Cryptoassets in the metaverse could cause systemic risk – Bank of England

In a blog, Owen Lock from the Bank of England’s resilience division and Teresa Cascino from its Fintech Hub explore how the metaverse and cryptoassets will affect systemic risk.

Cryptoassets could have important roles within the metaverse – a decentralised, immersive next generation of the internet. Cryptoassets enable verifiable ownership of digital items, and when built to common standards, can move interoperably between web applications – increasing the asset’s value proposition. They can also align the incentives of developers, content creators, users and investors on metaverse platforms, and are required to incentivise miners and validators to add metaverse-based transactions to the underlying blockchain.

We argue that if an open and decentralised metaverse grows, existing risks from cryptoassets may scale to have systemic financial stability consequences. Widespread adoption of crypto in the metaverse, or any other setting would require compliance with robust consumer protection and financial stability regulatory frameworks.

Our focus here is on blockchain-based cryptoassets because of their enabling technological characteristics (eg interoperability, incentive alignment in decentralised networks) for a decentralised metaverse. We do not seek to assess the suitability of any specific current cryptoassets, most of which are ill-suited as a medium of exchange, and are highly speculative assets.

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In the future, people could shop, exercise and socialise within the metaverse. For example, we may work as avatars at the Gucci store in ‘The Sandbox’ – an open-metaverse platform – selling branded digital avatar ‘skins’, and talking to customers about new items in physical stores too. After work, we may attend an interactive virtual concert with friends, held in another virtual world, wearing an avatar ‘skin’ we bought in The Sandbox.

This example is just a hypothetical illustration, and there remain significant hurdles to such a vision becoming a reality: computational technology (eg interoperability between virtual worlds, transaction speeds, network security), hardware (VR/AR glasses) and infrastructure (connectivity speeds) improvements are all required. But many of the enabling technologies to create this ecosystem do already exist. One of those is cryptoassets, which can be broadly defined as transferrable, cryptographically secured representations of value or contract rights which exist on a distributed ledger (typically a blockchain). Types of cryptoasset include non-fungible tokens (NFTs), cryptocurrencies, utility and security tokens.

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Cryptocurrencies are critical to the operation of the blockchains that the open-metaverse is built upon. Miners and validators who undertake the work of verifying new transactions, and adding them to the blockchain are paid block rewards and transaction fees in the native-blockchain cryptocurrency (eg Ether on Ethereum). Therefore, as demand for metaverse-based transactions increases, so does demand for native-blockchain cryptocurrencies to pay transaction fees.

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The importance of cryptoassets in the open-metaverse means that if an open and decentralised metaverse grows, existing risks from cryptoassets may scale to have systemic financial stability consequences.

The nature of the financial stability risks currently posed by cryptoassets and DeFi have already been outlined by central banks and regulators including the Bank of England, IOSCO, the FSB and the BIS. Some of these are similar to other traditional assets: many cryptoasset prices are highly volatile – exposing holders to significant losses in adverse market conditions. This risk is amplified by the use of leverage, which is readily available on crypto exchanges and DeFi lending protocols. Asset-backed stablecoins such as Tether, which claim (sometimes unsuccessfully) to maintain stable value against a national currency or other asset, are currently critical to cryptoasset ecosystem liquidity, but are vulnerable to runs in the event that investors lose confidence in the liquidity of the backing assets. None currently meet the Bank’s standards for a systemic stablecoin.

But some risks posed by cryptoassets are new: oracles (which supply smart contracts with off-chain information such as asset prices), smart contracts and custodians are all vulnerable to hacks, which could undermine confidence. Confidence could also be undermined by issues with the blockchain settlement layer (eg Ethereum), including: miners extracting rents by front-running transactions, and high transaction fees and validator concentration, which can enable malicious behaviour in how new blocks are added to the blockchain.

If a sizable open-metaverse materialised, households may hold a greater share of their wealth in cryptoassets to make metaverse-based payments or for investment purposes, and corporates may increasingly take payments for goods and services in cryptoassets, and sell digital assets (eg clothing NFTs) in the metaverse. Indirectly, if people are increasingly employed in jobs in metaverse-based settings, their employment outcomes may be affected by risks from cryptoassets (a loss of confidence in the cryptoasset ecosystem could result in reduced metaverse-based activity and subsequent job losses). Non-bank financial institutions may increase their holdings of cryptoassets if a growing open-metaverse improves the investment prospects of cryptoassets and improves their supporting infastructure (eg custodians, KYC/AML checks and market liquidity). They may also choose to take advantage of opportunities to leverage their positions on DeFi lending and derivative protocols. Finally, banks may choose to increase their exposure – through custodial roles, offering market-making services, and extending credit to companies with significant direct exposure to cryptoasset risks.

This evolution of the metaverse is uncertain, and the above scenario is a possibility, rather than a certainty. That said, were these exposures to materialise, a cryptoasset risk crystallising could result in: balance sheet losses for households and corporates, an impact on unemployment, fire-sales of traditional assets from non-banks to meet margin calls on cryptoasset positions, and negative profitability impacts on exposed banks. All else equal, the larger the size of the cryptoasset market, the larger the risks are and the more systemic they might become. An important step is therefore for regulators to address risks from cryptoassets’ use in the metaverse before they reach systemic status.

Full article here