulation. The systemic risk here lies in the quality, liquidity, and transparency of the reserve assets. If reserves are illiquid, risky, or insufficient, a ‘digital bank run’ (mass redemption) could lead to a de-pegging event and fire sales of underlying assets, impacting traditional financial markets where those assets are held (e.g., commercial paper, government bonds) (suerf.org, 2023).
- Crypto-backed Stablecoins (e.g., DAI): These are over-collateralized by other cryptocurrencies. Their stability relies on robust liquidation mechanisms if the value of the underlying crypto collateral falls below a certain threshold. Systemic risk can arise from extreme volatility in the underlying collateral, oracle failures (incorrect price feeds), or liquidation cascades during sharp market downturns.
- Algorithmic Stablecoins (e.g., TerraUSD): These attempt to maintain their peg through automated arbitrage mechanisms involving a second, volatile cryptocurrency (e.g., LUNA for TerraUSD) and no direct fiat or crypto collateral. They are inherently fragile, relying entirely on market incentives and sustained demand. Their collapse demonstrates the extreme systemic risk they pose due to their algorithmic fragility and potential for a ‘death spiral’ during periods of stress.

4.3 Potential Pathways for Systemic Risk Amplification

Digital assets can introduce or amplify systemic risk through several interconnected channels:

Digital Bank Runs and Liquidity Crises: Similar to traditional bank runs, a sudden loss of confidence in a stablecoin issuer’s ability to redeem its tokens at par can trigger a mass redemption event. If the underlying reserves are illiquid or insufficient, this can force the issuer to sell assets rapidly, creating market dislocations and liquidity pressures that spill over into traditional financial markets. This mechanism was tragically demonstrated by the de-pegging of algorithmic stablecoins like TerraUSD in May 2022 (suerf.org, 2023).
Contagion through Interconnectedness: As traditional financial institutions (TFIs) increase their exposure to digital assets, either directly (by holding them on balance sheets, lending to crypto firms) or indirectly (through payment systems, clearing, and settlement services), channels for contagion emerge. Losses in the digital asset market could translate into direct losses for TFIs, or lead to a loss of confidence that triggers withdrawals or funding difficulties. The concentration of stablecoin reserves in specific traditional assets (e.g., commercial paper, treasury bills) could also create common exposures, linking the stability of stablecoins to the health of those traditional markets.
Leverage and Procyclicality: The digital asset ecosystem, particularly DeFi, features significant leverage through margin trading, collateralized lending, and rehypothecation. This leverage amplifies both gains and losses. During downturns, rapid liquidations of collateralized positions can exacerbate price declines, creating a procyclical feedback loop that quickly transmits stress across platforms and assets, potentially overwhelming market liquidity.
Operational Risks and Cybersecurity Threats: The reliance on nascent and complex DLTs, smart contracts, and decentralized protocols introduces significant operational risks. These include cybersecurity breaches (hacks of exchanges, wallets, or smart contracts), software bugs, oracle failures (incorrect data feeds to smart contracts), and network congestion. A major operational failure or cyber-attack on a widely used digital asset platform could disrupt critical financial services, erode confidence, and lead to systemic instability.
Concentration Risk: Despite the ethos of decentralization, the digital asset ecosystem exhibits significant concentration. A few large centralized exchanges (e.g., Binance, Coinbase) dominate trading volumes, and a few large stablecoins (e.g., Tether, USDC) command the majority of stablecoin market capitalization. The failure or significant disruption of one of these critical entities could have widespread systemic implications.
Regulatory Arbitrage and Gaps: The global and decentralized nature of digital assets makes it challenging for national regulators to establish comprehensive oversight. Firms may exploit regulatory gaps by operating in jurisdictions with laxer rules, creating an uneven playing field and allowing risks to build up outside the perimeter of effective supervision. The lack of consistent international standards exacerbates this issue.
Payment System Disruptions: If stablecoins become widely adopted as a means of payment for real-economy transactions, their instability could directly impact the payments system, leading to disruptions in commerce, public confidence, and monetary policy transmission.

