Why unregulated cryptocurrencies could trigger another GFC

Cross-posted from The Conversation:

The price of bitcoin hit $17,000 late last year and – although the cryptocurrency has plunged since then – there are signs that an absence of regulation can hurt investors and trigger the next financial crisis.

Despite the laudable blockchain technology and the great opportunities it offers in enabling quicker transactions, numerous problems can be associated with its products – such as bitcoin and other cryptocurrencies – if regulation is delayed. As I have previously argued, global measures for the use of digital currency should swiftly come into force.

However, it’s worth considering how the market for cryptocurrencies has grown outside of any concrete regulatory framework leading to a number of potential risks.

Money

For a cryptocurrency to function as money it needs to fulfil three requirements.

First, it should act as a medium of exchange whereby people can use it to buy and sell. This is the most promising feature of the blockchain technology as it facilitates peer to peer transactions across various industries.

Second, it must be a store of value. However, due to the bitcoin’s price volatility, it doesn’t meet this requirement. According to a report from Goldman Sachs, bitcoin was six times more volatile than gold in 2017.

Third, it should be a unit of account – in other words, used to represent the real value or cost of an item. Again, due to its volatility, only a few businesses are currently prepared to accept bitcoin before they know details of the fiat currency equivalent.

Importantly, cryptocurrencies would not need to be classed as money for them to be able to trigger a financial crisis. They simply need to be treated or traded as financial securities and/or commodities, and for enough systemically important financial institutions to hold and trade them when a downturn occurs – as was the case in the 2008 financial crisis.

Financial security

Bitcoin and other cryptocurrencies operate in many ways like a financial security such as a stock or commodity. Here, they have been used mostly by blockchain startups as a means to fund projects or business ideas by issuing digital “tokens” to subscribers who pay using mechanisms including prominent cryptocurrencies – such as bitcoin or ether – or through fiat currency in order to acquire proprietary interests in the business or project.

Some firms have used this as a mechanism to raise finance to start businesses. These startups would have found it almost impossible to raise finance through the traditional initial public offering (IPO) method, due to regulatory requirements that they probably wouldn’t have been able to fulfil.

Under an IPO, companies need to be listed on a domestic stock exchange and, to do so, are required to fulfil prospectus requirements including disclosure of their accounts. This method is designed to protect retail investors and preserve market integrity.

By bypassing any requirement to access financing from the public through exchanges or intermediaries, it becomes cheaper, quicker and easier for new companies to raise funds to finance their business. Blockchain startups have raised over US$1.5 billion in funding through ICOs (initial coin offerings) since the start of 2017.

However, ICOs do not receive the same regulatory scrutiny as IPOs. Instead, a firm seeking financing via an ICO is expected to circulate a white paper setting out the basic objectives of the business, the cost of setting it up and how this would be done. And that’s it.

But because the business is a blockchain company and the issuing is done on that digital ledger of transactions, the identity of those subscribing to tokens are hidden. The true identity of the issuing company may also be disguised regardless of statements in the white paper – which poses a potential threat to subscribers.

As the true identities of parties are largely unknown and as regulation within this space is sparse, firms seeking funding in this way currently aren’t obliged to know their subscribers under, for example, anti-money laundering (AML) requirements. Which makes these platforms easy targets for miscreants.

Commodity

Bitcoin has no intrinsic value and the surge in its price in December 2017 was largely driven by speculation. This is also associated with the argument that it is a bubble – which is when an asset trades at a price that strongly exceeds the intrinsic value. Very little needs to happen before that bubble might burst, such as the introduction of more regulation or another hack of a major cryptocurrency exchange.

But if the bubble bursts, could it trigger a financial crisis on the same scale as that of 2008? It would depend on whether or not cryptocurrencies and their derivatives can pose a systemic risk to the financial system. And it is a possibility.

In 2007, the fall in the value of mortgage-backed securities in the US and their ensuing derivatives held by financial institutions resulted in a credit crunch among banks which precipitated the financial crisis a year later.

Back to the future

The interest among financial institutions in bitcoin derivatives contracts highlights worrying reminders of the not-too-distant past.

