The European Central Bank (ECB) has recently published an article highlighting the existence of a cryptoasset information gap – with potential implications for monetary policy, market infrastructure and payments, and the stability of the financial system.
Why is the ECB interested in a potential information gap?
Cryptoassets currently have a (partially) unregulated nature. This is one of their main risks, as holders of unregulated cryptoassets will not benefit from the legal protection associated with regulated instruments. Rules relating to safeguarding and segregation, or schemes of arrangement, do not apply. This means that cryptoasset holders are exposed to the risk of bankruptcy or the hacking of a service provider controlling access to a customers’ holdings (i.e. crypto-wallet providers).
The cross-border dimension arising from a lack of governance and distributed architecture further complicates matters. Distributed ledger technology (DLT) allows cryptoassets to dispense with an accountable party. This means that the roles and responsibilities for identifying, mitigating and managing the risks tolerated in the cryptoasset network cannot be allocated. This elevates the risks of money laundering and terrorist financing.
The ECB is of the view that the stability of the financial system and monetary policy, and the safety and efficiency of payments and market infrastructures, are directly exposed to risks posed by the growth of intermediaries, trading platforms and custodian wallet providers, which provide the connections and gateways between cryptoassets and the broader financial system. In light of the implications for the stability and efficiency of the financial system and the economy, the ECB is of the view that cryptoassets warrant continuous monitoring.
Monitoring, however, requires an effective framework and the ECB's efforts to develop a cryptoasset monitoring framework draw attention to the data issues and important gaps that currently exist.
What is the information gap?
Effective monitoring is dependent on quality data. The difficulty highlighted by the ECB is that statistics and supervisory reporting mechanisms do not generally cover cryptoassets. Regulators are reliant to a large extent on publicly available third party aggregated data in order to monitor cryptoassets; for example, estimated market capitalisation, prices and trading volumes on exchanges. However, since there are no prescribed standards in relation to publication of such data, there are deficiencies in the information available affecting, for example, the ECB's understanding of broader systemic risks posed by cryptoassets.
The ECB in particular highlights that a major data gap exists with respect to the direct cryptoasset holdings of banks and corporations, not least because of the potential for these investments to have been obtained using third party finance. Potentially large and unhedged exposures to cryptoassets could have financial stability implications, particularly given there is currently no prudential treatment for cryptofasset exposures of financial institutions.
The information gap also concerns the real economy, where there is little information relating to transactions made with cards supporting cryptoassets, sales by merchants accepting cryptoassets and the value of withdrawal transactions from cryptoasset ATMs.
The pricing problem
For consistency, the ECB has chosen to define a cryptoasset as an asset recorded in digital form and enabled by cryptography that does not represent a financial claim on, or a liability of, any identifiable entity.
The fact that a crypto-asset does not constitute a claim on any identifiable entity means that its value is supported only by the expectation that others will be willing to pay for it in the future, rather than by a future cash flow on which users can form their expectations.
The valuation of cryptoassets is widely acknowledged as being challenging. The ECB explains this is because cryptoassets lack fundamental value (such as the right to a future cash flow or to discharge a payment obligation) so their valuation is inherently speculative.
Unlike any other market, the cryptoasset market operates 24 hours a day, with no standardised “close of business” time. This contributes to the challenges of pricing cryptoassets as there is low liquidity and data aggregators provide lower frequency data (in line with their preferred time frame convention) which may not coincide with that of other providers.
To address the issue of low liquidity, data providers:
- adjust the contributions of the prices achieved on the less liquid exchanges in the overall indicator of a price of a cryptoasset; and
- correct unusual spikes and erratic trading behaviour using boundaries or other exclusion criteria-based on benchmarks.
The lack of standard naming convention for cryptoassets and their identifiers also contributes to the difficulty in getting reliable data.
Furthermore, the main characterising element of a cryptoasset is that it is not a claim on either an issuer or a custodian. Users instead attach value to the belief that: i) the supply will remain limited, and ii) market participants will agree on who is entitled to sell any of the units of the relevant cryptoasset in circulation.
According to the ECB, cryptoassets lack fundamental value by definition. This contrasts with financial or payment instruments, where value stems from future cash flows and the right to discharge a payment obligation respectively. Due to the above, cryptoassets have a tendency to experience extreme price volatility.
The market capitalisation problem
In order to calculate market capitalisation, the value or price of a cryptoasset has to be complemented with information on the aggregate supply, which can be measured in several ways. Information difficulties here include the following:
- Information provided by reliable sources, such as institutionalised exchanges trading bitcoin futures or ETPs, may not be fully comparable, due to differences in the specifications of the underlying contracts or investment pools.
- The size of the cryptoasset market, according to the ECB's analysis, can vary by a factor of 20 and this problem is exacerbated given the wide variety of indicators (provided on the internet by commercial and non-commercial websites supplying cryptoasset-related information, or by research groups and academics) that aim to represent the total market of cryptoassets.
The on-chain/ off-chain problem
To assess the availability and reliability of data on cryptoassets, the ECB considers it is important to differentiate between “on-chain” and “off-chain” cryptoasset transactions:
- On-chain cryptoasset transactions are those recorded directly on a distributed ledger.
- Off-chain transactions are recorded either on the book of an institution, for instance in the case of trading platforms, or in a private network of users that use the distributed ledger of a cryptoasset to record the net transactions among participants.
Information concerning on-chain data is often publicly available, but it is currently a difficult task to identify the value of a cryptoasset transaction and whether different cryptoasset wallets belong to the same individual (or institution). In fact, a number of initiatives are being developed by the cryptoasset community to make identification of these transactions even more difficult. With respect to the off-chain transactions, there is very limited availability and transparency of the data that is reported or the methodologies used.
The ECB is of the view that the aggregated price information of a cryptoasset is impacted, among other things, by the selection of trading platforms, the underlying trading volumes, conventions concerning the 24-hour close-of-business time, factors to address low liquidity levels, failures of trading platforms, data and connectivity.
Can the information gap be closed?
The ECB highlights two areas of future work. First, it plans to continue to work on indicators and data by dealing with the complexity and growing challenges of analysing "on-chain" and layered protocol transactions. It will also continue to investigate new data sources, and, with respect to off-chain transactions, the ECB plans to focus on increasing the availability and transparency of the reported data and developing best practices for indicators on cryptoassets.
However, in order to attempt to close the gap properly, what is needed is a monitoring template that competent authorities can issue to financial institutions to identify and measure the level and type of cryptoasset activity. The ECB recognises that the dataset for a functioning cryptoasset monitoring framework will need to be flexible enough to keep up with changing monitoring needs and rapid developments in the market, while remaining proportionate to the potential risks posed by the cryptoasset market.
Osborne Clarke comment
As the ECB highlights, there are important information gaps and challenges in relation to the monitoring of the cryptoasset market. The ECB is planning further work in an attempt to address these gaps and challenges, but new and unexpected data needs may emerge with further advancements in cryptoassets and in related areas of innovation.