The recent collapse of the crypto exchange FTX and the ensuing sell-off in the crypto markets have placed a spotlight on the vulnerabilities in the crypto ecosystem, the Economic Survey 2022-23 presented in Parliament said on Tuesday. 

Crypto assets are self-referential instruments and do not strictly pass the test of being a financial asset because it has no intrinsic cashflows attached to them.

US regulators have disqualified Bitcoin, Ether and various other crypto assets as securities. 

A rare joint statement by the Federal Reserve, Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) on January 3, 2023, highlighted their concerns about crypto-asset risks to the banking system, it noted.

The geographically pervasive nature of the crypto ecosystem necessitates a common approach to the regulation of these volatile instruments, and the global response to cryptos is evolving, it said.

Observing that crypto assets are new forms of digital assets implemented using cryptographic techniques, the survey said its market has been very volatile, with its total valuation swinging from almost $3 trillion in November 2021 to less than $1 trillion in January 2023. 

The volatility of the crypto asset ecosystem has brought to the forefront their fragile backing and governance problems, as well as the increasing complexity and non-transparency, it said. 

With related financial stability risks rising, the issue of crypto asset regulation has recently moved up the policy agenda of many nations. International fora like OECD and G20 are discussing a globally coordinated approach to regulating crypto assets, it noted.

Monitoring and regulating cryptocurrencies have been tricky, and regulators across the globe find it challenging to keep track of the new and emerging issues in the fast-moving uncharted field, it said. 

While crypto assets were apparently designed to disintermediate traditional financial services, this has created new unregulated intermediating entities, it said, adding the promise of decentralisation has yet to be realised in practice. 

New centralised intermediaries, such as crypto asset exchanges, wallet providers, and crypto conglomerates, require users to trust centralised entities, it said. 

The increasing importance of these entities could force regulators to consider them as systemic financial market infrastructures (FMIs), it said, adding still, the fact that they are yet largely unregulated is a cause for concern globally.

Interestingly, it said, holdings of crypto assets are primarily concentrated in the hands of a few 'whales'.

Estimates show that around 85 per cent of all circulating Bitcoins are held by 4.5 per cent of entities, and the underlying protocols used to create crypto assets may also conflict with other public policy objectives, for instance, the massive energy intensity of 'mining' crypto assets.

There are minimal global standards applicable to unbacked crypto assets, which do not currently mitigate all risks and vulnerabilities, it said. 

"Even as Standard-Setting Bodies (SSBs) have been making efforts to adjust and develop standards, these remain mainly focused on specific issues (financial integrity), sectors (payments, securities and banking), products (global stablecoins), or entities designated as systemic by domestic authorities," it said.

Thus, there are regulatory gaps at each stage when crypto assets are issued, transferred, exchanged, or stored by non-bank entities. Crypto’s cross-sector and crossborder nature limits the effectiveness of uncoordinated national approaches, it said. 

The terminology used to describe the different activities, products and stakeholders is not globally harmonised. The term "crypto asset" itself refers to a broad spectrum of digital products that may need the attention of multiple domestic regulators based on their actual or intended use.