If there was one principle uniting the diffuse challenges facing G20 finance ministers at this weekend’s meetings, from inflation to climate change, it was that prevention would have made all of them much easier — and cheaper — to deal with. The same applies to one of the most prominent issues of financial regulation: setting global rules for managing cryptocurrencies. Perhaps this was why the finance ministers wisely accepted the conclusions of a report by the Financial Stability Board into the sector.
No major changes in regulation were announced. But agreement to accelerate monitoring and to find regulatory gaps that need filling, are welcome first steps in the journey to ensure speculation in crypto remains an individual, rather than a socialised, risk.
Policymakers used to assume that crypto, while problematic for a number of reasons — including its potential to defraud ordinary investors and launder criminals’ ill-gotten gains — would not threaten the health of the financial system. This assumption may not be safe for much longer as cryptocurrencies and related assets become more mainstream. Problems in markets for cryptocurrency may increasingly “leak” into the broader financial system — imperilling the stability of banks, other lenders and so the wider economy. Cleaning up after such a crisis will be more expensive than preventing it from happening in the first place.
A survey published in June 2021 found that hedge funds expected to expand their holdings of so-called cryptoassets substantially. Instruments linked to cryptocurrency, such as derivatives, are likely to proliferate: many traders use options to bet on bitcoin’s value. Fidelity, one of the world’s biggest asset managers, launched a bitcoin exchange traded fund last week. Crypto’s move out of the shadows increases the risk that a sharp drop in price could shake confidence in major players, especially those that have funded their exposure through borrowing.
The nightmare scenario would be a crypto version of the 2008 financial crisis. On that occasion, uncertainty over which institutions were exposed to a collapse in novel financial securities was enough to cause financial markets to freeze up. For the moment though, there is no comparative “shadow banking” system that backs lending to the real economy with cryptoassets. Few would consider bitcoin a “safe asset”, unlike the mortgage-backed securities that were at the centre of the 2008 crisis.
If anything is to fulfil this role it is likely to be stablecoins, which account for a significant majority of all trading in cryptocurrency. These tokens are meant to be fully convertible to ordinary currencies, usually the US dollar. This grants them, with their apparent safety and stability, many of the same properties of bank deposits — which are similarly meant to be convertible to state-backed money on request. A big enough shock to crypto markets may lead to investors seeking to “cash in” their stablecoins, behaving like depositors in a bank run. This would force stablecoin providers to sell their assets in order to get investors their money. If this resulted in a fire sale, other markets could similarly be destabilised.
These risks are small for now. Crypto does not yet have the scale to make them more acute. But global finance moves fast. That is why the G20 is right to get on the front foot. In a world awash with money, allowing investors to seek out the speculative gains associated with crypto must remain a second order priority to financial stability.