This scenario can be dismissed on the basis that – at the moment – cryptocurrencies do not pose such a risk because they aren’t mainstream. But it is clear that an increasing number of systemically important financial institutions engage in trading cryptocurrencies such as bitcoin. Once cryptocurrencies become more mainstream the tables could turn very quickly and exposure to digital currency could pose a systemic risk.

It’s worth remembering that part of the rationale for the inception of digital currency included dissatisfaction with banks and other financial institutions. And it’s no surprise that bitcoin was developed within a year of the credit crunch. While the introduction of cryptocurrencies has arguably been a “panacea” for the prevention of a financial crisis on the scale of 2008, it may yet lead to the next financial crisis if regulation is delayed.

Article by Iwa Salami, Senior Lecturer in Financial Law and Regulation, University of East London

Comments

  1. this article is superficial nonsense

    It can’t trigger a financial crisis, unless banks have been writing loans using bitcoin as collateral

    Me trading $100, $1000 or $1,000,000,000 for a shiny token doesnt change the amount of money in circulation: someone else just holds the money now
    So how could there be a crisis?

    How can you be a senior lecturer and not understand this?

    The only question that remains is: have they been writing loans using bitcoin as collateral?

    EDIT: i see now Ms Salami is probably a beneficiary of discriminatory hiring policies, and can therefore be expected to be somewhat deficient

    • I remember when derivatives actually made the financial system more stable, and there was no way a few defaulting sub-prime borrowers could bring down the whole system.

    • “The only question that remains is: have they been writing loans using bitcoin as collateral?”

      Yes. Exactly.

      • “the fall in the value of mortgage-backed securities in the US and their ensuing derivatives held by financial institutions resulted in a credit crunch among banks which precipitated the financial crisis a year later.”

        You see the key words here?

        “mortgage-backed”
        “credit crunch”

        if no credit is being created to purchase cryptos, there can be no credit crunch as the valuations are irrelevant to the overall financial system

      • Did I say any of that?
        You’re trying to compare apples to oranges, mate.

        I don’t know about you, but seems to me like there’d be more than a few ripples come out of the crash of a $700 billion dollar industry.

      • the $700 billion dollars just goes somewhere else, wherever the people who sold out of crypto at the right time want it to go

        There is no contraction in the money supply, there is no insolvency of deposit taking institutions

        that’s what a financial crisis is

        unless banks are engaged in the trade themselves, or are creating loans with crypto as the collateral…

      • Brenton – I’m not sure whether or not the ripples would amount to much.

        On one side, $700B is not much when you consider it is dispersed globally. Some people would lose heavily, while the winners would be those who sold out at the peak. But overall the financial system would have the same amount of money in it pre-crash and post-crash. Just different people would hold it. Nor is crypto an industry that employs a lot of people. (It does consume a lot of electricity, so there may be some effects there).

        On the other hand, the blow to sentiment might well be material. And sentiment moves markets. I tend to think that $700B is not enough to really cause problems (again, particularly noting losses will be dispersed globally) but I could be wrong on that – sentiment is not always predictable or rational!

      • Comming…

        The credit issuance was not the driver to the GFC, it was the massive control fraud and incentives enabled over decades like a boiled frog thinking the waters fine. Even then the whole imbroglio would have been a minor event like the S&L debacle save the aggressive shorts. This is the bit that drives some around the twist because of their mis-comprehension about how markets work aka in a vacuum. The shorts drove a liquidity moment, not the crappy credit issuance, tho the issuance did give punters a huge opportunity to make ludicrous sums based on a psychological trade. Furthermore we know that some actually front run the whole thing with product designed to blow up.

        In addition MBS is just – one – aspect of portfolio theory wrt credit issuance and cash flows, which IMO work on paper, tho when humans are incentivized to break all the rules to make a life time of money on a short term view, welllie what is actually the agency driving things….

        disheveled… come on comming… neoliberal ideology drove events… not credit…

      • Guys … Coming has a point: the weakness in the financial system stems from the collateral underpinning loans. Once confidence in the collateral wanes, the institutions providing funding to those exposed to the deteriorating situation shut the credit spigot off.

