Throughout financial history, many speculative manias have been characterized by a repeated mix of basic ingredients: from the enthusiasm of uninformed investors motivated by “disruptive” innovations, the inevitable illusion of easy profits to the infallible reference to the “paradigm shift” that will supposedly sustain the momentum over time, often conveniently seasoned with abundant global liquidity.
All manias end in the same way, with a sharp correction that collapses prices like a house of cards as the classic narrative of Kindleberger (1978) and the more recent one of Reinhart and Rogoff (2009) pointed out. In a nutshell, it’s another case of greed negating fear until it is too late for anything but panic.
The recent saga of the crypto ecosystem reproduces these elements, enhanced by a techno-anarcho-libertarian “stick-it-to-the-man” attitude against the established two-tiered monetary and financial system. The search for the benefits of anonymity—mainly against taxes and, occasionally, the law—and for complete decentralization in transactions—trying to get rid of noncompetitive fees of the financial industry and the seignorage of “exploitative” central banks—tended to generate many elements of financial fragility, and, occasionally, outright fraud.
Triggered by the Fed´s monetary tightening and over a few weeks, the crypto debacle comprised a succession of dramatic events, including:
- the implosion of the flimsy Terra/Luna ecosystem;
- the confidence crisis on the star stablecoin Theter that briefly lost its peg to the dollar;
- the run against the crypto shadow bank Celsius that “dropped the gate” (suspended convertibility) on its depositors;
- the problems in crypto lending apps like Solend, which altered its decentralized finance (DeFi) logic to avoid a crash; and, last but not least,
- the jitters in several exchanges that announced losses and layoffs.
All that against the backdrop of a sell-off that printed, at the time of this writing, a vertiginous correction of roughly 66 percent from its November 2021 $3-trillion peak, after growing explosively in the bubbling pandemic years, courtesy of the oversized monetary and fiscal impulses in core economies. The collapse surprised both mom-and-pop savers and large professional investors alike, and prompted an open letter to Congress, signed by more than 1,500 technologists, urging the body to “take a critical, skeptical approach toward industry claims that crypto-assets … are an innovative technology that is unreservedly good.”
So how good (or bad) are crypto assets for healthy financial development?
Crypto ’revolution’: What do we talk about?
Since the introduction of bitcoin at the beginning of 2009, the number of cryptocurrencies has soared to some 15,000, although in many cases they are mere replicas with very low trading volumes in search of unwary investors (the top 20 crypto assets account for 90 percent of market capitalization). Alongside this proliferation—and inefficient inherent fragmentation opposed to the needs of a sound payment system—unregulated activities such as loans and leverage, and new varieties (stablecoins) have emerged to address some of the most ostensible weaknesses of the first crypto assets.
While they currently represent less than 1 percent of the global financial market, and their interconnections with it are still—luckily—quite limited, the recent trend of explosive growth, if undeterred, could pose potential risks to financial stability, just as the tiny subprime market did in 2008. And this is true not just in emerging economies where the lack of monetary credibility and limited financial access can foster currency substitution and credit disintermediation or “cryptoization”—the digital version of “dollarization.” In advanced economies, competition from the large technological platforms in the provision of digital means of payment could limit national monetary autonomy, lead to concentrated market structures as a result of network economies, and add to financial fragility as the append-only, irreversible nature of blockchain transactions makes the unwinding of system errors—essential to any payment system—almost impossible.
More than a decade after its launch, bitcoin has so far failed in its original objective of establishing itself as a suitable substitute that fully fulfills the functions of money. Paradoxically, bitcoin´s original call to replace central banks—which ensure price stability by elastically matching money demand—with a decentralized scheme based on a rigid supply of a unique cryptocurrency that replicates the “barbarous relic” logic of the gold standard and its deflationary bias may end up in hyperinflation due to the uncontrolled spread of competing cryptocurrencies.
Lacking intrinsic economic value, crypto prices are inherently volatile, as they are tied exclusively to the fluctuations of their demand—the opposite of what one would expect of a good unit of account. Moreover, because of their decentralized nature, their application cannot be escalated without inefficiently high fees, congestion problems, or security risks (the so called Buterin’s Trilemma). Finally, if massively adopted, they could generate an environmental disaster due to the energy-intensive “proof-of-work” of most crypto systems. Unsurprisingly, then, cryptos have so far failed to play a significant role as a reliable means of payment—with the exception of informal, illegal, or criminal transactions—leaving them as a vehicle for die-hard speculators, herd investors, and institutional asset managers belatedly lured by their alleged diversification advantages, if not just by FOMO-inducing hype.