4.4 Case Studies of Digital Asset-Related Instability

Recent events underscore the vulnerabilities inherent in the digital asset ecosystem and highlight potential pathways to systemic risk:

The Terra/LUNA Collapse (May 2022): This event serves as a stark reminder of the fragility of algorithmic stablecoins. TerraUSD (UST) was designed to maintain a 1:1 peg to the US dollar through a complex algorithmic relationship with its sister token, LUNA. Users could arbitrage price differences: if UST traded below $1, they could burn UST to mint LUNA, and vice versa. This mechanism worked during periods of growth but proved fatally flawed under stress. In May 2022, a large withdrawal from a key UST liquidity pool, coupled with significant selling pressure, caused UST to de-peg. This triggered a ‘death spiral’: as UST fell below $1, arbitrageurs tried to mint and sell LUNA, which flooded the market with LUNA, causing its price to plummet. LUNA’s collapse in turn weakened confidence in UST, accelerating its de-pegging. Both UST and LUNA lost virtually all their value within days, wiping out over $40 billion in market capitalization. While not directly causing a traditional financial crisis, the Terra collapse had significant contagion effects within the crypto ecosystem, contributing to the failures or severe distress of several major crypto lenders (e.g., Celsius, Voyager) and hedge funds (e.g., Three Arrows Capital) that had significant exposure to Terra or were operating with high leverage on crypto assets (suerf.org, 2023).
The FTX Exchange Collapse (November 2022): FTX, once one of the largest cryptocurrency exchanges, along with its affiliated trading firm Alameda Research, collapsed due to alleged fraud, misappropriation of customer funds, and opaque balance sheets. Alameda reportedly used billions of dollars in FTX customer deposits for its highly leveraged and risky trading activities. When a leaked balance sheet showed Alameda’s assets were heavily concentrated in illiquid FTX-related tokens, a wave of withdrawals from FTX ensued, exposing a massive liquidity shortfall. The collapse demonstrated the extreme risks posed by centralized, unregulated crypto intermediaries that operate without the robust prudential safeguards, transparency requirements, and segregation of client funds mandated in traditional financial markets. The FTX implosion caused widespread panic in the crypto market, significant losses for millions of users and institutional investors, and further contagion to other crypto firms, underscoring the urgent need for comprehensive regulatory oversight of centralized crypto platforms.
Silicon Valley Bank (SVB) Collapse (March 2023): While primarily a traditional bank failure, the SVB collapse highlighted critical vulnerabilities related to concentrated, uninsured deposits and demonstrated how rapid digital communication can accelerate bank runs. SVB’s business model was highly concentrated on tech startups and venture capital firms. During the era of low interest rates, SVB had invested heavily in long-duration US Treasury bonds and mortgage-backed securities. When interest rates rose sharply in 2022-2023, the market value of these bonds declined significantly, creating large unrealized losses on SVB’s balance sheet. A loss of confidence, spurred by concerns over these losses and a demand for liquidity from its tech clients, led to a rapid bank run. A notable aspect of the run was its speed, facilitated by digital banking channels and social media. While SVB’s exposure to digital assets was not the cause of its collapse, its substantial holding of uninsured deposits from crypto firms, notably from Circle (issuer of USDC), contributed to the rapid outflow of funds during the run (bankofengland.co.uk, 2023a). This specific aspect underscored how large, concentrated, uninsured deposits, irrespective of their source, can exacerbate traditional bank fragility when combined with interest rate risk and the speed of digital withdrawals. The USDC stablecoin itself maintained its peg throughout the crisis, demonstrating the importance of reserve quality and transparency, but the incident drew attention to the financial stability implications of large stablecoin issuers’ banking relationships.

These cases illustrate that while digital assets may not yet pose a direct threat to global financial stability on the scale of a traditional banking crisis, their rapid growth, interconnectedness with parts of the traditional financial system, and inherent fragilities warrant proactive regulatory attention to prevent future, more impactful systemic events.

Many thanks to our sponsor Panxora who helped us prepare this research report.

5. Regulatory Responses to Digital Asset Risks

Recognizing the burgeoning systemic risks posed by digital assets, particularly stablecoins, global regulators and policymakers are actively developing and implementing frameworks to bring these novel instruments within a regulatory perimeter. The overarching goal is often articulated as ‘same risk, same regulation’ – meaning that activities posing similar risks should be regulated similarly, regardless of the underlying technology.

5.1 European Union’s Markets in Crypto-Assets (MiCA) Regulation

The European Union has been at the forefront of establishing a comprehensive regulatory framework for digital assets with its landmark Markets in Crypto-Assets (MiCA) regulation, which is expected to come into full effect by late 2024. MiCA aims to provide legal certainty for crypto-asset markets within the EU, support innovation, ensure consumer protection, and address financial stability risks. It covers a broad range of crypto-assets not already regulated under existing EU financial services legislation.

