Can Crypto Result in Financial Instability?

Can crypto result in financial instability? The regulators and financial experts are wary about the potential of cryptocurrencies to the extent of believing that this digital asset class can result in financial instability and may lead to the next financial crisis.

The current rage of crypto speculation and the fact that Decentralized Finance or DeFi comes with growing dangers may affect businesses all over the world.

They think that people are focusing more on the positives of this interesting and innovative technology but less on its potential downsides.

This article deals with those particular aspects that may hinder the growth of the world economy.

Some of the major concerns of the financial experts and regulators are:

• Crypto is the most favored means for money launderers and other artists of financial scams
• It consumes insane amount of electricity to operate and
• It poses a significant risk to the current financial system.

Cryptocurrencies are kind of electronic assets that are protected by cryptography, but the technical details vary.

It is true that the threat to financial stability by crypto will increase as and when it finds extensive economic use.

It may either coexist with fiat money or displace it completely.

It is then that crypto will have a very strong and harmful effect on financial equality, stability, and social cohesion.

All these worries regarding crypto call for a proper and immediate regulation on crypto, experts say.

Can Cryptocurrency Result in Financial Instability?

There is no central authority to govern crypto or route the transactions via a centralized mechanism or third parties.

Instead, these are set up via a distributed ledger system where transactions and ownerships are processed, recorded, and protected by cryptographic calculations.

This is done through a blockchain, which is an encrypted ledger that is duplicated and distributed across the globe and is accessible by millions of computers.

The chain contains the immutable records of the transactions as well as the proof of coin ownership.

It is this innovative technology that helps the crypto assets to operate offers a whole new world of opportunities to earn active and passive income apart from allowing the users to make quick and easy payments.

The crypto ecosystem even offers inventive financial services and easy access to those people who live in those parts of the world that are considered to be ‘unbanked’ and do not have access to traditional financial services.

However, in spite of the opportunities and benefits offered by crypto, there are some significant risk factors of it that are worth considering.

The regulators all over the world are worried about these risks more than the merits of crypto.

The Global Financial Stability Report describes these risks of the crypto ecosystem.

It also suggests a few policy options that the regulators should consider that will help them to navigate the unexplored territory of crypto and find better ways to eliminate these risks.

Moreover, these coins are quite controversial.

For example, cryptocurrencies mainly serve as a speculative asset and the financial experts do not see much economic use of these digital assets outside that.

That is why they say that it can cause social and financial instability and inequality.

On the other hand, the crypto advocates consider it to be a better form and alternative to fiat money.

And the specific reasons they give to substantiate their claim are:

• It offers freedom while making a financial transaction
• It expedites a transaction and makes it hassle free
• It has several useful economic functions
• It offers extraordinary returns in different forms via different avenues and
• It acts as a hedge against inflation and unfavorable policies of the government.

However, the skeptics are concerned about the impact of crypto on the environment and its lower investor protection.

In spite of these controversies and worries, the total market value of all different types of crypto coins available in the market have crossed trillions of dollars, and it is increasing every year by multiple folds.

The entire crypto ecosystem is flourishing with different players taking part in it such as:

• The crypto exchanges
• The crypto traders and investors
• The crypto miners
• The stablecoin issuers and even
• The crypto wallets.

However, the risk here is that most of these entities do not have or follow robust governance and operational or risk practices.

For example, as a result of such lacunas the crypto exchanges face significant disruptions when there is a notable market movement.

In addition to that, there are also several incidents of hacking of the systems and theft of funds.

Though these incidents have not had a significant impact on the financial stability now, the importance and the potential implications of these will surely increase when crypto becomes more mainstream.

Then, as said earlier, there is the significant risk of consumer protection due to the insufficient oversight and limited disclosure.

Apart from that, the crypto coins pose significant risks by themselves with most of them having disappeared from the market for varying reasons.

For example, there are more than 16000 different types of coins listed in different crypto exchanges but you will not find more than 10000 in the market as of now.

This is primarily because most of the coins did not have significant trading volumes to sustain.

Moreover, in a number of cases, the developers of the projects have simply walked away.

And, there were many projects that were created simply for the purpose of speculation or even out-and-out fraud.

As you may know, crypto transactions are essentially anonymous in nature which is good for the users but bad for the regulators.

