Cryptoassets, the Metaverse and Systemic Risk – Bank Underground

Owen Lock and Teresa Cascino

Cryptoassets can play important roles in the metaverse – a decentralized, immersive next generation of the Internet. Cryptoassets enable verifiable ownership of digital items, and when built to common standards, can move interoperably between web applications – increasing the asset’s value proposition. They can also align the incentives of developers, content creators, users and investors on metaverse platforms, and are required to incentivize miners and validators to add metaverse-based transactions to the underlying blockchain. We argue that as an open and decentralized metaverse grows, existing risks of cryptoassets can scale to have systemic financial stability consequences. Widespread adoption of crypto in the metaverse, or any other environment, will require compliance with robust consumer protection and financial stability regulatory frameworks.

Our focus here is on blockchain-based cryptoassets due to their enabling technological features (e.g., interoperability, incentive alignment in decentralized networks) for a decentralized metaverse. We do not seek to determine the suitability of any particular current crypto-assets, most of which are not suitable as a medium of exchange, and are highly speculative assets.

What is the metaverse?

Although there is no set definition of the metaverse, it can be considered an immersive next generation of the Internet, where people can interact to socialize, learn, play, and work in a persistent computer-generated environment. It includes many platforms, with interoperability a critical component. Virtual reality (VR) and augmented reality (AR) technology enables the user to feel that they are inside the virtual world itself, where their identity is represented in the form of an avatar.

The metaverse is in its early stages of development, and there is disagreement about whether it should be built by large technology companies in a centralized format, or in a community-owned way – the open metaverse. Which vision will dominate, when and to what extent, is uncertain. A silo-centralized metaverse has building efficiency benefits, but comes at the cost of rent extraction: from users through uncompensated use of private data, and content creators through high fees. Blockchain and cryptoassets are enablers of the open metaverse, where interoperability of digital items across many separate platforms, self-sovereignty over one’s digital assets and data, and greater value sharing are key features. In this post, we focus on the open-metaverse vision.

In the future, people can shop, exercise and socialize in the metaverse. For example, we can work as avatars at the Gucci store in ‘The Sandbox’ – an open metaverse platform – selling branded digital avatar ‘skins’, and also talking to customers about new items in physical stores. After work, we can attend an interactive virtual concert with friends held in another virtual world, with an avatar skin we bought in The Sandbox.

This example is just a hypothetical illustration, and there remain significant obstacles to such a vision becoming a reality: computing technology (eg interoperability between virtual worlds, transaction speed, network security), hardware (VR/AR glasses) and infrastructure (connectivity speeds) improvements are all needed. But many of the enabling technologies to create this ecosystem already exist. One is cryptoassets, which can be broadly defined as transferable, cryptographically secured representations of value or contract rights that exist on a distributed ledger (typically a blockchain). Crypto asset types include non-fungible tokens (NFTs), cryptocurrencies, utility and security tokens.

The role of cryptoassets

The open metaverse will require a way to own and trade digital objects that are interoperable between virtual worlds. We think cryptoassets are well placed to play an important role here for several reasons.

First, they are built according to common technical standards on the same blockchains as the applications in which they are used. This opens up the possibility of seamless integration of digital assets across web applications, which is a key feature of the open metaverse. This interoperability unlocks significant value, as goods and services are no longer tied to a single web platform. A user can buy an avatar skin on one platform and sell it at a marketplace on another. The value proposition of that asset can therefore be enhanced by use cases or services beyond its original application. This interoperable capacity has been demonstrated by decentralized finance (DeFi), which replicates financial services such as lending and exchange that are typically performed by a centralized authority, but in a decentralized manner. Bits of code called ‘smart contracts’ dictate the functionality of these DeFi applications, and can interact with many cryptoassets due to their common technical standards.

Second, NFTs can demonstrate authenticity, ownership and uniqueness of a digital asset. NFTs are what allow an individual to demonstrate unique ownership of their digital Gucci ‘skin’ for their avatar, or ticket to a virtual concert. The functionality of an NFT is programmable, meaning (eg) an NFT event ticket can be designed to be non-transferable, so it cannot be resold.

