ECB executive board member Fabio Panetta sounded the crypto alarm bells this week with a firebrand speech that warned of the growing risks of “the Wild West of crypto finance.” However, the clamour for regulation must not come at the detriment of innovation.
On Wednesday afternoon, the global crypto market cap sat at $1.79tr — almost $500bn larger than the sub-prime mortgage market on the eve of the 2007-2008 global financial crisis.
Panetta drew further parallels in his speech on Tuesday: just like 15 years ago, the promise of high returns is driving rampant speculation, with the exploitation of regulation leaving investors with scant protections.
“Limited understanding of risks, fear of missing out and intense lobbying of legislators drive up exposures while slowing down regulation,” he added to the list of comparisons of the two eras.
The wild speculation and highly volatile price swings were in full display earlier this week as the meme-themed Dogecoin jumped about 20% after Twitter agreed to Doge enthusiast Elon Musk’s takeover. A day later the coin was firmly in the red.
Similarly, last year, alarm bells were sounded over the influence that so called stablecoins had on short-term debt markets, with Fitch repeatedly warning of the contagion risk posed by these crypto assets.
These stablecoins are pegged 1:1 with fiat currencies and are designed to allow crypto investors to shift between crypto currencies without ever leaving the digital world.
Although stablecoins claim they are backed by cash, that is rarely the case. For instance, only $4.2bn of the largest stablecoin Tether’s underlying assets were held in cash at the end of 2021, with the vast majority instead backed by US Treasury bills, commercial paper and certificates of deposit, making the as of now unregulated stablecoin one of the biggest players in the short-term money markets.
Before the bubble bursts
As a result, regulators must ensure they do not wait too late to act before the bubble bursts, and repeat the mistakes made in the run up to the sub-prime mortgage crisis, Panetta said.
Of course, Panetta is right that central banks and financial regulators must act before crisis-level damage is done
The ECB, for instance, plans to hold cryptocurrencies to the same standards imposed on the rest of the financial system.
Crypto’s role in money laundering, tax avoidance and sanction skirting are all set to come under the central bank’s panoptic microscope, Panetta said. Similarly, the central bank will have to strengthen the disclosure and regulatory requirements in the industry — especially for stablecoins like Tether — which is currently murky and highly fragmented.
However, the genie is out of the bottle. Cryptocurrencies are already deeply ingrained in the financial system that regulating them to such an extent would require global cooperation on a level on par with the Basel Accords.
And not every jurisdiction will agree to the same level of regulation. Russia, Iran and North Korea have all been accused of using cryptocurrencies to avoid international sanctions and embargos. Last year, Russia accounted for 11% of global bitcoin mining, Iran 3%, according to the Cambridge Bitcoin Electricity Consumption Index.
Instead of worrying about potential scams and bubbles, the ECB should look to harness the benefits that cryptocurrencies could bring the bloc. After all, the ECB has form in this regard. It eventually decided that securitization was a way to finance SMEs, despite the part it played in the 2008 crisis, and it even created the "simple, transparent and standardised" label for the safest versions of the product as a benchmark of quality.
The UK already unveiled its own ambitious plans to promote crypto innovation, which would see stablecoins made respectable, sandboxes set up to encourage innovation, tax treatments made competitive and distributed ledger technology used for sovereign debt.
The ECB must ensure it does not fall behind. As Panetta points out, central banks must promote innovation through improved financial infrastructure, payment systems and introducing central bank digital currencies.
The central bank has already taken steps in the right direction — the digital euro study, for instance, is set to conclude next year. However, it must make sure these developments are not prematurely snuffed out by overzealous regulation.