This is because this anonymity results in data gaps which make it literally impossible for the regulators to identify any unwanted and open doors for laundering money and even funding the terrorists.

However, there are a few sophisticated mechanisms that enable the authorities to track illicit transactions but these systems can hardly identify the parties to it.

This is primarily because the crypto ecosystem typically extends in different countries that have dissimilar regulatory frameworks.

This makes it very challenging to establish proper and seamless coordination.

Since most crypto transactions happen on exchanges and entities that mainly operate in and from offshore financial centers, it makes it all the more challenging and nearly impossible for proper enforcement and supervision with no international alliance.

And the stablecoins, that have their value pegged against the US dollar, are also pretty misleading especially when it comes to the composition of their reserves.

These coins can be vulnerable to runs.

These runs are usually driven by the concerns of the investors regarding the quality and quantity of the reserves.

They are also worried about the speed at which the reserves may be liquidated when it comes to meeting the potential redemptions.

All these will have a knock-on effect on the financial system.

Therefore, crypto, in all its forms and functionalities, can surely result in financial as well as social inequality and instability if it is allowed to function the way it is now.

Understanding the Problems in Itself

As said earlier, crypto in itself has a lot of issues that may affect the financial stability in different ways in the long run.

The first, and perhaps the most significant, issue is the electricity consumption which is mainly due to the Proof of Work or PoW system on which the crypto coins operate and are protected.

This PoW system involves making an ever-more difficult calculation while processing transactions and validating and adding new blocks to the blockchain.

Tampering with any block on the chain will need out-calculating the whole of the remaining community altogether.

This is quite a good concept but it consumes huge amounts of electricity to the tune of 130 terawatt-hours per year, if not more, depending on the type of the crypto coin.

This is much more than the total amount of electricity consumed by countries like Sweden, Romania, and others.

This results in enormous greenhouse gas emissions.

Then, crime is another obvious issue involving crypto transactions.

This is mainly due to the reason that crypto transactions are pseudonymous and are irreversible.

This makes the perfect recipe for criminal activities and financial frauds including and not limited to:

• Money laundering
• Avoiding taxes
• Ransom extortion
• Pump and dump scams
• Short and distorts
• Rug Pull
• Ponzi schemes and so on.

Apart from that, one of the biggest potential threats of crypto is the creation of a new financial structure that does not need the supervision or governance of any regulator.

This means that this so-called Decentralized Finance or DeFi lets users create financial contracts by using crypto outside the usual Wall Street structures.

This even includes traditional stuffs such as:

• Financial derivatives
• Insurance and
• Smart contracts.

However, DeFi has some notable similarities to the traditional banking system but with fewer regulations and protections.

Since every financial system is susceptible and can be subject to panic, the crypto market too can implode with prices skyrocketing or plummeting, thereby seizing the entire financial system which may even cause a government bailout.

If DeFi is allowed to grow as it is, more and more institutional investors and traditional banks will also get involved and rely on it completely.

But, in absence of government controls, it is only a matter of time before the system experiences some form of a DeFi quasi-bank run.

Add to that, the frenzied price gyrations that are so common in the crypto space, also poses a significant threat.

If there is a random crash in the value of the crypto coins, the retail and institutional investors will experience knock-on damage.

Moreover, the justification of DeFi however seems to be pretty vague.

It is true that it allows easy access loans, insurance, savings and trading crypto coins without requiring any intermediaries but ordinary banks serve these purposes quite well.

And, it also offers convenience and security.

Economists and regulators argue that DeFi may be useful for the unbanked and the poor on the margin but it is something that has to do more with poverty rather than the theory of short of access to financial services.

Essentially, as it is today, there is already a bit too much financial speculation made in the United States and there is no need for more ways that will allow the people to make more economic gambles.

Therefore, experts say that allowing DeFi and making the current financial system unstable is not required right now because ordinary people seldom make speculations to beat the Wall Street sharks.

What is more required for the working class is more and better jobs with higher wages rather than giving them a momentary chance to gamble on meme coins and win huge payouts, that are anything but uncertain.

However, if it is not possible to eliminate or beat DeFi, the regulators need to build a safer and more secure structure.

It is only then DeFi and crypto will be a cheaper, better, and more useful alternative to the current financial system that really needs some tough competition badly and not be a threat to its stability.