Third, cryptocurrencies are critical to the operation of the blockchains on which the open metaverse is built. Miners and validators who undertake the work of verifying and adding new transactions to the blockchain are paid block rewards and transaction fees in the native blockchain cryptocurrency (eg Ether on Ethereum). Therefore, as the demand for metaverse-based transactions increases, so does the demand for native blockchain cryptocurrencies to pay transaction fees.

Fourth, cryptoassets are a core part of the operating model and governance of many open-metaverse applications themselves. For example, decisions to change the functionality of an application can be made in a decentralized manner by holders of driving credentials, rather than in a top-down manner by an executive board. This model can enable all types of network participants (developers, creators, investors and users) to be co-owners and benefit from increases in an app’s popularity. Decentralized applications also use utility tokens to incentivize critical activities (eg ‘staking’ in a liquidity pool), and can issue security and utility tokens as a way to raise capital, instead of using traditional shares.

Finally, stablecoins—a subtype of cryptocurrency whose value is (mostly) pegged to fiat currency—are often used as a store of value within the open metaverse. Users retain sovereignty over all their metaverse-based cryptoassets and data within a cryptographically secured digital wallet.

Why does this matter for financial stability?

The importance of cryptoassets in the open metaverse means that as an open and decentralized metaverse grows, existing risks of cryptoassets can scale to have systemic financial stability consequences.

The nature of the financial stability risks currently posed by cryptoassets and DeFi have already been outlined by central banks and regulators, including the Bank of England, IOSCO, the FSB and the BIS. Some of these are similar to other traditional assets: many cryptoasset prices are highly volatile – exposing holders to significant losses in adverse market conditions. This risk is amplified by the use of leverage, which is readily available on crypto exchanges and DeFi lending protocols. Asset-backed stablecoins such as Tether, which claim (sometimes unsuccessfully) to maintain stable value against a national currency or other asset, are currently critical to cryptoasset ecosystem liquidity, but are vulnerable to runs in the event that investors lose confidence in the liquidity of the supporting assets. None currently meets the Bank’s standards for a systemically stable coin.

But some risks posed by cryptoassets are new: oracles (which provide smart contracts with off-chain information such as asset prices), smart contracts and custodians are all vulnerable to hacks, which can undermine trust. Trust can also be undermined by problems with the blockchain settlement layer (e.g. Ethereum), including: miners extracting rents through pre-running transactions, and high transaction fees and validator concentration, which can enable malicious behavior in how new blocks are added to the blockchain.

If a sizable open metaverse materializes, households can hold a larger portion of their wealth in cryptoassets to make metaverse-based payments or for investment purposes, and companies can increasingly take payments for goods and services in cryptoassets, and sell digital assets (eg. NFTs) in the metaverse. Indirectly, if people are increasingly employed in jobs in metaverse-based environments, their employment outcomes may be affected by cryptoasset risks (a loss of confidence in the cryptoasset ecosystem may lead to reduced metaverse-based activity and subsequent job losses). Non-bank financial institutions can increase their holdings of cryptoassets as a growing open metaverse improves the investment prospects of cryptoassets and improves their supporting infrastructure (eg custodians, KYC/AML checks and market liquidity). They can also choose to take advantage of opportunities to leverage their positions on DeFi lending and derivative protocols. Finally, banks may choose to increase their exposure – through custodial roles, offering market-making services and lending to companies with significant direct exposure to crypto-asset risks.

This evolution of the metaverse is uncertain, and the above scenario is a possibility, rather than a certainty. That said, should these exposures materialize, a cryptoasset risk could crystallize into: balance sheet losses for households and companies, an impact on unemployment, fire sales of traditional assets from non-banks to meet margin calls on cryptoasset positions, and negative profitability impact on exposed banks. All else being equal, the larger the size of the cryptoasset market, the greater the risks and the more systemic it can become. An important step is therefore for regulators to address risks of cryptoassets’ use in the metaverse before they reach systemic status.

Owen Lock works in the Bank’s Resilience Department and Teresa Cascino works in the Bank’s Fintech Hub.

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