Headline: Cryptocurrency has to interact with Traditional Finance
Body:
Imagine that you were a marijuana grower, certified legal within the State, but you could only sell your products in exchange for cash. The tricky part is that you tried to find a bank that would setup an account for your legal enterprise, but due to the stigma against marijuana nobody will accept your deposits. The outfall is that you have a very serious safe with an ever-growing amount of cash piling up in it. Cryptocurrency firms are currently facing a version of this. In recent years, Silvergate and Signature, especially, had become integral parts of the digital asset ecosystem by offering both traditional banking services as well as speedy payments networks. Now that both banks have gone bankrupt, there is some question of how crypto firms are supposed to be banked within the framework of Traditional Finance.
It’s a Conspiracy, I Tells ‘Ya.
Yeah, some people do believe that it is a conspiracy of traditional financial institutions to hold on to power. “It’s hard to look at this and not see a coordinated effort to choke off the industry,” said Ryan Selkis, CEO of crypto research firm Messari. Others seem to believe that the problems faced by these institutions were mainly due to poor risk management practices (Such as loaning a crypto firm money and taking as collateral, the tokens they themselves created. One State regulator was quite pithy. “When you lose depositor confidence,” Williams said, “not even the strongest bank can stand up.”
“I think if it hadn’t been for FTX and the extreme nervousness about crypto, that this wouldn’t have happened — even to [Silicon Valley Bank] or to us,” said the Massachusetts Democrat who was a key architect of new rules enacted in the aftermath of the 2008 crisis. “And that wasn’t something that could have been anticipated by regulators.” Now that 20% of Americans own cryptocurrency, this nexus with traditional finance has to be figured out. In 2008, the financial crisis spiraled out of control due to unchecked risk-taking by financial institutions that were highly interconnected with each other. Innovative derivatives that were largely unregulated, complex and opaque connected one financial institution to another. Underlying assets that were not high quality represented resulted in hidden exposures and vulnerabilities. This generally outlines both the hopes of and potential dangers of cryptocurrency, and it greatly overlaps with other assets.
Digital assets have recently shown to have financial stability risks with similar themes as in 2008. In May, there was the collapse of TerraUSD, an algorithmic stablecoin, and related crypto-asset Luna which was critical to Terra’s peg. TerraUSD, the then-third largest stablecoin with an $18 billion market capitalization, broke the buck, triggering redemptions across the Terra ecosystem. Those controlling a Luna-related foundation may have liquidated as much as $3.5 billion of Bitcoin, placing downward pressure on Bitcoin, affecting all with exposure. Tether, the largest dollar-based stablecoin, also broke the buck, reducing its total market capitalization by almost $9 billion. Given that these were supposed to be tied to the value of the dollar, this seems very important.
Novel Risks for Crypto Assets that Could Increase Financial Stability Risk
Novel technology brings novel risk. The anonymity that can be associated with crypto assets has led to the use of cryptocurrency for terrorist financing, money laundering, and dark-net illegal transactions. Fraudulent scams abound. Cyber hacks and thefts pose significant risk. Legitimate crypto-related exchanges and other companies well aware of this dark history say they want to be regulated. However, their business may be structured in a way that is different to what financial institutions are used to seeing, particularly if customer assets are not segregated, and there are unresolved conflicts of interest. Any financial institution interested in crypto should undertake substantial due diligence to determine vulnerabilities in the following areas, and even then, may find these novel risks difficult to assess. This difference can cause traditional banks to stay away from firms representing cryptocurrency and other sources of wealth. Beyond this different source of wealth, many people point to the disproportionate level of frauds related to cryptocurrency All of these considerations make it difficult to reconcile cryptocurrency with traditional finance.
The Verdict
The question must be asked out loud is , “Now that we know we have a fundamental problem, what is the solution?” There are a few things I might suggest.
- Banks need to display some level of courage.–> Cryptocurrency is to a bank what steroids can be to an athelete; In the short term, they can really help an athelete’s performance, but when used chronically, there can be big problems. In a career, each individual must decide what he or she is willing to risk for performance, and then take that stand. I argue that banks should be forced to take a similar line.
- There should be some way to weigh the risks of cryptocurrency projects.–> When selling off Mortgage Backed Securities, a bank might organize them into tranches of increasing probability of default. To compensate the buyer for this risk, the interest percentage must be much higher. In a similar manner if a client’s holding is above a certain percentage in cryptocurrency, the bank charges a higher level of interest.
Whatever the mechanism, traditional finance (banks) must develop a model to properly evaluate the true value of cryptocurrency firms. Or, if they so choose, they can take the stand that they do not risk their clients’ money in this way, and doubtless, they would receive some new, more traditional clientns,
REFERENCES
Case Study: Should We Embrace Crypto? (hbr.org)
Is Wall Street Killing Cryptocurrency? (investopedia.com)
Editor’s Note: Please note that the information contained herein is meant only for general education: This should not be construed as Tax Advice. Personal attributes could make a material difference in the advice given, so, before taking action, please consult your tax advisor or CPA.