Challenges

The rise of crypto use and adoption poses unique challenges to financial stability which is why the regulators need to step in.

Some of the significant challenges are:

• Reducing the ability of the central banks to reinforce monetary policies efficiently along with an increased risk of solvency and funding
• Significant currency mismatches that may reduce financial integrity as well as consumer protection
• Rise in tax evasion due to improper fiscal policies and lack control on the system by any central authority
• Decline in the profits accrued from the right to issue currency especially due to the difference between their production costs and their face value, usually termed as seigniorage and
• Unimpeded capital outflows due to increase in the demand for crypto assets that may affect the foreign exchange market.

Also, due to the huge amount of energy required for crypto mining, migration of miners from China after the ban on crypto will affect the economies of developing countries.

The countries that rely heavily on a more CO₂ intensive variety of energy and have subsidized energy costs will be affected the most due to such additional energy use.

Policy Actions

There is no doubt that without proper and strict government rules and regulations, the current financial system cannot be protected from the effects of crypto.

When there is a proper policy action the downsides of the use of crypto will be reduced if not eliminated and it will be possible to achieve something good from it.

Fortunately, such policies have already been designed and new rules are in place as of now in the form of the Treasury Department reporting requirements on crypto transactions.

However, the regulators need to do a lot more than that.

It is necessary by the supervisors and the regulators to monitor developments around the crypto ecosystem which is quite rapid and risky.

They need to track and tackle data gaps swiftly.

It is also required that the policymaker improve cross-border synchronization to reduce the perils of regulatory arbitrage so that effective enforcement and supervision are ensured.

Apart from that, the national regulators should prioritize the existing global standards in crypto and implement them immediately.

They should typically look over and beyond money laundering and schemes on bank exposures and focus more on securities, payment systems, settlements, and clearing aspects.

When it comes to the stablecoins, the regulators need to proportionate the risks these coins pose to the financial stability as well as look into their economic functions.

They should also prioritize amplifying macroeconomic policies and think about the benefits of issuing Central Bank Digital Currencies or CBDCs, of course with better payment machinery.

Therefore, on a global scale the regulators, policymakers and the supervisors need to prioritize ensuring that making payments across borders is cheaper, faster, and more transparent.

It should however be comprehensive and in accordance with the G20 Cross Border Payments Roadmap.

However, timing everything perfectly is the key here and it is also needed to make sure that the policy actions are far more decisive, fast, and well-coordinated at a global level so that the benefits flow as well as the vulnerabilities are well addressed at the same time.

Financial Stability and Fairness

A few observers think that the financial stability of the current system is threatened by crypto because it has all the necessary attributes to replace fiat money.

This is mainly because the integrity of this private and digital money is underpinned not by government guarantees but by algorithms.

However, there are others who do think so mainly because this asset class is new and has a relatively small market value as compared to all other assets overall.

They also think that crypto is more of a speculative asset than something that has a lot of economic use cases.

Therefore, the financial experts seem to be pretty divided about the financial instability, or stability, factor.

However, it is with respect to the current scenario. If this change and crypto, especially Bitcoin, becomes the day-to-day currency then it can have some significant consequences to the current financial system.

This may result in a financial crisis irrespective of the underlying fiscal system with extreme amounts of endogenous risks leaving the economy with nothing to do but react.

Creation of money is the basis of financial instability.

In the present fiat system, it is the central banks that create the base money and the financial system builds higher forms of it such as M1 and M2.

When this process is reversed due to excessive and faster deleveraging, it causes primary damage from the financial crisis.

It is the same with crypto where the mining process controls the creation of new coins.

The creation of crypto M1 and M2 and its supply are however under control of nobody.

Few people say that it is not going to happen in crypto since it is a full-reverse system, but the financial experts believe that it is not the case.

This is because crypto users will want to lend out or borrow crypto, and if all these claims are traded, which is more likely in crypto than in a fiat system, it will create crypto M1 and M2.

This means that the crypto banks will operate just like the fractional reserve institutions do today and will also find it to be very profitable.

There are also some additional systemic risks in the crypto system which are not present in the traditional fiat systems.

Most money in the crypto ecosystem, whether it is crypto M1 or M2, is coin claims only.

