Will digital currencies cause a financial cataclysm?

This article was originally published in Global Risk Regulator on 19 November 2021 and can be found here.

The phenomenal growth of the global digital currency market has made headlines throughout this year. No surprise, perhaps, given that its aggregate value has surged from $800bn to $2.3tn during that time. This raises the question as to whether or not they represent a serious systemic threat. 

By contrast, the combined value of all global crypto assets five years ago was a much more modest $16bn. Having reached such extraordinary heights in such a short space of time, the popularity of cryptocurrencies continues to surge, as the Biden administration in the US seems set to prepare the way for regulation. Beyond the protection of investors, US legislators are also keen to address the growing use of cryptocurrencies in fraud and money-laundering. Yet despite the political rhetoric, it will take considerable time before any crypto-specific legislation and practical guidelines is passed.

On this side of the Atlantic, Sir Jon Cunliffe, the deputy governor of the Bank of England, recently gave a speech entitled: ‘Is crypto a financial stability risk?’ In a doom-laden warning, he outlined “a plausible scenario” in which “a massive collapse in the price of unbacked crypto assets” could occur and that there are “justifiable and growing concerns around investor protection, law enforcement and market integrity” in relation to crypto. His downbeat assessment was also widely reported. 

He is not alone in casting doubt over crypto and its potential to lead to a financial collapse. On both sides of the Atlantic, regulators have been banging the same drum. Nikhil Rathi, CEO of the UK’s Financial Conduct Authority and Gary Gensler, chair of the US Securities and Exchange Commission, have made speeches echoing these sentiments. Both have argued that regulation of cryptocurrencies is a top priority, with the latter asserting that crypto trading platforms are more likely to succeed if they submit to regulation under existing tax compliance, money-laundering and insider trading laws. 

Contagion risk?

In his speech, Mr Cunliffe emphasised that the immediate risk of contagion from a crypto crash is low. But, he cautioned, that could change very rapidly if crypto continues to develop and expand in a largely unregulated space, and when it does, a collapse could quickly contaminate other related markets. “A large fall in crypto valuations could affect investor risk sentiment more broadly, causing investors to sell other assets that are judged to be risky and those perceived to have a similar investor base. Interconnectedness creates the possibility that shocks are transmitted through the financial system,” he explained.

Like cryptocurrencies themselves, warnings about their potential dangers are a global phenomenon. The potential risks for investors and the general public have been highlighted by politicians and regulatory watchdogs worldwide: they point to a dangerous regulatory void in the rapidly evolving crypto marketplace and argue for the necessity of a stable regulatory framework. Foremost among them is US Treasury Secretary Janet Yellen, who argues that there remain important questions about the legitimacy and stability of cryptocurrencies. She recently suggested that these questions “underscored the need to act quickly to ensure there is an appropriate US regulatory framework in place”.  

But the collective rush to create a regulatory regime for crypto assets needs to be tempered by practical realities: the process to implement it will be complex and difficult. To succeed at a practical level, it might be beneficial if crypto legislation could be drafted using a holistic approach, which might include its myriad areas of impact: data privacy, fraud, taxation, money-laundering and the environment, for example.

CBDCs complicate picture

If the crypto industry wants clarity, so do most investors: regulatory clarity that enables them to make decisions with certainty. But regulation is potentially further complicated by the potential for new central bank digital currencies (CBDCs): the European Central Bank and the Bank of England (BoE) are keen advocates of the idea. In November, the BoE announced that it will begin consulting on plans for launching a ‘Britcoin’ next year, adding that no such central digital currency will arrive before 2025.  

These regulations will need to take account of individual privacy – a critical feature of distributed ledger technology which underpins the cryptocurrency ecosystem. Equally, those tasked with drafting them must avoid making regulations too Draconian or non-practical since that might create potential pitfalls. Should they be too restrictive, the cryptocurrency market might disappear underground to avoid any regulatory scrutiny. They might even become an impediment to innovation – a critical factor as fintech evolves – deterring investors and diminishing future opportunities that might be provided by entrepreneurs and innovators.

To prevent this scenario from becoming reality, multiple participants in the digital currency value chain should be consulted by regulators. This would allow two things to happen: they would develop a thorough understanding of the technology that supports crypto assets and bespoke regulations could be crafted which go beyond the adaptation of current regulatory concepts. Any focus confined to the latter would be insufficient and possibly dangerous. 

Working with regulators

At the same time, crypto market participants must engage with regulators. In a recent interview with the Financial Times, Mr Gensler said that cryptocurrency trading platforms are threatening their own survival, unless they work within the US regulatory framework. These platforms must focus on advocacy, education, and active engagement with regulators. 

Such open dialogue will assist regulators in creating a framework that outlines the conditions for issuing or trading cryptocurrencies, protecting investors and preserving financial stability, while ensuring that digital currencies can play a sustained role in technological advancement and innovation.