S.Korea crypto bonds pose ‘major’ risk to financial stability

South Korea’s booming crypto scene could one day threaten the country’s economic well-being due to the industry’s growing ties with traditional finance, according to a report by the Korea Institute of Finance.

The Seoul-based independent research institute said the crypto sector currently had “minimal” influence on the country’s financial markets, but that was changing.

“In regards to [South Korea’s] increased exposure [to crypto] and relevant criminal cases, virtual assets may become a major threat to financial stability,” Lee Dae-gi, a senior researcher at the institute, wrote in the report published on September 2.

Lee cited data from International Monetary Fund (IMF) economist Tara Iyer, who said the correlation between cryptocurrencies and the stock market has become increasingly strong, which could amplify the effect crypto has on financial markets.

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According to Iyer, the volatility correlation between Bitcoin and the US S&P 500 index was 11% from January 2017 to December 2019. This figure rose to 46% from January 2020 to November 2021. Lee wrote in his report that this phenomenon could be seen in the South Korea in the future.

At the end of 2021, Korea’s crypto market had an average daily trading volume of 11.3 trillion Korean won ($8.2 billion), compared with an average daily trading volume of 15.4 trillion won on the KOSPI, the country’s main stock index, according to the country’s financial intelligence unit.

The number of crypto users in Korea is showing strong growth, rising from 1.21 million in 2020 to 5.58 million users by the end of 2021. The latter figure represents more than 10% of the country’s total population.

The growing relationship between traditional finance (TradFi) and crypto could ultimately threaten financial stability in various ways, Lee wrote. Financial institutions with greater crypto exposure should expect higher volatility in earnings, which could ultimately damage the institution’s reputation and solvency, he warned.

Local laws require cryptocurrency exchanges, or virtual asset service providers (VASPs), to establish partnerships with regulated banks to issue customers with real deposit and withdrawal accounts. The banks themselves and other financial institutions are banned from investing in crypto or running crypto-related businesses.

Lee’s report added that price volatility, combined with technological and operational risk, could undermine confidence in banks linked to VASPs and result in aftershocks across equity, bond and currency markets.

Despite the crypto ban on financial institutions, an increasing number of them have started to dabble in crypto through equity investments or joint ventures.

Park Sun-young, professor of economics at Dongguk University, said Discard that currently the crypto industry had “minimal” impact on financial institutions due to existing restrictions on them.

Even May’s multi-billion Terra-LUNA meltdown had little or no impact on South Korea’s financial markets, she said, adding: “When you compare [it] with global markets, Terra-LUNA is very small in size.”

See related article: Spurred by Terra-LUNA, South Korea moves ahead with digital asset reform

That may be the case at the moment, but South Korea is moving quickly to adopt crypto in its public and private sectors.

In July, head of the Financial Services Commission (FSC) Kim Joo-hyun called for a radical reform of the country’s financial industry to be in line with global digital trends. This could include discussions about whether banks should be allowed to conduct crypto business directly.