25 April 2022

ECB's Panetta: For a few cryptos more: the Wild West of crypto finance

170 years ago Americans pushed westward across the frontier to seek their fortune in the gold rush. Greed and lawlessness turned this promised land into the Wild West, where the few exploited the dream of the many.

Fast-forward a century and a half and, amid the global financial crisis, growing distrust of banks, coupled with technological innovation, gave rise to a new dream – a digital gold rush beyond state control.

Satoshi Nakamoto – or rather the software developers using that pseudonym – created the source code of what they thought could be decentralised digital cash. Their 2008 white paper^[1] shows a great fascination with technology, notably cryptography, but not necessarily an in-depth understanding of payment and money issues. They aspired to realise an anarchistic utopia of a stable currency free from public scrutiny.

Almost 15 years on, crypto-assets are what everyone’s talking about. Crypto enthusiasts marvel at the rise of the crypto market, with many feeling they should take their chances on the crypto gamble. An ecosystem has emerged, from miners to intermediaries, all seeking to expand into digital finance. Crypto evangelists promise heaven on earth, using an illusory narrative of ever-rising crypto-asset prices to maintain inflows and thus the momentum fuelling the crypto bubble.

But appearances are deceptive. Satoshi Nakamoto’s dream of creating trustworthy money remains just that – a dream.

Crypto-asset transfers can take hours to process. Their prices fluctuate wildly.^[2] The supposedly anonymous transactions leave an immutable trail that can be traced.^[3] A large majority of crypto holders rely on intermediaries, contrary to the avowed philosophy of decentralised finance. In El Salvador, for instance, which is the first country to adopt bitcoin as legal tender, payments are carried out via a conventional centrally managed wallet.

Crypto-assets are bringing about instability and insecurity – the exact opposite of what they promised. They are creating a new Wild West.^[4] To quote Littlefinger from Game of Thrones, “chaos is a ladder”. The story does not end well for this character. However, it only takes a few to climb high on the ladder – even if their gains are only temporary – to convince many others that they are missing out.

Indeed, the crypto market is now larger than the sub-prime mortgage market was when – worth USD 1.3 trillion – it triggered the global financial crisis.^[5] And it shows strikingly similar dynamics. In the absence of adequate controls, crypto-assets are driving speculation by promising fast and high returns and exploiting regulatory loopholes that leave investors without protection. Limited understanding of risks, fear of missing out and intense lobbying of legislators drive up exposures while slowing down regulation.

We must not repeat the same mistakes by waiting for the bubble to burst, and only then realising how pervasive crypto risk has become in the financial system. And while some may hope to be smarter and get out in time, many will be trapped.

Now is the time to ensure that crypto-assets are only used within clear, regulated boundaries and for purposes that add value to society. And it is time for policymakers to respond to the people’s growing demand for digital assets and a digital currency by making sovereign money fit for the digital age.

Today I will argue that at present crypto-assets are not only speculative and high-risk investments, but they also raise public policy and financial stability concerns. I will then discuss some elements of the public policy response which is necessary in order to protect investors and preserve financial stability without suffocating innovation.

The rise of crypto-assets

Let me start with the underlying drivers of crypto-assets.

At their root, crypto-assets are the result of advances in cryptographic methods and distributed ledger technology. Innovation has made it possible to create an asset that lacks any underlying claim. In the initial set-up of what we today call “unbacked crypto-assets”, nobody is liable, nor are these assets backed by any collateral or managed by a trustworthy operator. This makes them purely speculative in nature, and hence highly volatile.

To address the risks of unbacked cryptos, “stablecoins” have emerged, with their value linked to one or more low-risk assets. But, if left unregulated, they are stable in name only.

In fact, they can be low-risk but not riskless, and cannot guarantee redeemability at par at any time.^[6] They do not benefit from deposit insurance, nor do they have access to central bank standing facilities. They are therefore vulnerable to runs.^[7] They are often purely speculative assets, exposed to high financial and operational risks: research finds that one-third of stablecoins launched in recent years have not survived.^[8]

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