Therefore, if a time comes when the confidence of people on a specific crypto coin evaporates, it will result in a panic.

The fiat systems, on the other hand, also face similar endogenous risks but these systems come with a safety valve.

Infinite amount of liquidity can be created in this system when it is required to meet the demand and minimize deleveraging.

This will prevent disasters and failures and keep the economy going.

This means that the market believes that the central bank will do whatever it takes to mitigate a crisis which makes the fiat system more reliable and efficient in dealing with systemic risks than crypto-based systems.

Talking about fairness, when crypto becomes the real competitor of fiat money, it will surely make a profit, and fairly so.

However, the success of crypto means that a considerable amount of public goods will be transferred to the private speculators resulting in a historic expropriation of public goods which will eventually instigate enriching some citizens and impoverishing others.

Still, if crypto really displaces fiat money, the sovereign will have to comply in order to make purposeful decisions so that it can be used along with or in place of dollars.

The reason behind is that fiat money is a legal tender and the government needs to permit displacing it.

It is strongly believed, though some crypto advocates dispute that if this idea is supported, it will benefit the entrepreneurs by creating a more competitive marketplace by including public goods rather than by unfair expropriation of public money supply to a handful of crypto speculators.

Backed and Not Backed Crypto Assets

Crypto coins can be backed, like the stablecoins, or not backed by any valuable assets.

However, the un-backed crypto coins make up about 95% of all crypto coins and their market value. Out of all these coins, Bitcoin is of course the most important one.

The value of these un-backed coins is typically determined by the price a buyer is willing to pay for them at any given point of time.

Therefore, the prices of these coins swing so wildly making them extremely volatile.

This is the primary reason to consider crypto as a speculative investment asset class. Also, this particular aspect makes them inappropriate for making payments.

However, over time, the concept and belief on crypto has changed and now more and more people are showing interest in them.

As a result, more composite investment strategies have come up now such as crypto futures, derivatives and option trading.

Traditional finance and market infrastructure companies are now considering the use of digital currencies and several banks have already come up with their own digital currencies.

They are also contemplating on providing other services such as:

• Custody services
• Trading crypto futures
• Non-deliverable forwards
• Crypto investments and its management
• Exchange platforms and apps to facilitate matched trades
• Crypto payments and
• Settlement of transactions in their networks.

However, concerns surrounding the un-backed crypto assets about market integrity, investor protection, and financial crime can have serious financial stability implications.

One of the most serious ones is their volatile nature that results in significant price correction which is comparatively a frequent event during the short lifespan of the un-backed crypto assets.

Therefore, from the perspective of financial stability, it could happen to the existing financial system if there is a substantial collapse in the prices of the un-backed crypto assets.

However, it will take some time for such a thing to happen but the chances still remain.

Now, taking a look at the backed crypto assets or the stablecoins that have its value tied with US dollars, a few people argue that it can be used as a mode of payment.

Though the stablecoins make up a very small proportion of crypto assets, they are being used by large corporations and wholesale players of the financial market.

In fact, there are lots of proposals from the big tech companies to develop new schemes or expand the existing ones to use these coins for payments at a larger scale.

This, with its ability to make millions of transfers per minute, will become the major element of the core infrastructure of the economic system.

Businesses and households will rely on them increasingly and will tend to use less physical cash.

This will disrupt the effective and continuous operation of the current financial system and jeopardize its stability causing significant economic damage.

This cannot be allowed and therefore the regulators need to create uniform standards that will be applicable to any systemic international payment system.

Ideally, financial experts believe that the Principles for Financial Market Infrastructures or PFMI should be applied to stablecoin arrangements.

This, they believe, would ensure proper governance and make things clear about stablecoin arrangements.

There should be one or more legal authorities accountable for the operation of the stablecoin arrangement as well as for ensuring a better management of the inherent risks.

This includes better governance standards for the arrangement on the whole ensuring wider interdependence of functions within the system.

However, a decentralized crypto algorithm may fall short of this requirement but if it is put into practice by jurisdictions then it may result in some changes in the structure of the current stablecoin arrangements to meet the international standards.

This includes:

• The asset pool
• The loss-absorbing capital and
• The responsibilities of operators within the arrangement.

Therefore, even though the demand for stablecoins from businesses and households is impossible to forecast with certainty, with careful designing and execution the impacts of changeover from bank deposits can be reduced significantly.