Key provisions of MiCA for stablecoins, which it categorizes as ‘e-money tokens’ (EMTs) and ‘asset-referenced tokens’ (ARTs), include:

Authorization and Supervision: Issuers of EMTs and ARTs will require authorization from national competent authorities and will be subject to ongoing supervision. This brings stablecoin issuers within a prudential regulatory framework akin to traditional financial institutions.
Reserve Requirements: MiCA mandates that EMT and ART issuers maintain robust reserve assets that are fully backed, highly liquid, segregated from the issuer’s own funds, and held in custody by a credit institution or a financial institution authorized to provide custody services. For EMTs, the backing must be predominantly in cash or highly liquid financial instruments. This aims to ensure that stablecoins can be redeemed at par at all times, mitigating digital bank run risks.
Redemption Rights: Holders of stablecoins under MiCA will have a direct right to redeem their tokens at par value from the issuer at any time.
Transparency and Disclosure: Issuers must publish clear, fair, and not misleading white papers (prospectuses) detailing the characteristics of the tokens, their underlying technology, the reserve assets, and the risks involved.
Prudential Requirements: Issuers will be subject to capital requirements, ensuring they have sufficient financial resources to cover operational risks.
Systemic Importance Safeguards: MiCA includes provisions for ‘significant’ ARTs and EMTs (those meeting certain thresholds regarding user base, value, and transactions) to be subject to enhanced supervision by the European Banking Authority (EBA) and potentially additional requirements, including capital surcharges, liquidity management rules, and even limits on issuance if they become too large and pose a threat to financial stability (cointelegraph.com, 2024).

Despite its comprehensive nature, concerns have been raised regarding MiCA’s potential impact. Some argue that stringent reserve and capital requirements could concentrate the stablecoin market among a few large players, potentially stifling innovation. There are also debates about the potential for large stablecoins to disintermediate traditional banking systems if they become widely adopted for payments, although MiCA’s limits on ‘significant’ stablecoins aim to mitigate this.

5.2 Bank of England’s Approach

The Bank of England (BoE) has been actively developing its regulatory framework for stablecoins, focusing particularly on those used in systemic payment systems. Its approach is guided by the principle that ‘systemic payment systems using stablecoins and related service providers should be regulated to achieve outcomes equivalent to those for traditional payment systems, with adaptation as necessary to reflect the unique features of stablecoins and DLT’ (bankofengland.co.uk, 2023a).

Key aspects of the BoE’s proposed regime include:

Definition of Systemic Importance: The BoE identifies stablecoin arrangements as ‘systemic’ if their failure or disruption could pose risks to financial stability, considering factors like transaction volume, number of users, and interconnectedness.
Prudential Standards: Systemic stablecoin issuers and service providers (e.g., wallet providers, exchange platforms) would be subject to robust prudential requirements, including capital, liquidity, risk management, and governance standards analogous to those applied to traditional systemically important payment systems.
Reserve Asset Requirements: Emphasis is placed on the high quality and liquidity of reserve assets backing stablecoins, ensuring they are held in low-risk, highly liquid assets and segregated appropriately.
Resolution and Recovery: The BoE is developing specific frameworks for the orderly resolution of failing systemic stablecoin arrangements to minimize disruption and protect users.
Holding Limits: To mitigate financial stability concerns and prevent large-scale deposit outflows from the banking system that could arise from widespread stablecoin adoption, the BoE has explored the possibility of setting holding limits for certain stablecoins by non-bank payment service providers. This would prevent any single stablecoin from growing to a size that could significantly disintermediate bank deposits and pose an immediate systemic threat.

5.3 International Coordination

Given the borderless nature of digital assets, international cooperation is paramount to developing consistent and effective regulatory responses. Key international bodies leading these efforts include:

Financial Stability Board (FSB): The FSB has developed a ‘roadmap’ for crypto-asset activities, providing high-level recommendations for the regulation and supervision of crypto-assets and stablecoins. Its focus areas include achieving consistent and comprehensive regulation, addressing data gaps, and enhancing international cooperation and information sharing (Financial Stability Board, 2023).
Bank for International Settlements (BIS): The BIS, often referred to as the ‘central bank for central banks,’ has been instrumental in analyzing the financial stability implications of digital assets. Its Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) have published guidance on applying the ‘Principles for Financial Market Infrastructures (PFMI)’ to stablecoin arrangements, emphasizing the need for robust risk management, governance, and operational resilience (Bank for International Settlements, 2023d).
International Monetary Fund (IMF): The IMF advocates for a comprehensive, consistent, and coordinated global regulatory approach to crypto-assets. It has proposed key elements for effective crypto policies, including establishing a clear regulatory perimeter, robust licensing and authorization requirements, and comprehensive oversight of all crypto actors (International Monetary Fund, 2023).
G7 and G20 Initiatives: These groups of leading economies have consistently highlighted the need for international collaboration on crypto-asset regulation, emphasizing that no single jurisdiction can effectively regulate a global phenomenon in isolation. Their discussions contribute to shaping global policy agendas and fostering harmonization.

