Crypto’s $10 trillion runaway train potentially threatens the financial system

As Congress considers legislation on crypto stablecoins, the Securities and Exchange Commission on April 4 freed certain stablecoins from the burden of registering as securities if, among other things, they are fully backed by high-quality liquid assets such as Treasurys.  

If you have been following along over the last 16 years, you know that cryptocurrencies have been able to avoid most of the arduous rules that a broad constellation of financial firms must follow. I include stablecoins in the same bucket for these purposes with unbacked floating rate cryptocurrencies because stablecoins are unsupervised, and they have provided ample reasons in the past to doubt the high-quality backing that they are supposed to maintain.  

With numerous crypto scandals having unfolded, it isn’t that the debate about regulating them hasn’t occurred — it just hasn’t produced anything workable. This is largely because, apart from the impact of millions in campaign contributions made by crypto executives, policymakers act as if they are locked into the system we have rather than the one we need.  

I have argued that we should stop wasting valuable time trying to shoehorn cryptocurrencies into obsolete regulatory categories developed in the 1930s and debating whether they should be regulated by the Securities and Exchange Commission or Commodity Futures Trading Commission. Crypto raises novel 21st century issues that require completely new levels and forms of regulation. 

In February, I suggested several factors be considered by the president’s recently established Working Group on Digital Assets to ensure that assets such as cryptocurrencies do not create a significant threat to global financial stability. Among them was the uniqueness of doubling as money and an investment, and the ugly reality that cryptocurrencies have evolved into the payment median of choice to transact unparalleled levels of global crime.  

But now, let’s turn to what will happen in the likely event that the novel risks created by cryptocurrencies are not fully addressed.  

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 New York Fed blog post 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 of crypto companies filing to become banks, it makes sense to regulate them with an obsolete system of oversight rather than allow them to be an unregulated segment that can impact the country’s financial stability.

In early 2022, both the Federal Reserve Board and the Financial Stability Oversight Council began issuing reports warning that the continuing insinuation of cryptocurrencies, and particularly stablecoins, into the bloodstream of on U.S. economy could result in wide-scale destabilization. The frequency of devastating hacks of cryptocurrency networks (more crypto has likely been stolen in the last few years than the money taken in bank robberies over the last two decades) and the likelihood of operational failures due to abysmal management (see FTX) further add to a volatile mixture of risks.   

Selling into a crypto panic is the only way that a holder can realize any value when confidence erodes. As that happens on the ground, the value of hundreds of billions of dollars of crypto-derivative instruments on Wall Street may be called into question, and the lines of credit supporting their purchase may disappear. Without government or central bank backing or a consumer protection backstop like federal deposit insurance, it would be difficult to stop the cascading effect of such a run.  

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.”