        The Bear Stearns hedge funds and Lehman Bros were funding substantial on (and off) balance sheet positions in subprime mortgages in the wholesale funding market i.e. overnight repo, 7-day, 14-day, 30-day etc. Once confidence in the subprime collateral evaporated, the funding to these guys was shut off — and just like that they were insolvent. It has to do with duration mis-matches in lending which is standard banking practice and one of the main reasons banks are able to generate such large profits (but also means they remain inherently risky — only Central Banks stand between them and insolvency).

        Bitcoin’s volatility means that collateralized loans against it would attract massive haircuts — probably more than 50%. The danger, if any, is that posed by positioning in the futures market and the exposure of CME members to the risk being run on that exchange.

        In general, I would ignore the opinions of academics when it comes to the subject the financial market mechanics. They rarely display a decent grasp of the subject.

    • OK Macro, so you write “In 2007, the fall in the value of mortgage-backed securities in the US and their ensuing derivatives held by financial institutions resulted in a credit crunch among banks which precipitated the financial crisis a year later.” This was for example becuase of CDS and CDO’s that were often dodgy, but banks were regulated how did it happen? now we talk about regulating the crypto market. They had a regulated market, it was called the banking industry with government oversight, but regulation didn’t work as we saw in 2008 because there are so many vested interests. The movie The Big Short is such a good reminder of why crypto is a good idea. At least with a decentralized currency no one big entity can control.

      • MFGlobal, Storm Financial ad infinitum. Plenty of establishment regulation, but No accountability anywhere! Hardly a banker or politician in jail anywhere in the world.

        “No one big entity can control……..” But the global Mafia’s not just going to let the new kids invent a different game without their “wise inputs”. One that invalidates, or doesn’t pay tribute, or diverts from Their well refined funneling, ticket clipping trough.

        They will ruthlessly Trojan horse, false flag, morph it until it’s ‘their own’, whatever it takes to get whatever they want out of it that turns a buck for them & keeps power centralised & away from the peasants! They’re used to making the rules – they’re not adverse to using violence to enforce them if necessary – Their angle’s predictable throughout history……..

    • It can’t trigger a financial crisis, unless banks have been writing loans using bitcoin as collateral

      But what if a lot of punters have taken loans to buy crytpos, and they all go south? Lots of defaults?

      • are you saying took out loans using their houses as collateral?

        then its really housing credit that will eventually cause the crisis

        Can’t really blame crypto in that case

      • R2M – I agree, if one bank has loaned an absolute fortune to a heap of punters without collateral so they could buy BTC and BTC crashes, that bank could go under… and if it’s a systemically important bank, maybe bad stuff happens… but is there actually much unsecured debt fuelling bitcoin purchases? Would any important lender take a risk like that?

    • It can’t trigger a financial crisis, unless banks have been writing loans using bitcoin as collateral

      Obviously, this is the only way leverage can be introduced into crypto trading. There’s no chance in hell that a plethora of dickheads across the world have taken out personal loans, drawn down various lines of credit or maxed out visa or mastercards in order to double their money in a day…

      Also – http://www.saltlending.com, for those who wish to monetise their new found crypto wealth without having to sell…

      • Wow – that SALT is something else. Well, good luck to them – the risk is on them – they are holding the crypto as collateral and it could all become worthless… but would the world actually notice if SALT Lending went bust?

        Likewise, the presumed numpties who maxed out their credit cards to buy BTC and then saw it crash will be no different from someone else who can’t pay their credit card debt – I guess they get to try to pay it off, otherwise the debt gets sold to someone more … persuasive… and the numpty gets a visit from the nice repo man or a bikie. I don’t think it will trigger a GFC though.

      • cant really blame crypto if thats the case, can you?

        lol just checked out saltlending.

        Now THIS is the investigation that Ms Salami should have been doing
        Yes, its going to cause a crisis – book it

      • you want to see something even more horrifying, check out sweetbridge.com

        Lend yourself money.

        From assets you own.

        Interest-free.

        Without another party.

        A user can buy $2,000 worth of Sweetcoin, then transfer $10,000 worth of Bitcoin into their Asset Vault. Then the user can borrow $5,000, issued in Bridgecoin, and exchange the Bridgecoin for US Dollars without fees. The user continues to benefit from the appreciation of Sweetcoin and Bitcoin while using the borrowed $5,000 for other needs or wants.

