The writer is an economic consultant and head of research at the Bank for International Settlements
There is a bitter irony in the turmoil currently gripping the cryptocurrency universe. Cryptocurrencies were born in the depths of the Great Financial Crisis of 2008 as a backlash against the failures of the conventional financial system, with its overleveraged shadow banks and daisy chain of leverage and maturity mismatch. Bitcoin’s original white paper released that same year sold a vision in which money was reshaped as a self-sustaining peer-to-peer transfer system without the need for intermediaries. However, today’s upheaval bears all the hallmarks of the very failures the industry’s early proponents railed against. As businesses slump and coin prices plummet, the unraveling of this new daisy chain of overleveraged shadow cryptocurrencies is now in full swing.
As we examine the wreckage and chart a course for policy response to curb the sector, we need to keep a few key facts in mind. Cryptocurrencies operate under the banner of decentralization, but are highly centralized in two crucial respects.
First, many seemingly decentralized protocols turn out to be highly concentrated in terms of who actually governs and controls things. Often the founder and a small number of VC lenders are responsible, as evidenced by the implosion of stablecoin Terra in May. In most cases, cryptography is decentralized in name only.
Secondly, centralized intermediaries, such as Sam Bankman-Fried’s FTX, play a vital role as a gateway to the world of cryptocurrencies from the conventional financial system. They channel the flow of new investors, which is the oxygen that keeps these speculative dynamics alive. BIS research in this area has highlighted how cryptocurrencies only really work when they do. To the extent that recruiting new investors is critical to the survival of cryptocurrencies, centralized intermediaries are key to sustaining the building.
The current collapse of FTX and other falling dominoes in the industry, has led to a lot of soul searching among cryptocurrency promoters. Predictably, we are hearing calls for the industry to “go back to its roots” and be reborn in a purer form. The vision is to go back in time to the days when cryptocurrencies were the preserve of a small group of enthusiasts rather than something marketed as a traditional financial product. In this view, it would be more like a niche hobby among a small minority of followers, rather than entering our living rooms through television advertising in an attempt to attract retail investors.
This pure form of cryptocurrency, which imagines getting rid of centralized intermediaries, would only have a very small footprint. But cryptocurrencies would not have grown to their current size without these entities funneling funds into the industry. Rather than opposing each other, centralized intermediaries and cryptocurrencies feed off each other. For this reason, any policy intervention now undertaken to mitigate the impact of cryptocurrencies will need to take into account this mutual dependency, as well as the role stablecoins play as a gateway from the conventional financial system.
Some say “let cryptocurrencies burn,” but the idea that it will disappear on its own might be wishful thinking. When financial conditions change, even a very small sector that is the preserve of purists could still provide the fuel for the new entry of centralized intermediaries.
Any intervention would have to overcome a key challenge: if politics allows cryptocurrencies to intertwine with the traditional financial system, it will introduce something that has hitherto been avoided. In particular, if stablecoins are brought into the regulatory perimeter, their role as an entry point to the rest of the crypto ecosystem will need to be addressed. Politics should prevent them from becoming the “cuckoo in the nest”. The new standards issued by the Basel Committee on Banking Supervision on cryptocurrency banking sector activities are a significant step in the right direction.
More broadly, the approach to regulation will need to distinguish the underlying economic function of cryptocurrencies from what it appears on the surface. Even during the worst excesses of the subprime mortgage boom, the chain of leverage eventually led to real-world activity, obviously buying a house with the money. Cryptocurrencies, on the other hand, are largely self-referential; its activities involve trading other types of cryptocurrencies and have little reference to tangible economic activity.
Ultimately, any public policy response must begin with a realistic assessment of the economic value that derives from blockchain technology. Blockchain’s returns have been remarkably poor considering the early hype. One after another, projects that explored its potential benefits came up empty handed.
A more promising approach is through central bank digital currencies that operate within the larger digital monetary system. This is an approach that builds on the faith inherent in central bank money and could serve the public interest in a future monetary system. The benefits of the technology go to real-world economic activities rather than just other types of cryptocurrencies. The economic benefits of decentralization should also be examined more effectively. We are now seeing what happens when an industry simply relies on an article of faith.