Commentary on Political Economy

Friday, 18 November 2022

Let crypto burn 

Just say no to legitimacy-inferring regulation 


Stephen Cecchetti is the Rosen Family chair in international finance at Brandeis International Business School. Kim Schoenholtz is clinical professor emeritus at NYU’s Stern School of Business. 

 In the aftermath of the collapse of FTX, authorities should resist the urge to create a parallel legal and regulatory framework for the crypto industry. It is far better to do nothing, and just let crypto burn. Actively intervening would convey undeserved legitimacy upon a system that does little to support real economic activity. It also would provide an official seal of approval to a system that currently poses no threat to financial stability and would lead to calls for public bailouts when crypto inevitably erupts again. Finance is all about trust. The loss of trust from surging failures already is bringing about crypto’s demise. The market capitalisation of the myriad “coins” is down by about 75 per cent from its November 2021 peak. Crypto market capitalization ($tn), 1 Jan 2017 to 13 Nov 2022 © Source: Coinmetrics. Note that the levels here are somewhat lower than those from CoinMarketCap. It is hard to imagine trust in crypto recovering from the scale and scope of FTX’s failures. Until very recently, FTX was a leading exchange and was widely touted as a guiding light in an industry rife with charlatans. However, FTX intentionally chose to locate in a jurisdiction beyond the legal and regulatory purview of those nations with the largest financial systems. Moreover, reports now reveal that FTX lacked transparency, misused customer funds, engaged in related-party dealings, had weak corporate governance, and accepted phantom collateral, along with other unsafe practices. Put simply, the crypto system as it currently exists is unsustainable. Absent clear and easily enforceable property rights, relying solely on private investors to monitor and discipline the behaviour of opaque intermediaries has never been safe and effective. There is no prospect for a technological solution to these age-old problems. So, the big question is whether authorities ought to create a new regulatory and supervisory framework that protects property rights and enforces the principles of safety and soundness. Concerned about further losses from the collapse of crypto, many people are calling for new rules to protect consumers. Ironically, however, attempts to create a separate structure for regulating and supervising crypto will just make the financial system less, not more, safe. This is true for two reasons. First, it will encourage banks both to purchase crypto assets and to lend against them as collateral, making the banking system vulnerable to plunging market values. In contrast, even the ongoing collapse of crypto values and institutions has had virtually no impact on the wellbeing of the traditional financial markets and firms. Second, new rules would lead to a migration of financial activity from traditional finance to the still less regulated, but newly sanctioned, crypto world. Both crypto and traditional finance are simply combinations of a database and computer code. It would be straightforward for a group of technicians to convert any set of conditional cash flows from one into the other. For example, imagine someone choosing to issue claims on their firm as a crypto token rather than as conventional equity to take advantage of looser rules for disclosure, accounting, custody, and the like. If any new rules are needed, they are ones that limit exposure of traditional leveraged intermediaries to the crypto world. Banks, dealers, insurers, and pension funds should not be allowed to purchase and hold crypto or accept it as collateral. For the most part, crypto today is just a multiplayer online video game (like World of Warcraft). If virtually all the transactions remain internal to the crypto world without links to the real economy, the process might as well be occurring on Mars, leaving traditional finance unaffected. The overriding goal of policymakers should be to keep crypto systemically irrelevant. The best way to do this is let it implode under the pressure of its unsafe and unsound business practices. Meanwhile, authorities should constantly point to the record that crypto is rife with failures and fraud. Rather than creating a new legal and regulatory framework that legitimises crypto, we should simply let it burn.

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