There is an irony in the rise of bitcoins and other cryptocurrencies. Although they were supposed to usher in a new paradigm of finance, removing the need to trust centralized institutions, it is through such institutions that people can make transactions on them. And hardly a week goes by without news that a financial intermediary, be it well-known or not, is delving into a largely unregulated space in an effort to capitalize on speculative fervor.
Of course, there is nothing wrong with an entrepreneurial drive to give people what they want, even if it will somehow throw away their savings. However, some remedies are urgently needed to protect the inexperienced and the economy as a whole from the consequences.
Crypto was meant to make governments and banks obsolete. In their place, software protocols will issue money in the form of digital tokens, and a voluntary network of computers will maintain a public registry that allows people to transact directly using cryptographic keys to demonstrate ownership. However, this brave new world has its challenges. Security is an ongoing concern, as illustrated by the $ 600 million PolyNetwork protocol hack this week. If you send tokens to the wrong address, or if your keys are lost or stolen, you have no support service. Sharp price fluctuations also make cryptocurrencies like Bitcoin largely useless to save or buy, except for illegal ones. The computing power needed to support the blockchain, in addition to accelerating climate change, also makes transactions slow and expensive, especially for small amounts.
Surprisingly, none of these shortcomings dampened enthusiasm for cryptocurrency. On the contrary, they provided opportunities for financial intermediaries. For traders, digital tokens are the main speculative vehicle - "assets" created out of thin air, not tied to any cash flows or commodities. For institutional investors like funds and pension funds, they are a way to potentially make a goose profit. For exchanges, banks and many other organizations, simply helping people buy and sell can lead to excessive commissions and attract new customers. For traditionally conservative custodians specializing in cryptocurrency storage, difficulties with cryptocurrency storage open up a new line of business.
There are plenty of examples, from beginners to established firms. Director Spike Lee, for instance, is touting ATM machines that, for a substantial fee, they will turn "systematically repressive" dollars into "positive, inclusive" Bitcoin. Payment services such as PayPal and Cash App also became providers for retail customers, receiving commissions from both sides of the trade. Fidelity is also one of several firms seeking regulatory approval for a publicly traded fund that will allow retail investors to trade bitcoin as stock. As for others such as JPMorgan, Morgan Stanley and Goldman Sachs, they are reportedly offering or planning to offer cryptocurrency investments to wealthy clients, since a recent poll said more than half of institutional investors admitted that they own digital assets. Bank of New York Mellon and State Street are also expanding into the market, alongside smaller crypto specialists.
Such services can be less cumbersome and costly than using blockchain, not to mention can reduce risks for people who choose to speculate in cryptocurrencies. But they overlap with the regulatory world, as neither the Securities and Exchange Commission nor the Commodity Futures Trading Commission have the authority to control cryptocurrency. As a result, dealing with an institutionalized cryptocurrency often requires much more trust than the traditional financial services that cryptocurrency had to supplant.
But if approved by the SEC, crypto trading will be as easy and cheap as investing in stocks. However, in order to access coins and determine the prices of their shares, people must rely on specialized crypto exchanges like Coinbase and Kraken, which are not within the purview of the SEC. This means that the platforms do not face security and reliability requirements, conflicts of interest and many others that securities transactions must comply with. Little else but a reputation prevents them from manipulating prices or otherwise exploiting customers.
PayPal is another example. When its customers buy bitcoins, they do not receive any tokens. Instead, their balance reflects their stake in a PayPal account on a cryptocurrency exchange operated by a limited-purpose trust company called Paxos. The NYS Department of Financial Services has registered Paxos and sets some regulatory standards, but it is unclear what these are, let alone how effective they will be. It also did not require the company to publicly disclose its assets or even capital, liquidity, and other special requirements that it must meet.
Similar services may soon be available at other public banks. White-label trading will allow people to buy, sell and store cryptocurrency through mobile apps or bank websites across the country, helping the latter stifle the flow of customer funds to services such as Coinbase. Behind the scenes, clients will actually be doing business with another small group of specialized trust companies established by the NYDFS, which will not be eligible for federally-backed deposit insurance and will not be controlled by any federal banking regulator. Such companies are also behind many of the crypto investment tools offered to the wealthy.
The more money flows into this gray area, the higher the systemic risks. For example, an attempted exodus from bitcoin has overwhelmed cryptocurrency exchanges, making trading impossible. Investment funds may have to sell other assets in order to pay off - a dynamic that could destabilize markets, especially when leverage is involved. Another example is if Paxos encounters a problem on the cryptocurrency balance at PayPal. The rush to withdraw money can harm such payment services, which, by the way, do not have banking regulation or direct FDIC insurance. Since banks offer similar trading services, they can be harmed more broadly in the event of a disruption.
Current and former regulators, including SEC Chairman Gary Gensler, are well aware of the dangers in this market. Ideally, the Congress will provide the SEC or CFTC with clear authority over cryptocurrencies, as well as the resources needed to implement them. This would allow them to make demands on exchanges and custodians commensurate with the risks.
If Congress is inactive, regulators can still make progress. As noted by Gensler, the SEC could expand its powers by designating digital tokens as securities where needed. It can also use its authority to approve ETFs, but only if they interact with regulated exchanges like the SEC. This will put pressure on the respective exchanges.
Banking supervisors also have a role to play. First, they may require that any stocks of volatile cryptocurrencies be fully funded with loss-absorbing capital, as suggested by the Bank for International Settlements. In addition, to eliminate the risks associated with white label services, they can issue a warning: if suppliers do not comply with certain standards of security, reliability and information disclosure, assets will be treated as if they were on the balance sheets of banks, with all the attendant needs for capital. Banking supervisors may also take a closer look at PayPal and Cash App, which increasingly offer banking services but are not regulated accordingly.
Despite all the irrational abundance they inspire, digital assets and blockchains still have valuable applications, not to mention they can help transform finance in the desired way. But if people want to realize this potential without causing unnecessary damage, some new regulation is needed.
