FRANKFURT EU rules to protect the financial system from risks stemming from cryptocurrencies contain a loophole that allows banks to circumvent some safeguards and should be fixed urgently, the European Central Bank's chief supervisor Andrea Enria said on Tuesday.

The cryptocurrency market is starting to bounce back a year after the collapse of exchange FTX and other big players in 2022 crushed prices, tarnished the industry and prompted a regulatory crackdown.

Enria listed a number of challenges for European financial watchdogs as they prepare to tackle the crypto market using newly approved EU and global regulation set by the Basel Committee on Banking Supervision (BCBS).

He warned the EU's framework placed banks' activity as a 'crypto-asset service provider' -- such as acting as a custodian for customer wallets, exchanging tokens or managing crypto portfolios -- outside of the ECB's purview as a banking supervisor.

This prevents the ECB from having a full view of a bank's exposure to cryptocurrencies and from effectively applying safeguards, such as a limit on how heavily a lender can be exposed to a single client, Enria argued.

"One aspect that concerns us at the moment is the possibility of circumventing the soon-to-be-applicable prudential regulatory framework," he said in the text of a speech delivered at a conference in Venice.

"In fact, if crypto-asset service providers controlled by banks are not within the scope of their prudential consolidation, the BCBS standard and especially the exposure limit may become ineffective."

He added crypto asset service providers should be added "as a matter of urgency" to the list of financial institutions that the ECB supervises under EU rules.

In another warning, he said the EU Markets in Crypto-Asset Regulation's (MiCAR) provision that issuers of stablecoins keep 60% of reserves in bank deposits may have "have unintended consequences" for financial stability if that cash is withdrawn.

He said banks should not rely "on volatile deposits, especially those of crypto-asset players" but the latter should also be forced to work with various banks when MiCAR is fully rolled out.

MiCAR entered into force at the end of June and will take full effect by the end of next year. The Basel Committee's global standards on exposures to crypto assets are due to be transposed into EU law by Jan. 1, 2025.

Enria's term as the chair of the ECB's Single Supervisory Board will run out at the end of this year, when he will be replaced by Claudia Buch, currently the Bundesbank's vice-president.

(Reporting By Francesco Canepa; Editing by Susan Fenton)