Crypto Won’t Stay Dead: A Conundrum for Regulators and Central Bankers. An Opportunity for Canada.

The demise of “crypto exchange” FTX (only a short time ago), and the resulting collapse in the value of crypto, may have been greeted by central banks and financial services regulators with relief. Some pronounced private digital currencies like bitcoin officially dead. Others believed there would be time to figure out what to do about crypto and its challenge to official (“fiat”) currencies.

The alleged fraud at FTX, while devastating for investors in FTX and its crypto depositors had no impact on the broader financial system and raised no “systemic risk”. Officials knew however; that given the exponential growth they had been seeing in crypto, a failure like FTX had it occurred three years down the road might have significantly impacted the broader financial system.

The recent bank liquidity crisis and the resulting central bank interventions (unlimited backstopping of deposits and liquidity infusions), has upended the regulators’ timeline. Crypto has roared back. It will not stay dead.

Regulators face a fork in the road. Lean in and embrace digital currency in some fashion or shut it down knowing that will push it away but not kill it.

Growth of crypto caused worry among regulators

There are three reasons that people have been drawn to “private” digital currencies (the only flavour available now): 1) to speculate (its volatility is an attribute to trade on); 2) for pseudo- anonymity (more about that later)-you don’t need anyone’s permission to move digital money from “A’ to “B” because digital assets are outside the central banking system and; 3) because it is getting easier all the time to use digital currency rather than traditional currency even if that “official:” currency can be transferred electronically as is the case in Canada. Using a national currency is “sticky” and there is “friction” (growing reporting requirements and the like) which slows and complicates legitimate transactions.

Financial regulators have been concerned about the growth of crypto, through the conversion of everyday (national) currencies into crypto, because private currencies and their sponsors are unregulated, leaving the public exposed to fraud. They are also concerned because crypto is an obvious avenue for money laundering and terrorist financing.

Central bankers have a special concern: Private digital currency is a threat to the monopoly on the issuance of official currencies, the principal mechanism by which national central banks control monetary policy vital to a country’s ability to control its economic destiny. Private digital currencies impede the view that central monetary authorities need to have into currency operations in the economy (But that’s the point, crypto proponents would say.)

Crypto and official national currencies (“fiat currencies”) are in an inverse relationship. Think of it like a see-saw: One goes up, the other goes down. So too the relationship of bullion to dollars; but with one difference. You can’t easily use bullion to buy anything. It’s too heavy to be portable. A digital asset is very light-indeed ephemeral some might say and it is portable at the tap of key stroke. But digital assets, like crypto, have been mostly stuck in the speculative asset category- something (like bullion) only tradeable in and of itself. Regulators may wish it would stay that way. It may not.

The digitalization of money

Canadian officials are studying the digitization of money and there is some pressure on them to find a way to modernize Canada’s currency. There is a global race between countries to create more digital and nimble versions of their national currencies in order to harmonize the relationships between a central bank, (the issuer of currency), commercial banks (with direct customer facing relationships) and the end user (you and me). That could mean, among other things, allowing a digital currency to become “a unit of account” to buy things, just like an official currency. There is not much interest among central bankers to facilitate the opportunity for private digital currencies to do that. In any event, at present, crypto pricing volatility is an impediment to that big step.

CBDC is not an easy answer

An alternative is to create an official central bank digital currency (a “CBDC”) as China has done. China has also banned private digital currencies in most transactions. A CBDC would offer individuals the convenience and flexibility of digital currency without a central bank losing its monopoly on the issuance of currency. But CBDCs have problems.

From the perspective of users, an official digital currency will put individuals in a direct relationship with the central bank. There is an interesting question whether the public would accept the resulting loss of anonymity that would entail. Most crypto enthusiasts believe that when they use crypto they are anonymous, They are not. Want to be anonymous? Use cash. That said, a growing cohort of people may be unimpressed by how easy it is right now to use official currency electronically and they may remain unmoved by the launch of an official digital currency. They are enticed however by the relentless marketing efforts of private sector digital developers and promoters.

A CBDC would also antagonize Canada’s banks by stealing their customers. With an official digital currency individuals would have a direct relationship with the Bank of Canada. This would cut out the intermediary role now played by a nation’s banks which act as the conduit for the safeguarding and transmission of capital. It would be ironic; but a CDBC would fulfil the crypto dream of cutting out the middleman!

Finally, a CBDC would expand central bank balance sheets enormously.

Back to the future. Where to from here?

In the immediate aftermath of the recent bank failures, the exponential growth of crypto assets slowed by the FTX debacle has resumed. This is fueled by a new (or renewed) lack of confidence in traditional financial institutions and the view that central authorities lack the discipline to maintain the value of traditional currencies.

Crypto ideologues see a salutary result in the recent bank failures-reminding people about the basic crypto (blockchain) promise: that digital assets give you the power to cut out the costly bank intermediary function and the risk of dealing with (failing) financial institutions.

