Roy Keidar February 15 2022 Report on financial stability provides rare glimpse into Bank of Israel's attitude to cryptographic assets Arnon, Tadmor-Levy | Banking & Financial Services - Israel Roy Keidar Banking & Financial Services Interactions unavailable in preview. IntroductionRisks posed by cryptoCommentIntroductionIt is rare to get a glimpse into the mindset of the central bank. Such an opportunity was recently presented by the Bank of Israel's report on financial stability in the second half of 2021. In its report, the central bank decided to include, for the first time, a special chapter on cryptographic assets (crypto) and their effect on banking financial stability.The report stresses several concerns regarding the growing adoption of crypto by consumers and financial institutions. Such concerns include various familiar risks – such as crypto's volatility, operational risks, cyber risks, reputational risks and legal risks – all of which have been widely associated with crypto and publicly discussed in recent years. However, the report also elaborates on the specific risks crypto poses to banks, which are worth noting.Risks posed by cryptoThe first concern mentioned is the growing exposure of non-banking financial institutions to crypto. This indirectly exposes the banking system to crypto-related risks, as banks are often the financiers of non-banking financial institutions. The report argues that this should lead to tougher scrutiny of banks' interests in non-banking financial institutions.The second concern touches on the issue of "stablecoins" (ie, cryptographic tokens pegged to a stable asset, such as the US dollar). The report argues that stablecoins may affect the long-term financial stability of the traditional banking system. The concern is that wider adoption of stablecoins may lead customers to ultimately choose to withdraw funds from their bank accounts, purchase stablecoins and deposit them with virtual assets service providers in the hope of better returns than the banking system can offer. According to the report, this could lead to a reduction of liquidity for banks, which might eventually increase the cost of credit for consumers. Interestingly, the only regulator in Israel to publicly express their position in this regard is the governor of the Bank of Israel, who has claimed that stablecoins should be supervised by the central bank.Furthermore, as the demand for global stablecoins rises, especially by those living in smaller countries, the report argues that they may weaken local currencies, which has the potential to greatly impact such countries' local monetary policy and their financial autonomy.Lastly, the report notes that the increasing demand for decentralised finance (Defi) platforms providing services that are traditionally linked to banks, such as loans and savings, may in turn lead to a decline in demand for banking services. The report further points out that Defi applications pose unique regulatory challenge; while they offer financial products and services that would normally be regulated, such regulation is inapt and needs to be further adapted to better suit the financial character of crypto, as well as the risks emanating from the nature of the decentralised network. This requires a multinational cooperation and effort on both setting agreed standards and enforcement.CommentLooking at these risks as they are portrayed in the Bank of Israel's report leads to the question of whether they reflect a genuine concern about the financial stability of the banking system or a more basic fear about the ability of the banks to commercially compete with the constantly growing crypto market. There is no doubt that consumers are looking for alternatives, and some find crypto products more attractive than traditional banking alternatives. There is also no question that the crypto space needs to be regulated to reduce market risks and provide more transparency. However, regulation should not suppress competition; it should encourage it. Banks should not fight crypto; they should compete with it. If they choose the latter, the ultimate beneficiaries would be the consumers.For further information on this topic please contact Roy Keidar at Yigal Arnon & Co by telephone (+972 3 608 7777) or by email ([email protected]). The Yigal Arnon & Co website can be accessed at www.arnon.co.il.Arkadius Stark, student, assisted in the preparation of this article.