Cryptozoo: Beyond bitcoin
A priori, stablecoins are in a different class altogether, their main purpose being precisely to overcome the intractable volatility of conventional cryptocurrencies. Stablecoins come in two types. Type 1, “algorithmic,” is based on smart contracts that defend the peg by buying or selling it against other crypto assets in a scheme worryingly reminiscent of a Ponzi game, as the Terra-Luna fiasco vividly illustrated. Type 2, “custodial,” follows the principle of a traditional currency board (like Hong Kong´s long-standing exchange rate arrangement): The supply -of coins- is fully matched by a stock of liquid investment-grade assets denominated in the peg currency, so that holders can readily exchange them one to one on demand. In principle, only the custodial type might earn the “stable” moniker, but how stable are stablecoins in reality?
Two conditions are needed for the scheme to work. The first one is fairly obvious: There are no substitutes for actual reserve assets, the backing should be real and easily verifiable. In practice this has not always been the case: For example, doubts about the backing of Tether last year led to the company´s belated revelation that, indeed, less than half of the stock was actually backed by high quality and liquid assets (HQLA) like U.S. Treasurys, with the rest comprised of assets that could rapidly lose value under financial stress.
The second condition is more subtle and technical: Stablecoin deposits cannot be on-lent. If they are, part of these loans would go into new deposits, which could also be on-lent, multiplying the stock of crypto-denominated assets in excess of the original, fully backed supply of stablecoins, and exposing the whole scheme to a run that exceeds the stock of reserves (as in the collapse of Argentina´s currency board in 2001).
Now, if a “stable” stablecoin cannot be on-lent—a condition that we have elsewhere called the “stablecoin paradox”—and merely represents a digital avatar of a stock of liquid reserves denominated in the peg currency—and leaving aside the less than virtuous role of facilitating illegal activities: What explains their popularity and their relatively large turnover? Stablecoins are mainly used as a vehicle currency to support a wide range of endogamic DeFi products and services, posting collateral for other crypto operations or as insurance against hackers, lost keys, smart contract failures, and other cyber mishaps, without much contact with the real economy.
Add to that the absurd valuations, the endogamic trading prone to contagion and domino effects, the need of protection of small investors unfamiliar with the risks of opaque assets, the information gaps and the unclear legal status of crypto assets, and the lack of a liquidity backstop, and one starts to see why central banks around the globe have started to take the crypto revolution as a challenge to financial stability. While this has led some observers to argue that stablecoins should be banned altogether, central banks have so far adopted a more nuanced two-way response, requiring that they be properly regulated—and throwing their own central bank digital currency (CBDC) into the mix.
CBDCs: What´s the point?
Unlike cryptocurrencies, a CBDC is a digital token that represents a legal claim on the central bank—in other words, “digital cash.” As of this writing, out of the growing number of central banks exploring the feasibility of their own CBDC, 28 have already launched pilots (including one in China with roughly 260 million users), and at least three retail CBDC projects (in the Bahamas, Nigeria, and the Eastern Caribbean) are already in place.
Is this a new crypto-related fad, or the future of digital payments?
For starters, there is an issue that never ceases to be relevant to emerging economies: financial inclusion at reasonable costs. Private payment service providers (PSPs) such as PayPal, like banks and credit cards, tend to be concentrated and to charge high fees—which in less developed economies tends to favor cash transactions and informality—with several wholesale CBDCs focused on reducing cross-border transaction costs—most notably, of remittances. Moreover, in line with their inclusion mandate, retail CBDCs could allow for instant and final payments on a 24/7 basis at a negligible or zero charge for retail users, including those deemed unprofitable by private providers.
One could argue that many of those features are already covered by existing or forthcoming fast retail payment systems (FPRS). Based on a public data architecture and on the interoperability of different payment platforms, FPRS already allow for greater competition between banks and PSPs offering transactional accounts, while avoiding the pitfalls of monopolistic fees. Since their first launch in Korea in 2001, more than 60 jurisdictions have introduced FPRS, and many others are planning to do so. In Brazil, for example, after only 18 months of implementation, more than 70% of adults have used Pix, with 50 million first digital payment users. India´s successful Unified Payments Interface exhibits a comparable success, and Mexico´s Codi and Argentina´s Transferencias 3.0 are also making progress.
This notwithstanding, the continued research on CBDCs reflects additional concerns. In a context of ongoing digital innovation, many central banks fear a continuous decline in the demand for cash that risk losing the grip on monetary autonomy. On the upside (and more speculatively), a remunerated CBDC could potentially enlarge the monetary policy space, giving central banks new instruments to elude deflationary traps (a topical concern not so long ago).
The CBDC versus crypto debate is only starting and no doubt exceeds its more technical, monetary aspects. The crypto zeitgeist, like the hacker ethics of the ‘60s or the free software movements of the ‘80s, is often imbued with a cultural narrative that permeates lifestyles and ideologies—from tattooed billionaires to kamikaze politicians.
But ultimately it remains a financial issue that highlights the risks of mistaking technological ingenuity for monetary wisdom, jumping into the future without giving the future enough time to introduce itself.