Sixteen years ago, I often joked that what the financial system needed was a “Goldilocks crisis” – a shock just hot enough to force investors and regulators to wake up and see the Risks swell in credit markets, but not so hot that it caused the whole system to burn.
Unfortunately, at the time, this crisis never occurred; instead, credit derivatives and sub-prime mortgages continued to boom until they triggered the 2008 crisis that almost “burned” the financial ecosystem (until banks plants are coming with these quantitative easing extinguishers).
But the intriguing question today, amid another boom in financial innovation, is has that Goldilocks moment now arrived for digital assets? The crypto sector has recently exploded as dramatically as credit derivatives – and many investors are about as unaware of its workings as they were of secured debt in 2006.
But this month we experienced “one of the greatest disasters crypto has ever seen,” as Ran Neuner, a prominent crypto enthusiast, recently admitted. Most notably, Terra and Luna, the two so-called “algorithmic stablecoins,” imploded, creating $50 billion in losses in three days. Ouch.
Some now argue (or hope) that this shows that crypto should completely burn, given that the sector has failed to deliver on its promise of offering a reliable store of wealth or truly efficient payment mechanisms.
Maybe it will happen. The overall crypto market of around $2 billion has already shrunk by around 30%, and if a crisis now hits the $80 billion stablecoin (which is quite possible), it will decrease further. But if you believe (like me) that the crypto revolution has a core of potentially valuable ideas around blockchain technology, it makes no sense to demand a Chinese-style ban.
Yes, Luna has always looked crazy, as respected crypto experts such as finance professor Alex Lipton, warned last year. But Lipton always think that blockchain could transform industries such as forex trading and carbon markets, while some stablecoins have payment uses.
So the $50 billion question is, can the key player and policy makers now enact reform to eliminate the bad, while retaining some of the good? Can a Goldilocks pattern occur?
It is unclear. But there are five key questions investors should watch to determine the answer.
The first is whether the language of the sector becomes less confusing. Consider the “stable coin”. This word is currently used to market an array of different practices, ranging from algorithmic coins (which are really more like a synthetic derivative) to the USDC coin (which is more like a narrow mini bank). This obfuscation must change.
Second, regulators need to expand some oversight. In America, tokens that act as funky derivatives or mutual funds are best overseen by the Commodity Futures Trading Commission or the Securities and Exchange Commission. Coins that operate as mini-banks are best monitored by the Office of the Comptroller of the Currency. (Circle, which issues USDC coins, is now in active discussions with the OCC for precisely that.)
Third, if regulators get involved, they should require stablecoin issuers to provide verified and detailed asset disclosures and impose significant reserve requirements. It seems obvious. But that’s notably not what Tether, the largest stablecoin issuer, has done.
Fourth, regulators should require crypto exchanges to adhere to basic listing standards. And finally, there is an urgent need to clarify custody, given that exchanges not only act as platforms to strike deals, but often hold client assets as well.
This oft-ignored concentration of power mocks the decentralization mantra that is supposed to drive the crypto dream (and, as I recently noted, is just a contradiction in the creation mythology of this industry.)
But it also creates a practical risk: failure could trigger market panic. Some smaller non-US jurisdictions have custody rules that protect investors in the event of a stock exchange failure. This is not the case at the federal level in America, because Coinbase executives were forced to admit to investors last week. This absolutely must change.
These ideas are not remotely revolutionary; similar principles have already been imposed on other fields of innovation. Indeed, many of them were clearly spelled out in a report released by the President’s Financial Markets Task Force seven long months ago, which called for “urgent” legislation to address the growing risk.
But since then, Congress has notably failed to act; despite the fact that it is a rare topic on which there is bipartisan interest. Most mainstream crypto players have also ignored the issues. For example, even though the issuer of Tether was fined for accounting malfeasance, investors continued to use the coin.
Hence this Goldilocks question. If the industry and policymakers now (belatedly) respond to their burn by introducing a sensible framework, the world will finally be able to see if crypto can become something more than a fringe wild casino, with real uses. Otherwise, expect more scandals, shocks and pain for investors. In my view, the jury is still out on which scenario prevails.