      • Fark. Scary. So Salt is just a platform – they match crypto holders with lenders. The question is – do the people with actual (fiat) cash who have deposited it with those lenders know where it’s going?

        I presume the lenders are into it because the interest rates will be stupidly high and they’ll only lend you a percentage (say 50%?) of the “value” of your crypto holdings… but still sounds dizzyingly risky to me.

        As for sweetcoin / bridgecoin / howconvenientcoin /wtfcoin – my head just exploded. I can’t even. This is why I’m not a billionaire with a blockchain startup.

    • Coming,

      An article full of bulldust about crypto currencies that is also highly misleading about the broken, dysfunction and dishonest monetary system we are currently using?

      Knock me down with a feather.

      I dont mind people having whinges about cryptos as I am public money controlled by the public supporter but choice is very important. A public money monopoly by the public will only remain healthy if people have choice. Run a bad public money system and people move to other options.

      Its that choice thing that seems to upset so many.

      Or more to the point the choices made by ‘other’ people.

      Surely the enthusiasm for alternatives is telling us something?. People are fed up with our “sold out to greedy corporatist private bankers” public monetary system.

      But nope the Stalinist mind-set wants to crush it like an east European uprising.

      Here is something for those with an open mind on the subject of the future of money.

      https://www.gdi.ch/en/Think-Tank/Conferences/Our-Money-Our-Banks-Our-Country/244810_244813_2018020520180205/1

      The way that so many so called ‘progressives’ rush to defend the monetary status quo is really something.

      With private banker franchisees hijacking the current model there is not much to like but still they cling on like Klingons on the starboard bow.

      • Run a bad public money system and people move to other options.

        Yes, like precious metals. TPTB know this and control PM prices via paper metals finagling.

        Unfortunately, cryptos are even more vulnerable, as we are starting to see.

      • oo7…

        Your argument fails because most of the credit is issued outside the traditional banking sector, even more dire is the fact that labour has not seen a weighted increase in PPP in any aggregate for decades to to inflation hysterics.

      • No Skippy you fail because you don’t

        1. Understand the significance of banking system credit

        2. The difference between banking system credit and every other form of credit.

        3. That GFC was a consequence of those with a license in respect of banking system credit extending that credit to parties – including relates off balance vehicles – playing with other forms of credit. As a consequences fails in the markets for non banking system credit spread to the banking system.

        It is pretty simple but you don’t get it.

        Why?

        Because you are trying to conceal the role and protect the interests of your private banking buddies.

        All you and Sweeper do is try to conceal and obsfucate the role of private banks.

        You deny they are of any significance but insist they must retain their role.

        Hopelessly compromised supporters of the status quo.

  2. DarkMatterMEMBER

    “Third, it should be a unit of account – in other words, used to represent the real value or cost of an item.”

    A large part of the problems we have today are that we no longer know what the real value of anything is. Assuming assets – like houses – increase in value without changing, what measure do you use to find their real value?

    CryptoCurrencies, welcome to the confused club of things that think they are money.

  3. bolstroodMEMBER

    “However, it’s worth considering how the market for cryptocurrencies has grown outside of any concrete regulatory framework leading to a number of potential risks.”
    Isn’t this the Neo-Liberal ethos writ large?
    This is what Neolibs have worked to achieve for decades , low or no regulatory impediments.
    Now they start to worry?

  4. This article is absolutely brilliant in it’s foresight.

    Views differing from this above correct assessment fail to see the trigger mechanism for calamity; that is:
    1) The absence of loans and collateral is not a sufficient condition for a GFC-style prevention;
    2) The crux of GFC-related catastrophes is to be found in confidence and reliability;
    3) Note that the derivative system associated with crypto’s is the pertinent issue here, as crypto’s increasingly become more mainstream [ = we will later have crypto option/futures contracts ]
    4) Once believability in the derivative crypto-exchange-mechanism is destroyed, because of hacking/fraud/theft/corporate corruption/third-party failures to honour contractual derivative crypto-agreements, the crypto-system + related derivatives will go into meltdown at the crypto-exchanges, confidence in the particular medium and the investment/financial system is tarnished and collateral damage to related organisations [ who may have taken business operating loans ] may cause a financial collapse;
    5) This is essentially what happened in the months leading up to the GFC with the derivative-based property-backed mortgage securities ;
    6) So, yes, associated regulation thus needs to protect accordingly, especially as it relates to crypto derivative contracts, as is present with all the derivative exchanges in the world.

