To address potential financial stability risks and protect investors, it is important to arrive at a common approach to crypto assets, the Financial Stability Report released by RBI said on Thursday.

In this context, various options are being considered internationally, it said.

One option is to apply the same-risk-same-regulatory-outcome principle and subject them to the same regulation applicable to traditional financial intermediaries and exchanges, the report said.

Another option is to prohibit crypto assets since their real-life use cases are next to negligible and the challenge is that different countries have different legal systems and individual rights vis-à-vis state powers, it noted.

A third option is to let it implode and make it systemically irrelevant as the underlying instability and riskiness will ultimately prevent the sector from growing, it said.

The third option, however, is fraught with risks as the sector may become more interconnected with mainstream finance and divert financing away from traditional finance with a broader effect on the real economy, the report said.

Regulating new technology and business models after they have grown to a systemic level is challenging, it pointed out.

To promote responsible innovation and mitigate financial stability risks in the crypto ecosystem, the report said it is vital for policymakers to design an appropriate policy approach.

In this context, under India's G20 presidency, one of the priorities is to develop a framework for global regulation, including the possibility of prohibition, of unbacked crypto assets, stablecoins and decentralised finance (DeFi), it said.

The collapse and bankruptcy of the crypto exchange FTX and the subsequent sell-off in the crypto assets market have highlighted the inherent vulnerabilities in the crypto ecosystem.

Recently, Binance, the largest crypto exchange, also prohibited withdrawals of stablecoins on its platform. The implosion of FTX was preceded by the failure of TerraUSD/Luna, an algorithmic stablecoin, a run on Celsius, a crypto lender, and the bankruptcy of Three Arrows Capital, a cryptocurrency hedge fund.

Observing that the turmoil has provided several insights, it said crypto assets are highly volatile.

The price of Bitcoin has tumbled by 74 per cent (as on December 14, 2022) from its peak in November 2021. Other crypto assets have also experienced similar falls in prices and heightened volatility.

In addition, crypto assets exhibit high correlations with equities, it noted.

Furthermore, it said, contrary to claims that they are an alternative source of value due to inflation hedging benefits, crypto assets' value has fallen even as inflation rose.

Second, the report said, the collapse of TerraUSD/Luna is a reminder of how so-called stablecoins that promise to maintain a stable value relative to fiat currency are subject to classic confidence runs.

Finally, it said, the failure of FTX and Celsius reveals that crypto exchanges and trading platforms were carrying out different functions such as lending, brokerage, clearing and settlement that have different risks without appropriate governance structures.

This exposed them to credit, market and liquidity risk disproportionate to what was necessary to discharge their essential functions, it said, adding leverage is a constant theme across the crypto ecosystem, making failures rapid and losses huge and sudden.