The author 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 world. Cryptocurrencies emerged in the depths of the Great Financial Crisis of 2008 as a response to the failures of the traditional financial system, with overvaluations of shadow banks, debt chains, and maturity mismatches. The original white paper on Bitcoin, published the same year, sold a vision in which money was reinvented as a stand-alone peer-to-peer transfer system without the need for intermediaries. But agitation today bears all the hallmarks of failure that the early advocates of industry denounced. With the collapse of the company and the drop in the price of the coin, the unraveling of this new series of wildly overvalued cryptocurrencies is now in full swing.
As we examine waste and chart a course of policy responses to rein in this sector, we need to keep a few key facts in mind. Cryptocurrencies operate under the banner of decentralization, but they are highly centralized in two important ways.
First, many seemingly decentralized protocols are actually very centralized in terms of who directs and controls things. The founders and a few venture capital lenders are often to blame, as evidenced by the crash of the stablecoin Terra in May. In most cases, encryption is decentralized in name only.
Secondly, centralized brokers such as FTX Sam Bankman-Fried play a vital role as a gateway to the cryptocurrency world to the mainstream financial system. They direct the influx of new investors, and it is the oxygen that keeps the speculative dynamism alive. BIS research in this area has shed light on how cryptocurrencies truly work only when they do. To the extent that recruiting new investors is critical to the survival of cryptocurrencies, centralized brokers are key to sustaining development.
The current fall of FTX and other falling dominoes in the industry has caused a lot of soul-searching among cryptocurrency promoters. Oddly enough, we hear calls for the industry to "go back to its roots" and be reborn in a cleaner form. His vision is to go back to a time when cryptocurrencies were the sole property of a small group of enthusiasts and not something that was traded as a traditional financial product. From this perspective, it would be more of a niche pastime among a few followers than entering our living rooms via TV commercials in a bid to attract retail investors.
This pure form of cryptocurrency, which envisions getting rid of centralized middlemen, would have very little effect. But cryptocurrencies would not have reached their current size without these entities pouring money into the industry. Instead of contradicting each other, centralized brokers and cryptocurrencies feed off of each other. For this reason, any policy interventions now made to mitigate the impact of cryptocurrencies must take into account this interdependence, as well as the role of stablecoins as a gateway to the mainstream financial system.
Some say “let cryptocurrency burn,” but the idea that it will disappear on its own may be wishful thinking. As financial conditions change, even the minuscule sector owned by hardliners can still support the entry of new centralized brokers.
Any intervention would have to address a major challenge: If politics allowed cryptocurrencies to intertwine with traditional financial systems, they would introduce something hitherto avoided. In particular, if stablecoins are moved to regulatory frontiers, their role as entry points into other crypto ecosystems must be addressed. Policies should prevent them from becoming the "cuckoo in the nest." The new standard issued by the Basel Committee on Banking Supervision for the activities of the cryptocurrency banking sector is an important step in the right direction.
In general, the regulatory approach needs to distinguish between the core economic functions of cryptocurrencies and what appears on the surface. Even during the worst excesses of the mortgage boom, chains of leverage eventually led to real-world activity, obviously buying homes with cash. On the other hand, cryptocurrencies are mostly self-referential; Their activities include trading other types of cryptocurrencies and they have little reference to actual economic activity.
Ultimately, any public policy response must begin with a realistic assessment of the economic value derived from blockchain technology. Blockchain revenue is very low considering the initial hype. One after another, projects exploring profit potential came up empty handed.
A more promising approach is with central bank digital currencies operating within a larger digital cash system. It is an approach based on the inherent trust in central bank money and that it may serve the public interest in the future monetary system. The advantages of the technology are used for real economic activities and not just for other types of cryptocurrency. The economic benefits of decentralization should also be explored more actively. We now look at what happens when an industry relies solely on articles of faith.