    • It’s only the last bit of step 4 that I’m not sure I’d agree with. If people lose confidence in the crypto exchanges and cryptos more broadly, it shouldn’t mean people lose confidence in the financial system more broadly. Most people in the crypto market know they are taking a punt on an unregulated and volatile product – they just don’t care because they potential profits are so huge.

      I don’t think a crypto collapse will cause people to lose faith in banks, other loans, etc. Even more so since crypto markets itself as a sort of libertarian product completely different to those corrupt evil bankster bank types. (But I accept I could be wrong – see my comments on sentiment above).

    • you’ve described a crypto crisis

      how does it affect the broader financial system?
      if anything, it strengthens it

      • Yes, I’ve described a financial derivative-induced crisis [ this is actually what the author is concerned about in the absence of regulation ], precipitated by crypto-related failures. The fact that the other recognised exchanges are regulated must tell you that it is needed also in the case of cryptos.

        Failure of third parties was the underlying derivative-based problems in the GFC – this is a risk to the financial system, as such = many take loans to play/(operate their businesses in) the markets – these loans are backed by other assets; failure to settle transactions then results in the asset-backing being called in, you then have a domino-effect of forced sales/lower asset prices/etc.

        So, it affects the confidence in the financial system.

      • If a bunch of people cannot honor their bank loan obligations due to losses playing bitcoin bingo then the banks might experience a higher level of bad debts.

        Trust we will soon starting regulating stupid transactions generally on the basis they might cause bad debts and in doing so the amount of Banker Pseudo Fiat greasing the economy.

        Or we could just removing the privileges of Banker Pseudo Fiat and solve the problem once and for all.

      • oo7….

        Once again banks operate in the environment afforded them, histrionics bare this out, as well, as other industry’s, hence the problem has deeper roots than your umbrage at banks or any another credit issuer.

      • Skippy,

        “….hence the problem has deeper roots….”

        Yawn don’t you ever get bored of rolling out that excuse for doing nothing.

        According to your ‘theory’ those deeper roots are shadowy, wealthy and well connected forces that marshalled all their powers to brain wash the world.

        What a miserable depressing defeatist self perpetuating perspective.

        You spend all your time arguing against ANY reform mostly because you claim the “deeper roots” need to be dealt with first.

        But you claim they cannot be defeated anyway.

        Deep roots can be dealt with a few copper nails and a few litres of round up.

        There are a bunch of people getting married this year that did not accept your “nothing ever changes” gloom.

        Change happens when people stopping running telling everyone it is impossible.

      • Non sequitur.

        disheveled… there is actually a history that even with questions about specific agendas or advocacy transcends high order bias.

      • Skippy

        “…there is actually a history that even with questions about specific agendas or advocacy transcends high order bias….”

        Translation – do nothing because hey history and banks are just banks.

        Perfectly natural and unable to shape the regulatory environment in which they operate.

        Banks as inanimate objects.

        The only inanimate private corporates on the planet.

        Cute.

      • err… I hate to side with Skip here but yeah, he’s really not deviating from very old theories on money & power. Can’t postulate one without considering the other, that’s what the crypto-hodlers/white-power nutjobs do…. They haven’t realized the power was ceded and lost many, many generations ago. See – the porn industry or recording industry (post 1970’s).

      • Dystopeon,

        Those very old theories are precisely that.

        If they had any substance we would not even be having this discussion.

        The status quo always appears rock solid right up until the point it isnt.

      • oo7….

        Do nothing – ????? – is a fine example of your rhetorical slight of hand. I have pointed out numerous examples of what could be done wrt credit issuance as well as social programs.

        That it does not focus on your divinity informed money crankery seems to be your dilemma and not mine.

      • Skippy,

        Yep ..do nothing.

        What exactly is it that you think will address the problems arising from the role of private banks while preserving a role for them.

