Opinion: The $10 Trillion Cryptocurrency Boom Poses a Threat to Financial Stability

As Congress views laws regarding cryptocurrency stablecoins on April 4, the Securities and Exchange Commission freed specific stablecoins would be exempted from the requirement to register as securities provided that, amongst other criteria, they are supported by high-quality liquid assets like Treasury bonds.

If you've been keeping track over the past sixteen years, you're aware that cryptocurrencies have generally managed to bypass many stringent regulations that apply to various types of financial institutions. I place stablecoins in this category alongside non-backed digital currencies since both lack supervision, which has allowed them to proliferate without much oversight. ample reasons In the past, doubting the high-quality support they are meant to uphold has been difficult for them.

Given the many cryptocurrency scandals that have taken place, the discussion around their regulation isn't new — it simply hasn't led to any effective solutions. This mostly stems from the fact that, aside from the effects of millions in campaign contributions Created by cryptocurrency leaders, policymakers seem trapped within the current framework instead of envisioning the necessary changes for what we require.

I have argued We ought to cease squandering precious time attempting to force cryptocurrencies into outdated regulatory frameworks from the 1930s and arguing over whether they fall under the jurisdiction of the Securities and Exchange Commission or the Commodity Futures Trading Commission. Cryptocurrencies present unprecedented challenges for the 21st century that demand entirely fresh approaches and types of regulations.

In February , I suggested several factors be considered by the president’s recently established Working Group on Digital Assets To make sure that assets like cryptocurrencies do not pose a major risk to worldwide financial stability. One key aspect was their dual role as both currency and investment, alongside the harsh truth that these digital currencies have become the preferred method for carrying out unprecedented amounts of international criminal activities.

However, let us now consider what might occur should the potential hazards introduced by cryptocurrencies fail to be adequately tackled.

Maintaining financial stability relies on recognizing where confidence and fear intersect and the roles that certainty, transparency and verifiable values play. The great financial panic of 2008 was a perfect example: Markets eventually rejected the subprime mortgage narrative when confidence in the obscure alchemy of securitization eroded, leaving investors to rely on borrowers that couldn’t pay their mortgages and foreclosures on homes whose values were sinking rapidly.

Cryptocurrencies are even more problematic. Crypto speculation is the epitome of uncertainty fueled by the theory of the greater fool. It is impossible to disclose much about a financial product that isn’t there and has no liquidation value at all.

A recent Blog entry from the New York Federal Reserve Bank underscores the paucity of transparency in the proof of stake Ethereum blockchain, suggesting that such decentralized finance or “DeFi” networks “could potentially influence the broader financial system, affecting even those who have never directly interacted with crypto or DeFi.” This makes the margin for avoiding a crypto crisis of confidence razor-thin, and suggests that any such event would become a race to the bottom.

Economist Robert J. Shiller captures this phenomenon in his 2020 book about “narrative economics” in which he distinguishes economies driven by a narrative from those driven by economics. This explains mysteries such as how tulip bulbs became the most valuable commodities in Holland in the 17th century, trading for as much as six times the average annual salary until the whole house of cards completely collapsed years later.  Cryptocurrency values are similarly driven by narrative.

Under these circumstances, it is remarkable that crypto has been permitted to hurtle toward becoming a $10 trillion industry without significant oversight. When it gets that large, it will be roughly equal to 80 percent of the mortgage debt Americans have accumulated and 56 percent of the total deposits in U.S. banks. As we know, those businesses are highly regulated. So as reports circulate Given that cryptocurrency firms are seeking to operate as banks, it would be prudent to subject them to modern regulatory standards instead of leaving them uncontrolled, which could potentially jeopardize the nation’s economic steadiness.

In early 2022, both the Federal Reserve Board and the Financial Stability Oversight Council started producing reports cautioning that the ongoing integration of cryptocurrencies, especially stablecoins, into the U.S. economic system might lead to widespread instability. These warnings have become more frequent following destructive events. hacks of cryptocurrency networks More cryptocurrency has probably been taken. over the past several years rather than the funds seized through bank heists in the past twenty years ), and the probability of operational failures caused by poor management (see FTX ) further contributing to a precarious blend of hazards.

Selling during a cryptocurrency downturn is the sole method for investors to secure some worth once trust diminishes. If this occurs extensively, it could cast doubt on the trillions of dollars' worth of crypto derivatives traded on major financial markets, potentially leading to the withdrawal of credit facilities used to buy them. In the absence of support from governmental bodies, central banks, or safeguards akin to federal deposit insurance, preventing a domino effect triggered by such an exodus becomes exceedingly challenging.

But crypto seems to have backed into a solution simply by growing and becoming a significant part of traditional financial systems. As such, it can piggyback on the bailout that governments and central banks will inevitably provide when traditional financial services markets are threatened by a crypto meltdown.

To that extent, the Treasury and the Federal Reserve are already backstopping the crypto industry. They just don’t regulate it or get paid a penny for the insurance inferred. It is not the first time that a financial industry has enjoyed that luxury. And for those who can take advantage of it, it is a great deal. For crypto, it might be its greatest accomplishment yet.

Thomas P. Vartanian, a former senior banking regulator and practicing attorney, is the executive director of the Financial Technology and Cybersecurity Center. He is the author of “ The Unhackable Internet ” and “ 200 Years of American Financial Panics .”

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