How to stop crypto from crashing the financial system


Once upon a time, the cryptocurrency realm was a curious side show, a place where criminals did business and devotees had fun at their peril. Not anymore. It is rapidly evolving into a veritable Westworld of finance, where mock investment funds, banks and derivatives allow visitors to take immense risks – risks that could ultimately spill over into traditional markets and the world. economy in the broad sense.

Regulators are struggling to get it all under control. It is increasingly important that they succeed, and soon.

It’s still unclear whether crypto will turn out to be a good thing overall. As money, it has so far failed: Bitcoin’s volatility, transaction costs, and carbon footprint, for example, have made it largely useless for purposes other than speculation and ransomware (and even there it has flaws). That said, the underlying blockchain technology – which allows people from anywhere to transact and create indelible records without relying on a trusted intermediary – may still have uses beyond sale of “official” copies of video clips and commemoration of the fire of valuable works of art. In due course, this could help sovereign states improve their official currencies.

Lately, however, the crypto dwellers have replicated the work of traditional financial institutions, without any regulatory safeguards designed to control them. Left unattended, this is not likely to end well.

Coin 1 is stablecoins, representations of fiat currencies that work on the blockchain. They mimic bank deposits by claiming to be worth, say, exactly one US dollar per coin. But unlike banks, the organizations that run them have no deposit insurance, no recourse to emergency loans from the Federal Reserve, and no limits on where to invest the fiat currency reserves that back them up. Tether, the company behind one of the most popular stablecoins, has previously been caught lending its dollar reserves to its affiliate crypto exchange, and still claims to hold potentially volatile assets such as precious metals and others. digital tokens.

History has repeatedly shown how dangerous such a bare combination of deposit-like liabilities and risky investments can be. Even rumors of losses can trigger a buyout rush before the money is gone, with systemic consequences. Suppose, for example, that stablecoins become big buyers of commercial paper, a short-term debt that companies issue for such purposes as purchasing supplies and paying employees. (Tether says he already holds tens of billions of dollars of such paper.) A sudden wave of buyouts could starve the market for cash, rendering companies unable to make payroll – similar to what happened in 2008, when the Lehman Brothers bankruptcy triggered a run on money market funds that devastated the commercial paper market (a vulnerability that itself has yet to be fully addressed).

Exhibit 2 is the burgeoning world of decentralized finance, or DeFi. Working on the Ethereum blockchain, using “smart contracts” capable of automating transactions, often amorphous teams of developers have set in motion a host of applications. These include exchanges, banking-like platforms, and derivatives brokers where people can lend, borrow, and place high leverage bets. Many services have decentralized governance systems that leave decision making to an ever-changing community of users. Scams abound. Hackers frequently find ways to drain funds, as happened with the original stand-alone blockchain organization, the DAO. Think of it as a full-service parallel banking service with no one in charge.

So far, the sums at stake are relatively small – the equivalent of tens of billions of dollars, compared to the hundreds of trillions that roam global capital markets. But that could change quickly, with far-reaching repercussions, especially given the extent of leverage involved.

Imagine a group of hedge funds making a big bet on cryptocurrency. In DeFi, an algorithm would typically determine how much of their own money, or “margin,” they would have to commit to get a given amount of exposure. That could be 20 percent, enough to cover a $ 20 billion loss on a $ 100 billion investment. In the highly volatile field of cryptography, however, setting the margins is a tricky task. One mistake, hack, or abrupt market move could lead to a recalculation of the algorithm, suddenly forcing hedge funds to deliver billions more by selling assets in other markets – precisely the kind of contagion that tends to trigger larger collapses. And that’s just one of many possible scenarios.

What should a regulator do?

A promising solution for stablecoins: to force them to deposit their reserves only in traditional banks, which in turn would park the money at the Federal Reserve. This would make them equivalent to federally insured deposits, leaving them to compete on the quality of the payment services they provide, instead of profiting from unduly risky investments.

Properly regulated, stablecoins could have beneficial uses, such as making it easier and cheaper for migrant workers to send money to their families back home. The payment “rails” they help develop could even one day serve as an infrastructure for digital money issued directly by sovereign central banks.

DeFi will be more complicated. One of the challenges will be defining what a platform actually does: is it like a bank, an exchange, a stock broker, anything else? Another will be to determine who to hold accountable in a decentralized organization: developers, users? Multiple agencies will need to cooperate and new legislation will likely be needed to empower them.

The overarching goal should be to ensure that similar services compete on the merits, rather than on the degree of regulation they face or their tolerance for crime. In cases where this is not possible, some may need to be banned.

To their credit, global regulators are aware of the issues and are starting to engage. They have thought deeply about the options for dealing with stable coins. They met with DeFi participants to better understand the risks. They formulated concrete proposals to ensure the security of traditional banks. But they must act quickly. It could become very important and very dangerous, very quickly.

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Don F. Davis

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