Boosters of crypto were not necessarily embarrassed by the implosion of crypto “exchange” FTX. FTX, was operating as a surrogate for the intermediary functions provided by traditional banks and in the pristine world of ‘peer to peer’ relationships there should never have been a need for a “crypto exchange”. The crypto ‘true-believers’ conveniently ignore that many who hold crypto didn’t want solely the opportunity for pure ‘peer to peer’ functionality. They wanted to treat crypto like real money-to safeguard it somewhere, to lend it, to borrow it.

The lesson crypto proponents have been drawing from FTX is not that one. It’s that you should not hold your digital bearer assets in any third-party digital exchange; but hold these assets on your own just how the crypto world was to operate.

Further, the rescue of SVB and the related facilities put in place, are being talked about by the crypto zealots as proof (again) that official fiat currencies will not maintain their value because central banks can just print money as they appear to be doing to fund the rescue facilities. “And they say crypto is volatile”???

Regulators are worrying again about digital assets breaking out of the speculative category (into something more widely usable) and supplanting official currency. But for now, the value of crypto fluctuates wildly from one moment to the next. That volatility prevents crypto becoming a “unit of account” to buy things the way you do with the real dollars in your real pocket. With crypto values gyrating how do you price things?

Is Stablecoin an option?

So-called “stablecoins” a crypto currency backed by a reference asset (like a basket of official currencies) were designed to address the crypto volatility question. There was a “peg” to something measurable. A holder of a stablecoin could know at any time what its value was by reference to the reference asset. Stablecoins held the key to transitioning crypto from speculative asset to usable digital currency.

Even some regulators were intrigued by the promise of stablecoins. Stablecoins were less of a threat to official currencies than crypto because of the involvement of official currencies as a reference asset. If stablecoin worked, there might be no need for an official digital currency with all its attendant problems.

Even proponents of “stablecoins”, last year’s “new, new thing”, have had their confidence shattered because a large percentage of the backstop currencies for major stablecoin “USDC” were thought to be parked at SVB. No one knew for sure. So the “peg” to the US dollar, the basis for the stablecoins vaunted stability, broke to the downside. ”But stablecoins didn’t fail, the underlying financial institutions failed” the crypto boosters were saying. “Digital asset are not the problem, it’s financial institutions”. Stablecoins could now be abandoned in favor of (I can’t believe I’m saying this), old fashioned plain-vanilla crypto, like bitcoin. So, it’s back to the future.

Regulators must walk a policy tightrope

In Canada, even if a crypto currency became a recognized “unit of account” to buy things, it is hard to see why a digital currency (private or official) would be more effective than what we have now especially after the Canadian payments system is modernized to permit instantaneous and irrevocable transmission of funds. But crypto will still grow.

In the aftermath of the upheaval in the (traditional) banking space, the value of crypto has soared (bullion and silver too) and regulators are running out of time to figure out what to do. Crypto assets are going underground and offshore again (or more appropriately, into the digital universe).

The challenge for policy makers is to find a way to be hospitable to the digitization of money (Private digital currencies? Official digital currencies?) with all the efficiencies and possibilities this promises, and maintain the authority of central banks so vital to controlling price volatility in the broader economy. The question for individual countries is how do existing currencies become more digital in nature, drawing from new technologies in order not just to compete with private digital; but hold private digital currencies at bay.

Global digital tech developers are building a rival set of value propositions – offering speed, supposed anonymity, the prospect of being on the cutting edge of something new – and that nothing can go wrong (the depositors at FTX found out otherwise). For better or for worse, the digital developers can presently grow that capability outside the system; but not in it.

Not leaning into this new world has worked for regulators to date. If regulators are right, crypto will remain only important to speculators and money launders and they will be dealt with. The alternative, embracing digital currency still begs the question: “How?’ “How far”?

An opportunity for Canada

Canada has a policy choice. Banning digital currencies will not work. Canada isn’t China. But there is a way for Canada to embrace digital without creating an official digital currency.

The Canadian government could create the opportunity for a stablecoin to be issued by and promoted by its major banks. Call this the “digital loonie” or what you will; but it is not a loonie idea. The reputation of Canada’s banks, coupled with the stability of Canada’s currency could have Canada at the forefront in creating something the Canadian dollar has never achieved-to be a standard unit of account used globally. This promises enormous positive economic impacts.

For millions of people around the world without a banking relationship, or distrustful of their national financial institutions, a digital loonie offers the opportunity for financial inclusion. That’s what China’s digital Yuen is trying to be. Canada’s digital currency should be the better choice. We have the tech talent, the financial stability and the institutional credibility to make this happen.

The risk of doing nothing is that another jurisdiction strikes the policy balance in favor of light regulation of digital assets, and capital flows and tech talent follow.

If you would like more information, please contact:

Barry Campbell:

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