By Francesco Canepa and Tom Wilson
FRANKFURT (Reuters) -Cryptocurrencies will pose a risk to financial stability if the emerging sector maintains its rapid growth of the last two years and financial firms deepen their involvement, the European Central Bank (ECB) said on Tuesday.
The crypto market slumped sharply this month after the downfall of major "stablecoin" terraUSD. The crash has led to calls from the world's top financial leaders for "swift and comprehensive" regulation of the sector.
Cryptocurrencies - historically a niche asset favoured by risk-hungry investors, exploded in size during the COVID-19 pandemic. Institutional investors especially were drawn by claims that bitcoin acts as a hedge against inflation and offers high returns in the face of low interest rates.
The crypto sector hit a peak of $2.9 trillion last November up from less than $300 billion at the start of 2020. Still, bitcoin, the biggest token, since November has slumped by over half, dragging the value of the overall crypto market down to around $1.2 trillion.
The ECB in its biannual financial stability review said exposure to crypto by banks and other financial institutions on a wide scale could put capital at risk and damage investor confidence, lending and financial markets.
"Systemic risk increases in line with the level of interconnectedness between crypto-assets and the traditional financial sector," it said.
Highly leveraged trading offered by crypto exchanges has seen investors borrow funds to buy greater exposure to crypto, also heightening financial stability risks, the ECB noted.
Furthermore, data shortcomings in the sector are also hindering the assessment of financial risks, it said, warning that publications by crypto exchanges and data aggregators should be treated with caution.
Retail investors, long at the heart of crypto trading, have also piled in, the ECB noted.
One in ten euro zone households have bought crypto such as bitcoin, its Consumer Expectation Survey, which ran the poll in six countries.
The ECB said crypto was unsuitable for most retail investors and urged European Union authorities to approve new rules on crypto assets "as a matter of urgency".
The rules, first published in September 2020, have not yet been agreed by the EU, and are not set for approval until 2024 at the earliest, the ECB said.
($1 = 0.9376 euro)