South Korea’s booming crypto scene could someday threaten the country’s financial 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 about to change.

“Considering [South Korea’s] increased exposure [to crypto] and relevant criminal cases, virtual assets can become a major threat to financial stability,” Lee Dae-gi, a senior researcher at the institute, wrote in the report published on Sept. 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 stronger, which could amplify the impact crypto has on financial markets.

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According to Iyer, the volatility correlation between Bitcoin and the U.S. S&P 500 Index was at 11% from January 2017 to December 2019. That figure rose to 46% from January 2020 to November 2021. Lee wrote in his report that this phenomenon could be seen in 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 (US$8.2 billion), compared to an average daily trading volume of 15.4 trillion won at 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 steep growth, rising from 1.21 million in 2020 to 5.58 million users by the end of 2021. The latter number counts for more than 10% of the country’s total population.

The growing relationship between traditional finance (TradFi) and crypto could eventually threaten financial stability in different ways, Lee wrote. Financial institutions with greater crypto exposure should expect higher volatility in their profits, which could eventually damage the institution’s reputation and asset soundness, he warned. 

Local laws mandate that cryptocurrency exchanges, or virtual assets service providers (VASPs), must establish partnerships with regulated banks to issue customers real-name deposit and withdrawal accounts. The banks themselves and other financial institutions are barred from investing in crypto or operating crypto-related businesses.

Lee’s report added that price volatility, coupled with tech and operational risks, could undermine trust in banks tied to VASPs and result in aftershocks across stocks, bonds and foreign exchange markets.

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

Park Sun-young, professor of economics at Dongguk University, told Forkast that at the moment, the crypto industry had “minimal” impact on financial institutions because of existing restrictions on them.  

Even May’s multibillion Terra-LUNA meltdown had little-to-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: Scarred 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, Financial Services Commission (FSC) Chair Kim Joo-hyun called for a radical reform of the country’s finance industry to be in line with global digital trends. This could include discussions on whether banks should be allowed to directly operate crypto businesses.