After a series of noisy collapses last spring, the cryptocurrency market seems to be on the rebound, and politics is playing a role. Thomas Kalafatis and Richard Nesbitt write that newer frauds will keep coming up until the general public’s latent demand for cryptographically enhanced commerce is met by honest actors and through more uniform regulation that is less susceptible to arbitrage.
We are about to see the rebirth of crypto-enhanced commerce, driven by political considerations and the fact that regulators have begun to meet the challenge. If you want anecdotal proof of the direction of the market, look simply at the Bitcoin 2024 conference in Nashville. One of the candidates for president has now positioned himself as a champion of digital assets. His support even goes as far as promising significant restructuring of the Securities and Exchange Commission (SEC) should he be successful in his election hopes. It should be no surprise that the candidate almost simultaneously has announced that his organisation intends to enter the private crypto market with their own product.
Cryptocurrencies, in their purest current form such as bitcoin, are stores of wealth that exist outside of the control of national governments and banking systems. This feature makes them highly attractive for people who live in countries that are politically unstable, with volatile currencies, or that have weak banking systems. An alternative asset that can be obtained and held safely outside of the control of such states is highly attractive to many.
Unfortunately, it is these same characteristics that make it attractive to the unscrupulous criminal elements within the world economy. We have seen that the private creation of crypto-enhanced commerce has had a very challenging history. However, with proper regulation by national and international bodies, this type of commerce has the possibility of widening the involvement in our global economy of many people around the world.
Recent evolution
We have presented a framework for contrasting fiat currencies against various digital currency types such as crypto, stablecoins and central bank digital currencies (CBDCs) across the core characteristics of currencies (acceptability, fungibility, sponsorship, scarcity, portability, divisibility and durability).
This framework allowed us to see that bitcoin, in spite of its ups and downs, had more utility than lesser fiat currencies and was “here to stay”, while stablecoins faced challenges. Central bank digital currencies have the potential to hit all the marks in utility compared to stablecoins, as they would have the backing of governments providing benefits from both worlds. The actual experience would depend on matters of control and privacy and the nature of regulation.
Regulation as a necessity
We are strong believers that financial markets are a public good. Strong regulation is a feature of fair financial markets. Otherwise, the incentives to “overgraze the commons” (cheat) are too strong.
The underlying theme in all our research has been the need for regulatory frameworks and footprint that recognise the borderless and digital nature of crypto-enhanced commerce but allowed for continued room for innovation. That means protecting the public from cheaters, but not discouraging participation from true innovators.
Here are our core forecasts for the future of regulation:
- Cryptographically-enhanced commerce is here to stay. The supply of the technology is too widespread, and its demand too pervasive to be reversed.
- As the financial impact of recent failures and negative externalities on investors is in the multiple billions of dollars, it will take years to know the actual impact on markets and public policy.
- Current regulations are quite clear. Market participants simply need to ask whether their stablecoins are deposits or securities.
There will continue to be more and new frauds until the general public’s latent demand for the benefit of cryptographically-enhanced commerce is met by honest actors and through more uniform and regulation that is less susceptible to arbitrage.
After the collapses of FTX, Luna, Three Arrows and Celsius, we had follow-on issues at major banks with crypto payment rail exposure including Silicon Valley Bank, Silvergate and Signature Bank. Regulatory intervention last spring at those banks seems at least to have been in part driven by regulators’ desire to exert more control in the space. This seemed to be the turning point where conditions changed.
The devastation in the private crypto-enabled commerce market has been well reported. Billions of dollars were lost. Frauds and scams are inevitable when humans come together with new ways to make money. You would think we would learn our lesson. But why would you think that, looking at the history of mankind? Greed and fear are said to be the primary drivers of financial fortune.
If you look at these incidents you will see that they follow a similar path of many financial failures in the past. Inadequate or non-existent due diligence on behalf of lenders, shareholders and other stakeholders. Borrowing short term and lending long term. These factors are all to be found in these failures as they are in most of human activities. They are the one thing we can be certain of and must protect ourselves against.
Greed is about to replace fear in the crypto world. As regulators attempt to protect the public, there is less fear, and more willingness to participate. Here are a few examples:
- The creation, in 2022, of the European Union Markets in Crypto-Assets (MiCA), a framework to maintain financial stability.
- Split of crypto responsibilities between the Securities and Exchange Commission and the Commodity Futures Trading Commission
- Approval and launch of bitcoin and ethereum exchange-traded funds (ETFs)
- And the entry of mainstream providers such as Blackrock and JP Morgan
Why, after all the devastation in the market, does growth look like it will continue? The reason is that bitcoin and other instruments of crypto-enhanced commerce continue to demonstrate their latent and inherent demand. Bitcoin’s blockchain itself has not been the origin of a scandal (but rather the operating ecosystem around it) and in fact its inherent value has continued to reflect a store of value. Put simply, regulation is beginning to protect a market that is ready to move from the early adopter phase to the truly mainstream.
Central bank digital currencies
Central bank digital currencies will slowly continue to develop as a solution to some consumer demands. This is going to take considerable time. It seems that some central banks are downright resistant to bringing themselves into the CBDC space. Many incumbents in traditional finance have been vocal critics, as privacy and control issues have been politicised. Time will tell on future CBDC developments, but we do not hold out hope that there will be major developments soon. As with everything government, it will be a slow painful process.
Criminal use is growing
In 2023, the FBI Cryptocurrency Fraud Report discussed the growth in crime involving cryptocurrencies. Complaints in the US are up by almost half since 2022. Losses in 2023 were US$ 5.6 billion, an increase of 45 per cent compared to 2022. They point out that the cryptocurrency characteristics that are attractive to many users are also the same reasons that criminals are increasing their use.
Despite this increase in use by criminals, we remain bullish on the politically fuelled growth of crypto-enhanced commerce. In many countries these instruments will represent a way for citizens to avoid a risky banking system and currency but to still participate in the global economy.
But, for everything explained above, buyers should beware.
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- This blog post represents the views of the author(s), not the position of LSE Business Review or the London School of Economics and Political Science.
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