Challenges to international coordination include differing national priorities, the rapid pace of technological innovation, and the complexities of jurisdictional reach and enforcement across decentralized networks. However, the shared understanding of potential systemic risks underscores the imperative for continued cross-border dialogue and harmonized regulatory frameworks to prevent regulatory arbitrage and ensure a level playing field.

Many thanks to our sponsor Panxora who helped us prepare this research report.

6. Interplay Between Traditional and Digital Financial Ecosystems

The increasing convergence and integration of traditional finance (TradFi) and the digital asset ecosystem create complex interdependencies, presenting both opportunities for innovation and significant challenges for financial stability. Understanding this interplay is crucial for effective risk management.

6.1 Integration Challenges

Regulatory Arbitrage and Perimeter Risk: The disparity in regulatory stringency between traditional financial markets and the less regulated digital asset space creates incentives for regulatory arbitrage. Firms may structure activities to fall outside existing prudential frameworks, or choose jurisdictions with lighter oversight, thereby migrating risk to less visible or less supervised parts of the financial system. This ‘perimeter risk’ can undermine the effectiveness of prudential regulation and allow systemic vulnerabilities to build up in the shadows.
Operational Risks and Cybersecurity Threats: The integration introduces new and amplified operational risks. Cybersecurity threats are paramount: the immutable nature of blockchain transactions means that once funds are stolen or lost due to hacks (e.g., exchange hacks, smart contract exploits, phishing attacks), recovery is often impossible. Furthermore, the interoperability between legacy TradFi systems and nascent DLTs can create technical vulnerabilities, data privacy concerns, and scalability challenges. Oracle failures, where external data feeds to smart contracts are compromised or inaccurate, can also trigger erroneous liquidations or actions within DeFi protocols, leading to significant losses.
Market Dynamics and Volatility Contagion: The high volatility characteristic of many digital assets can potentially spill over into traditional financial markets. If traditional financial institutions have significant direct or indirect exposures (e.g., through loans to crypto firms, holdings of stablecoin reserves, or investments in crypto-related equities), sharp declines in crypto prices could lead to balance sheet impairments, margin calls, and forced deleveraging in TradFi. Conversely, stresses in traditional markets (e.g., rising interest rates, liquidity squeezes) can affect digital asset valuations and liquidity, as seen with the impact on the value of collateral backing stablecoins or the willingness of institutions to provide liquidity to crypto markets.
Liquidity Flows and Disintermediation: A large-scale shift of funds from traditional bank deposits into stablecoins or other digital assets could have implications for bank funding and liquidity. If stablecoins become widely adopted as a store of value or medium of exchange, they could potentially disintermediate traditional banks, affecting their ability to lend and impacting monetary policy transmission. Rapid shifts of liquidity between the two ecosystems could also exacerbate market volatility.
Data Gaps and Opacity: The pseudonymous nature of many digital asset transactions and the fragmented data across various platforms (centralized exchanges, decentralized protocols, on-chain data) make it challenging for regulators and financial stability authorities to obtain a holistic, real-time view of exposures, leverage, and interconnectedness. This opacity hinders effective risk assessment and surveillance.
Legal and Jurisdictional Uncertainty: The cross-border nature of digital assets and the evolving legal landscape create uncertainties regarding asset ownership, collateral enforceability, contract validity (especially for smart contracts), and bankruptcy resolution processes across jurisdictions. This can complicate efforts to unwind failing entities or recover assets during a crisis.

