Cryptocurrencies have grown into a huge industry, worth trillions of dollars. They have mostly slipped under the regulatory radar that squeezes heavy restrictions on traditional financial institutions. No one is more alarmed by this than financial experts and regulators. Combined with the recent devastating hacks and the potential for economic destabilization, their concern has reached new heights. The rapid growth of cryptocurrencies, fueled in part by substantial campaign contributions from crypto executives, presents novel challenges that demand innovative regulatory approaches to safeguard the financial system.
Over the last year, cryptocurrencies have become a phenomenon. They have now reached a value equal to roughly one-third of all American mortgage debt and all bank deposits combined. All of this growth has happened without the same degree of regulatory oversight that has been applied to traditional financial institutions. The millions in campaign contributions poured into lawmakers’ coffers from crypto executives help make this double standard possible. This enables the industry to largely act in the dark.
The lack of strong federal regulation has resulted in a wave of catastrophic hacks of cryptocurrency networks. Public reports indicate that crypto-related theft has shot up exponentially in recent years. In reality, it’s closer to being six times the amount of all money taken in bank robberies over the last twenty years combined. This sobering figure from 2022 highlights the growing risk of the crypto space and the immediate demand for strong security to protect assets and data.
The potential risks extend beyond individual investors. The value of crypto-derivative instruments on Wall Street is measured in hundreds of billions of dollars. The moment confidence begins to crumble, this high-flying valuation would be put to grave question. That would set off a nasty domino effect. Lines of credit that finance these purchases may disappear, and this may shake the entire financial system to its core.
Stablecoins, cryptocurrencies that aim to keep their value pegged to a fiat currency or other asset, have been a source of concern as well. Their greater and greater integration into the U.S. economy’s financial bloodstream creates a risk of wide-scale destabilization. The Federal Reserve Board has been sounding the alarm on these risks just like the Financial Stability Oversight Council has. To mitigate these possible harms, they call for vigilant oversight and regulation.
Just like Ethereum moving to proof-of-stake, this change has made a blog post by the New York Fed about transparency quite timely. This last point, notably, requires more scrutiny toward decentralized finance (DeFi) networks. This lack of transparency hinders our ability to understand the consequences and make informed risk assessment and mitigation decisions of these rapidly emerging technologies.
One of them is economist Robert J. Shiller’s research on “narrative economics,” which sheds light on why cryptocurrencies rose so quickly, but could be exceedingly volatile. While market narratives can certainly move asset prices, narratives can shift just as fast creating violent market corrections.
The great financial panic of 2008 should be a lesson to all of us on how easily and quickly market confidence can be shaken. Thomas P. Vartanian first mentioned this in 200 Years of American Financial Panics. Once confidence erodes, markets can quickly stampede against a narrative, leading to acute systemic financial contagion.
In 2022, FTX – then the second-largest cryptocurrency exchange in the world – collapsed in spectacular fashion. This episode underscores just how operational deficiencies due to mismanagement and lack of accountability can prove dangerous. The unexpected fallout from these events revealed the considerable need for improved governance and risk management practices within the crypto industry.
Various regulatory bodies, including the Working Group on Digital Assets, the Treasury Department, and the Securities and Exchange Commission, are actively engaged in discussions about cryptocurrency regulation. We’re working to develop a clear, useful framework that meets the different challenges posed by digital assets. Simultaneously, we want to encourage innovation in this quickly moving space.
