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This crypto winter is warm compared to the next one

The Hill logo The Hill 7/1/2022 Thomas P. Vartanian and Stephen P. Harbeck, Opinion Contributors
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How in the world did we let cryptocurrencies become a $10 trillion industry before examining the systemic risks being created? Crypto coins, derivative securities, exchanges and the leverage created to support them now equal nearly half the asset size of the entire U.S. banking industry.

So, we really have caught a big break by having a crypto winter now before this unregulated industry grew even larger and subsumed other financial markets. 

What should we have learned from this? As Bill Gates correctly notes, everyone is beginning to appreciate that the current version of cryptocurrencies to some extent relies on the greater fool theory. Purchasers expect the price to rise solely because they will be followed by additional purchasers with the same expectations. No such investment scheme has ever succeeded, so the chances that crypto in its current form would just run away from the field and spike the football were never realistic. Larry David’s ironic Super Bowl commercials predicting that crypto would not work out were more prophetic than the sponsors anticipated. 

Our “good” fortune has been the result of five financial developments. They include (1) an increasing skepticism in floating rate cryptocurrencies as prices have plummeted; (2) the collapse of several do-it-yourself stablecoin regimes; (3) an increasing appreciation for the risks inherent in unregulated, decentralized financial technology (Defi) where there are no safety nets; (4) concerns about the sanctity of customer assets held by crypto exchanges; and (5) the general erosion of the economy now marked by 8.6 percent inflation, supply chain disruptions and the effects of the war in Ukraine.

Those who had been mesmerized by all things crypto have thankfully now been shocked into economic rationality. It has taken 13 years to seriously evaluate the impact of the collapse of a crypto coin or exchange, but here we are. Crypto purchasers were forewarned and may have assumed the risk that the price of a floating rate cryptocurrency might collapse with no underlying intrinsic value to support it or set a floor. When small investors use chat rooms and social influencers as their primary source of financial advice, and invest money they cannot afford to lose, one need not be a prophet to predict tragic results. Remember: This is a universe of investors that bought Jesus Coin.

Stablecoins were created by a wide variety of tech personalities often unfamiliar with financial systems or regulation. They were intended to stabilize the value of cryptocurrencies by “backing” them like money market mutual funds with marketable assets such as U.S. Treasury notes. Algorithmic stablecoins claimed to be able to operationally maintain their $1 stable value without such assets in reserve. But not surprisingly, this has all proven to be an illusion analogous to a street corner shell game or three card monte. 

Video: Cryptoverse: after crypto winter, a thaw? (Reuters)

We only now seem to be finding out that in a largely unregulated stablecoin world, “backed” didn’t always mean that the holders had a right to get their funds in a meltdown. So even if a particular unregulated stablecoin had reserves of marketable assets to cover 100 percent of the coins issued, those assets might be available to all creditors in a bankruptcy. Moreover, most crypto exchange customers likely didn’t understand that, as Coinbase recently explained, crypto instruments are not always held as securities are at a stock brokerage and could be subject to the claims of general creditors. 

Even in the best of cases, holders would likely have to deal with endless litigation that would delay any payout as legal processes ground forward over many years.

For example, the Securities Investor Protection Act does not contemplate cryptocurrency, suggesting that determining the entitlement to crypto assets in a stock brokerage bankruptcy will include fights between and among cryptocurrency customers and all potential other creditors. What would happen if only 10 percent of the Bitcoins that were supposedly held by a brokerage for customers are actually present? Can a bankruptcy trustee reverse crypto transactions as preferences or fraudulent transfers? 

As decentralized finance grows, for better or worse, many innovators have adopted a philosophy that “’tis better to ask forgiveness than permission.” People with uncanny skills at technological innovation often fail to anticipate unintended consequences in the real world of finance. Think “Ready, fire, aim.”  

The hissing sound you hear is air leaving the crypto bubble. Banking, securities and commodities regulators must install an organized oversight structure to this emerging financial market before the bubble expands further and really bursts.  

The crypto world mesmerized legislators and regulators into a decade of inaction as it grew exponentially. But there is still time for them to come to their senses, modernize financial regulation and regulate cryptocurrencies like the money and securities they purport to be.

Perhaps then, crypto can proceed toward a more lasting future. With the economy simultaneously being buffeted by the aftermath of the COVID-19 pandemic, inflation and global conflict, crypto investors should for now prepare for a difficult winter. But it will not be nearly as harsh as the next one if the crypto orgy continues without smarter investors and better oversight.

Thomas P. Vartanian was the general counsel of the FSLIC and is executive director of the Financial Technology & Cybersecurity Center and author of “200 Years of American Financial Panics: Crashes, Recessions, Depressions and the Technology that Will Change it All.” Stephen P. Harbeck served as president and CEO of the Securities Investor Protection Corporation from 2003 to 2018. They handled the failure, liquidation and protection of consumers in the collapse of hundreds of banks, S&Ls and securities brokerage firms.

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