6.2 Mitigation Strategies

Addressing the complex interplay between traditional and digital finance requires a multifaceted and proactive approach:

Enhanced Monitoring and Data Collection: Regulators must develop sophisticated tools for real-time monitoring of digital asset markets, including on-chain analytics, to identify emerging risks, leverage build-up, and interconnectedness. This requires bridging data gaps between traditional financial reporting and digital asset activity, and fostering information sharing among national and international authorities.
Adaptive and Technology-Neutral Regulation: Regulatory frameworks need to be flexible and adaptive to the rapidly evolving digital asset landscape. A ‘same risk, same regulation’ principle should be applied, focusing on the function and risks of an activity rather than just the technology. This involves extending existing prudential rules (e.g., capital, liquidity, risk management) to digital asset activities where appropriate, while also developing new, tailored regulations for unique risks (e.g., smart contract audits, decentralized governance). Regulatory sandboxes and innovation hubs can facilitate safe experimentation.
Robust Consumer Protection and Market Integrity Measures: Strong frameworks are needed to protect retail and institutional investors from fraud, manipulation, and illicit activities (e.g., pump-and-dump schemes, insider trading). This includes clear disclosure requirements, robust anti-money laundering (AML) and countering the financing of terrorism (CFT) compliance, and mechanisms for investor redress.
Cross-Sector and Cross-Border Collaboration: Effective mitigation requires seamless collaboration between financial regulators, central banks, and law enforcement agencies across jurisdictions and between traditional and digital asset sectors. This involves sharing information on risks, coordinating policy responses, and developing common standards and best practices to prevent regulatory arbitrage and ensure consistent enforcement.
Strengthening Operational Resilience: Financial institutions engaging with digital assets must invest heavily in cybersecurity, robust IT infrastructure, and comprehensive operational risk management frameworks. This includes conducting regular stress tests, developing incident response plans, and ensuring the resilience of third-party service providers (e.g., custodians, exchanges).
Developing Resolution Regimes: Clear and effective resolution frameworks are needed for failing digital asset entities, particularly those deemed systemically important. This would involve adapting traditional resolution tools or developing new ones to ensure an orderly wind-down, minimize disruption, and protect users and the broader financial system.
Central Bank Digital Currencies (CBDCs): Many central banks are exploring or developing CBDCs as a potential means to offer a safer, more stable, and regulated form of digital money. Well-designed CBDCs could mitigate some of the systemic risks posed by private stablecoins by providing a sovereign alternative, enhancing payment system efficiency, and strengthening monetary policy effectiveness (European Central Bank, 2023b).

Many thanks to our sponsor Panxora who helped us prepare this research report.

7. Conclusion

The integration of digital assets, particularly stablecoins, into the broader financial system represents a transformative shift that necessitates a fundamental re-evaluation of systemic risk and the commensurate development of robust, forward-looking regulatory frameworks. While digital assets offer considerable potential for innovation, efficiency gains, and enhanced financial inclusion, they simultaneously introduce novel pathways for financial instability and amplify existing vulnerabilities within an increasingly interconnected global financial landscape.

As evidenced by historical crises and recent events within the digital asset ecosystem, systemic risk is not a static concept but an evolving challenge deeply intertwined with financial innovation, market dynamics, and regulatory effectiveness. The unique characteristics of digital assets – their decentralization, borderless nature, programmability, and inherent volatility – demand a nuanced and adaptive approach to oversight. The collapses of Terra/LUNA and FTX underscored the dangers of algorithmic fragility, opaque centralized intermediaries, and excessive leverage, revealing potential contagion channels within the crypto ecosystem. The SVB failure, while a traditional bank run, demonstrated how the speed of digital communication and concentrated, uninsured deposits (including those from crypto firms) can accelerate liquidity crises, highlighting the critical interfaces between TradFi and the digital asset space.

Global policymakers and regulators are actively responding, as exemplified by comprehensive initiatives like the EU’s MiCA regulation and the Bank of England’s prudential frameworks for systemic stablecoins. These efforts represent crucial steps towards establishing clear regulatory perimeters, mandating robust reserve requirements, enhancing transparency, and improving oversight. However, the inherently global and rapidly evolving nature of digital assets means that national or regional responses, while necessary, are insufficient on their own. International coordination, led by bodies such as the FSB, BIS, and IMF, is paramount to prevent regulatory arbitrage, foster consistent standards, and ensure the resilience of a globally intertwined financial system.

Ultimately, safeguarding financial stability in the digital age requires a delicate balance: fostering technological innovation while diligently mitigating associated risks. This entails continuous monitoring of emerging trends, flexible and technology-neutral regulatory adaptation, rigorous enforcement, and seamless cross-border collaboration. As digital assets become more deeply embedded within financial infrastructure and services, ongoing research, proactive policy development, and a commitment to global cooperation will be essential to harness their benefits while effectively managing the evolving landscape of systemic risk.

Many thanks to our sponsor Panxora who helped us prepare this research report.