The Financial Stability Report which is released biannually and compiled by the Board of Governors of the Federal Reserve System presents the Federal Reserve Board’s current assessment of the stability of the US financial system for a certain period. According to the Federal Reserve, the financial system is considered stable when banks, lenders, and financial markets can provide households, communities, and businesses with the financing they need to invest, grow, and participate in a well-functioning economy—and can do so even when hit by unprecedented events.
In the November 2022 report, the Federal Reserve noted that since the release of the May 2022 report, the US economic outlook remains weakened, and the inflation rate remains high in the US as well as in many other countries, leading to central banks around the world responding with tightened monetary policies.
The report also includes a survey titled the “The Survey of Salient Risk to the Financial Sector” in which respondents include professionals at broker-dealers, investment funds, research and advisory organizations, and academics. In comparison to the survey result included in the May 2022 report, the latest released report reveals key financial vulnerabilities noted by surveyed respondents. They include:
- Persistent Inflation and Monetary Tightening: In the May report, 68% of survey respondents cited inflation as an existing condition that presented a risk to the US financial stability. In the November report, 62% of respondents still cite inflation as a major risk to US financial stability.
- Geopolitical Unrests: Conflicts between Russia and Ukraine and the risk of military or political conflict between China and Taiwan posed concerns to financial stability. In the May as well as the November Financial Stability report, respondents noted that these conflicts could disrupt the global supply chain and weigh heavily on investor sentiments.
- Market Fragilities: Respondents pointed to developments in the financial markets that could pose risk to financial stability. Some pointed out that in the sovereign bonds market, liquidity remains a challenge. Other respondents saw potential spillovers from the scale and speed of the strengthening in the U .S . dollar, including the prospect of disorderly moves and potential actions by foreign authorities to manage exchange rates, either through intervention or unanticipated shifts in monetary policy, according to the report.
Other financial systems vulnerabilities cited in the November 2022 Financial Stability Report include funding risks; the report reveals that structural vulnerabilities persist in money market funds, some mutual funds, and digital assets including stablecoins.
Digital Assets and Their Effect on Financial Stability
As digital assets are becoming mainstream, their effects — cryptocurrencies and stablecoins — on financial stability cannot be overlooked. While digital assets provide a host of useful innovations, the overall ecosystem faces certain vulnerabilities and risks outside of what typically occurs in traditional finance. The speculative nature of crypto-assets makes them very volatile; the total capitalization of the crypto market has experienced big price swings in recent years.
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Stablecoins are meant to be safe-haven crypto-assets, immune to the volatility of the crypto market. The November report cited the May implosion of the TerraUSD stablecoin; before the crash, TerraUSD was worth about $18 billion in market capitalization. The implosion was followed by a general bearish sentiment in the crypto market leading to another well-traded stablecoin Tether (USDT) to trade briefly below its peg. Another stablecoin AcalaUSD (aUSD) also lost its peg in August after an exploit on the Acala network. The market capitalization of stablecoins continues to decline, and the stablecoin sector remains vulnerable to liquidity risks, the report states.
The report, however, stated that the turmoil in the digital assets ecosystem did not have significant effects on the traditional financial system because digital assets do not yet provide significant financial services in the broader financial sector. The Federal Reserve in the report further said there is a potential for digital assets to grow rapidly and its connection to the traditional finance sector could increase; therefore, enforcing regulations and expanding the regulatory parameters is essential to the sector.
In September, the Federal Reserve Bank of New York also released a report, written by its staff authors, titled: “The Financial Stability Implications of Digital Assassets The Federal Reserve’s interest in digital assets once again proves that digital assets will slowly but surely become adopted as a key asset in the general financial market.