However, there can be risks in the transition.

It is true that it is not the responsibility of the financial authorities to preserve the stability of a financial system or the business models as well as the banking system.

However, they do have the legit interest and responsibility to ensure smoother transition without generating instability.

Decentralized Finance

A brief comment on Decentralized Finance or DeFi is necessary at this point for a better understanding considering the rapid growth of it.

DeFi, as such, increases the complexity as well as the potential risks in the crypto ecosystem.

These specific financial services rely typically on smart contracts that are based on algorithms and are provided through Distributed Ledger technology platforms without any intermediaries.

Provision of credit is one of the most prominent use cases of DeFi at the moment comprising nearly 50% of the entire DeFi market.

It also has several other useful financial services including and not limited to:

• Trading
• Savings
• Insurance and
• Derivatives

However, this particular sector also poses a unique set of challenges for the regulators across the globe.

Some of these challenges include:

• Market integrity
• Investor protection
• Accountability
• Degree of decentralization across platforms and
• Anti-Money Laundering provisions.

Though still in its stage of infancy, the regulators need to think seriously about DeFi and the risks and challenges to ensure uniform standards both domestically and internationally to manage it in a better way just as it is done in traditional finance.

What the IMF Says?

According to a few IMF or International Monetary Fund reports, the crypto assets pose significant challenges when it comes to ensuring financial stability by the governments.

However, the IMF does recognize the potential of crypto to facilitate cross-border payments and also in converting currency almost instantly.

They also admit that it has opened new opportunities but all these do not take away that fact that it poses financial stability challenges.

They also say that Decentralized finance can become the most sought after platform because it is inclusive, innovative, and transparent.

The volatility of the currency and the rapid growth in its adoption also poses financial stability challenges, the IMF says.

These coins are very unstable and therefore will affect the exchange rates thereby introducing instability.

Crypto will also destabilize capital flows due to its financial and operational integrity risks, investor protection risks, and insufficient reserves and disclosure.

In short, the IMF says, crypto has all the necessary attributes to be a fine investment asset class but it simply does not have the desired properties to be considered as a monetary aggregate.

If done, it will result in financial instability especially if there are no regulations and create momentous wealth inequality.

Few FAQs

Here are a few FAQs regarding crypto democratizing finance that are answered by several crypto enthusiasts and experts.

• How much money can people make if crypto emerges?

It will favor the people who are wealthy and will also create a lot of investment opportunities for them.

However, if the playing field is leveled things can be better for the others as well. After all, it is not the amount of money that one can make that matters in crypto, at least in principle.

• What may happen to cash?

The convenience and speed in making digital payments will win over cash and it is already happening. Rich countries like Sweden hardly use cash anymore and in other countries like China, use of cash is dropping at quite a rapid rate.

• What about the concerns regarding private companies like Amazon and Facebook issuing their own currencies?

When more and more such coins come to the market, there will be increased and direct competition with the US dollars.

This will give rise to all sorts of worries and concerns regarding visibility as well as all other aspects of the financial lives of people.

• What about the crypto bubble and its bursting?

Crypto bubble gives rise to speculative manias but no matter whatever happens to its value, especially to the value of Bitcoin, it will leave a very prominent legacy.

This will even stoke up the fire under the central banks to start thinking and issuing digital currencies of their own.

• How will digital assets give additional tools to the governments to have control over use of crypto and the citizens?

The Central Bank Digital Currencies or CBDCs will be the future and the tool that will allow every central bank to monitor money and ensure that it is not used for illegal purposes.

All transactions made will be traceable, auditable, and can be seen by the government agencies.

However, considering a dystopian world, it will be quite uncomfortable for the citizens because the governments will have the power to decide on what sort of commodities and services the money can be used for.

• How could crypto amplify economic inequality?

Well, it will do so simply by its underlying technology that will democratize finance and make financial products and services accessible more easily to the people.

However, lack of financial literacy will widen economic inequality and the risks of investing in crypto coins and its related products will affect the naïve retail investors the most.

Conclusion

The success of crypto will come at the cost of causing financial instability across the globe, as it is pointed out in this article.

Though the chances of it may not be very high as of now, with all other things remaining equal, it may not be the case for a very long time.