By Huw Jones and Tom Wilson

LONDON (Reuters) – Risks from the $2.6 trillion crypto market could grow quickly and regulators need pre-prepared measures to bring the sector to heel, the Financial Stability Board (FSB), a risk monitoring watchdog for the G20 economies, said on Wednesday.

While cryptoassets like bitcoin remain a small part of the financial system, data gaps make it difficult to assess their full use and many investors don’t fully understand what they are buying, the FSB said.

Traditional finance such as big banks and hedge funds are also becoming more involved, along with derivatives that reference cryptoassets in complex investment strategies, the FSB said in a report.

As such, financial stability risks could rapidly escalate, underscoring the need for timely and pre-emptive evaluation of possible policy responses, the report said in a hardening of earlier FSB statements that saw crypto as posing little threat.

“If the current trajectory of growth in scale and interconnectedness of crypto-assets to these institutions were to continue, this could have implications for global financial stability,” it said.

Regulators worry increasingly about how a meltdown in cryptoassets – markets which are highly volatile and still opaque – would feed through into the wider financial sector.

Last May, a sharp plunge for bitcoin and ether after China tightened curbs on crypto saw yields on benchmark U.S. and German government bonds fall, as investors dumped digital tokens for perceived safe-haven assets.

Bank of England Deputy Governor Jon Cunliffe said in October that a collapse in cryptocurrencies was a “plausible scenario”.

Decentralised finance (DeFi), a crypto offshoot, is also rising up the FSB agenda. It allows users to lend, borrow and save in cryptocurrencies while bypassing the traditional gatekeepers of finance such as banks and exchanges.

DeFi has soared in popularity during the pandemic as rock-bottom interest rates push investors to search for yield. DeFi has become a magnet for scams and other crime, throwing up additional challenges for regulators.

“Without sufficient regulation and market oversight, DeFi and associated platforms might present risks to financial stability,” the FSB report said.

Robert Ophele, chair of France’s securities watchdog AMF, said last week that regulators were behind the curve and that the FSB might have its first global framework for stablecoins and digital asset service providers within months.

The FSB has no powers to impose binding rules but its members commit to turning agreed principles into national rules.

The European Union is ahead of the pack in approving a new law to regulate markets in cryptoassets but regulators say a global approach is also needed given the sector’s cross-border nature.

(Reporting by Huw Jones and Tom Wilson; Editing by Raissa Kasolowsky)