The great crypto crisis is upon us

The author is an economic consultant and research director at the Bank for International Settlements

There is a bitter irony in the turmoil currently gripping the crypto universe. Crypto was born in the depths of the Great Financial Crisis of 2008 as a backlash against the failure of the conventional financial system, with its overleveraged shadow banks and the chain of leverage and maturity mismatch. The original Bitcoin white paper, published that same year, sold a vision in which money was recast as a self-sustaining system of peer-to-peer transfers without the need for intermediaries. Today's upheaval, however, bears all the hallmarks of the very mistakes that the industry's early proponents railed against. As companies collapse and coin prices crash, the unraveling of this new daisy chain of over-indebted shadow crypto banks is now well underway.

As we examine the wreckage and chart a course for the policy response to rein in the sector, we need to keep some important facts in mind. Crypto operates under the banner of decentralization, but is highly centralized in two crucial ways.

First, many supposedly decentralized protocols turn out to be highly concentrated in terms of who actually runs and controls things. Often it is the founder and a small number of venture capitalists who call the shots – as the implosion of the stablecoin Terra in May shows. In most cases, crypto is decentralized in name only.

Secondly, centralized intermediaries like Sam Bankman-Fried's FTX play a central role as a gateway into the crypto world from the conventional financial system. They channel the flow of new investors, which is the oxygen that keeps this speculative dynamic alive. BIS research in this area has shown that crypto only truly works when this happens. To the extent that recruiting new investors is key to crypto's survival, centralized intermediaries are crucial to propping up the building.

The current collapse of FTX and other falling dominoes in the industry has led to some intense soul searching among crypto advocates. Predictably, we are hearing calls for the industry to “go back to its roots” and be reborn in a purer form. The vision is to turn back the clock to the time when crypto was reserved for a small group of enthusiasts and not marketed as a mainstream financial product. In this vision, it would be a niche hobby for a small minority of followers, rather than reaching our living rooms through television advertising to attract retail investors.

This pure form of crypto, which imagines getting rid of central intermediaries, would have a very small footprint. But crypto would not have grown to its current size without these companies funneling funds into the sector. Instead of being in opposition, centralized intermediaries and crypto feed off each other. For this reason, any policy intervention taken now to mitigate the impact of crypto must take into account this interdependence, as well as the role that stablecoins play as a gateway to the conventional financial system.

Some say “just let crypto burn,” but the idea that it will disappear on its own may be wishful thinking. As financial conditions change, even a much-reduced sector reserved for purists could still provide the embers for the re-entry of centralized intermediaries.

Any intervention would have to overcome a key challenge: If policymakers allow crypto to become intertwined with the mainstream financial system, it will usher in something that has so far been avoided. Particularly as stablecoins are brought into the regulatory perimeter, their role as an entry point to the rest of the crypto ecosystem must be addressed. Politicians should be careful not to let them become a “cuckoo in the nest”. The Basel Committee on Banking Supervision’s new standards on banking sector activities in crypto are an important step in the right direction.

More broadly, the regulatory approach must distinguish crypto's underlying economic function from what it looks like on the surface. Even during the worst excesses of the subprime mortgage boom, the daisy chain of leverage ultimately led to real-world activity—most obviously, buying a house with money. Crypto, on the other hand, is largely self-referential; its activities deal with trading other types of crypto and have little relation to concrete economic activities.

Ultimately, any policy response must begin with a realistic assessment of the economic value derived from blockchain technology. Blockchain's returns have been remarkably meager given the early hype. Project after project that explored its potential benefits has come up empty.

A more promising approach is central bank digital currencies that operate within the broader digital monetary system. This is an approach that builds on the trust embedded in central bank money and could serve the public interest in a future monetary system. The technological benefits flow into real economic activities and not just other types of crypto. The economic benefits of decentralization should also be questioned more closely. We now see what happens when an industry simply relies on a belief.