        Keep in mind that every bit of regulation if it is effective will reduce the power of private banks with regard to power over public money.

        So you clearly have in mind some goldilocks amount of power.

        Well spell it out and explain how you will keep it at the goldilocks point considering foxes in hen houses have a predictable track record.

        You claim the banks can be regulated and made safe.

        Persuade us…. the onus is on you.

      • oo7…

        You keep making statements that have no foundations, its as if you think just saying stuff makes it so.

        “We agree that relying on Congress to raise/lower taxes to fine-tune the economy will not succeed. We agree with Janet Yellen that stronger automatic stabilizers are needed to enhance cyclical stability, taking pressure off lawmakers (and the Fed) to be responsive to changing conditions in the economy. Having said that, we would note that our tax system is likely already too biased to pull in more revenue when the economy booms, as evidenced by the expansion-killing surplus during the Clinton years.

        We would add, as Jamie Galbraith rightly argues, that overheating, while possible, hasn’t happened in at least two generations. As Jamie says, “There hasn’t been inflation in the economy since the early 1980s. It collapsed with the end of the Soviet Union and with the rise of China as a supplier for consumer goods. So the Fed has been patting itself on the back for decades [of] holding back a phenomenon that doesn’t exist. [The Fed is like] the little Dutch boy with the finger in the dike who never troubles himself to look over the levy to see that the lake is dry.” In other words, it’s been a couple of generations since the US economy experienced any significant inflation. Since then, inflation has become a highly global phenomenon.

        We also note that neither mainstream academic economists nor the Fed itself have a robust theory of inflation. By contrast, the academic economists who created MMT have a long history of studying inflation and formulating policy to fight it should overheating ever become a problem. See, for example, Papdimitriou and Wray 1992, Bill Mitchell, and the new MMT textbook by Mitchell, Wray, and Watts.

        In any case, relying on the Fed is the worst possible way to try to fight “overheating.” As the Bank of England has explained, central banks do not control the money supply nor do they have the tools to forcibly choke off an expansion of bank credit in order to fight inflation. The plain fact is that the Fed cannot “take money out of the economy”—as Jared presumes—like some kind of pickpocket rifling through our jeans in the dark of night. It relies on the overnight interbank lending rate (fed funds rate) as a policy instrument. It can take excess reserves out of banks (or put them into banks—e.g. via Quantitative Easing), but this does not work like a brake pedal or a gas pedal on bank lending—which is how money gets into the economy. No central banker today believes she can “take money out of the economy” as Jared puts it.

        While we will not go into it in detail here, we recommend a public option—called the Job Guarantee—in the job market at a base wage to anchor the currency, helping to stabilize its domestic value against inflationary/deflationary pressure as well as stabilizing its exchange value against other currencies. MMT has devoted thousands of pages of research and over a quarter of century to analyzing and reporting of the results. Indeed, we have completed a major study using conventional modeling techniques that shows that a universal job guarantee program would provide true full employment while actually moderating inflation.” – snip

        http://neweconomicperspectives.org/2018/01/answers-from-the-mmters.html

        disheveled…. conversely you want to play money crank games…..

      • Wow skip, I’m not sure how renaming the Dole a “Job Guarantee” is going to make much of a difference to anything, but have at it lol.
        And no economics theory will ever be “robust” as it is impossible to conduct repeatable accurate experiments to determine their validity.

  5. “If a bunch of people cannot honor their bank loan obligations due to losses playing bitcoin bingo then the banks might experience a higher level of bad debts.”

    There’s the nub of it. I’d say it all depends upon how far and broad and deep this stuff is allowed to go without appropriate regulation. Small Ponzi schemes are relatively insignificant overall when they come crashing down. Much larger ones can trigger financial crises that spills over into the broader economy.

    There aren’t really any “zero-sum games” in a world where everybody is indebted to the eyeballs and everything is driven by credit. Does it make any difference to the bank whether I can’t service my debt or repay at all because I have lost my job or if I can’t repay because I lost everything in a speculative game?

    • Again…. self regulation pared with decades of stagnate wages in the face of increases in productivity et al w/ a side of revolving door and defunding any government enforcement or oversight…

      disheveled…. free market own goal…