ECB’s Mersch calls for rigorous standards for virtual currency exchanges

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Virtual currencies and the entities whose activities involve them came under fire today in a speech delivered by Yves Mersch, Member of the Executive Board of the ECB. Right from the start, Mr Mersch made clear he was skeptic towards the use of distributed ledger technologies to create currency.

Given that nobody is liable for virtual currencies and that they are not backed by any trustworthy authority, “it may well be that VCs will fail, as so many other earlier forms of money did”.

Mr Mersch refuted the idea of cryptocurrencies being the latest incarnation of money. He stressed that Bitcoin is far inferior to existing payment options. Transactions generally require confirmation from six miners, which can take an hour, or potentially much longer due to network congestion, he said. The high cost of Bitcoin payments was also noted.

This critical stance echoes the opinion expressed by Mark Carney, Governor of the Bank of England, in a speech, delivered at the inaugural Scottish Economics Conference, Edinburgh University, earlier this year. In that speech, Mr Carney slammed cryptocurrencies as being incapable of fulfilling the roles of traditional, fiat currencies.

“In addition, there is unease that the combination of these vulnerabilities and widening retail participation could damage the reputations of those financial intermediaries connected to crypto-asset markets”, said Mark Carney.

The effects of a crash were also explored by Mersch. He said these could be further magnified if VC investors were highly leveraged.

“Not only would investors lack equity to absorb losses, but losses would also spread to creditors. Moreover, the use of derivative contracts could spread the losses more broadly across the economy by allowing other market participants to hold leveraged positions against VCs”, says Yves Mersch.

This risk has been taken into account in the new rules for CFD offering to retail investors outlined by the European Securities and Markets Authority (ESMA). Let’s recall that the regulator is considering imposing particularly heavy restrictions on leverage for CFDs on cryptocurrencies.

Mr Mersch also warned that a crash could affect the stability of the wider financial system if big banks were to hold huge unhedged exposures to virtual currencies. Furthermore, the widespread use of cryptocurrencies for payment or settlement could affect economic transactions on a large scale and disrupt the financial system.

Given these potential risks, Mr Mersch called for resolute ring-fencing measures to safeguard the integrity of financial sector services, protect investors and consumers, and prevent negative spill-overs to the real economy.

The four broad areas that require particular attention, according to him, are: (i) VCs themselves; (ii) the facilitators – VC exchanges, wallet-providers and brokers; (iii) financial market infrastructures (FMIs); and (iv) the banking sector. In particular, he seeks restraining of facilitators. Possible regulatory action to extend licensing and supervision rules to VC facilitators could be explored.

“We need to hold VC exchanges to the same rigorous standards as the rest of the financial system”, Mr Mersch says.

Finally, the regulators must also look at the banking sector, he noted. Due to the high volatility of the virtual currencies it might seem appropriate to require any VC trading to be backed by adequate levels of capital, and segregated from other trading and investment activities.

Due to the risks posed by leverage, according to him, banks should not accept VCs as collateral, or should only accept them with haircuts that appropriately reflect past volatility and liquidity, as well as market and operational risks. Likewise, limits on leverage could be examined.

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