After a series of noisy crashes last spring, the cryptocurrency market appears to be in full recovery mode, and politics is playing a role. Thomas Kalafatis And Richard Nesbitt write that new frauds will continue to emerge until the latent public demand for crypto-enhanced commerce is met by honest actors and by more uniform, less arbitrage-prone regulation.
We are about to witness a crypto trading renaissance, driven by political considerations and the fact that regulators have begun to rise to the challenge. If you want anecdotal evidence of where the market is headed, just look at the Bitcoin 2024 conference in Nashville. One of the presidential candidates has now positioned himself as an advocate for digital assets. His endorsement even goes so far as to promise a major restructuring of the Securities and Exchange Commission (SEC) if he succeeds in his election hopes. Not surprisingly, the candidate announced almost simultaneously that his organization intends to enter the private cryptocurrency market with its own product.
Cryptocurrencies, in their current purest form, such as bitcoin, are stores of wealth that exist outside the control of national governments and banking systems. This characteristic makes them very attractive to people who live in countries that are politically unstable, have volatile currencies, or have weak banking systems. An alternative asset that can be obtained and held securely outside the control of these states is very appealing to many.
Unfortunately, it is these same characteristics that make it attractive to unscrupulous criminal elements within the global economy. We have seen that the private creation of crypto businesses has had a very difficult history. However, with proper regulation by national and international bodies, this type of business has the potential to expand the involvement of many people in our global economy.
Recent developments
We presented a framework to compare fiat currencies to various types of digital currencies such as cryptocurrencies, stablecoins, and central bank digital currencies (CBDCs) across the fundamental characteristics of currencies (acceptability, fungibility, sponsorship, scarcity, portability, divisibility, and durability).
This framework allowed us to see that bitcoin, despite its ups and downs, had more utility than smaller fiat currencies and was “here to stay,” while stablecoins faced challenges. Central bank digital currencies have the potential to achieve all of the utility goals compared to stablecoins because they would benefit from government backing that offers benefits of both worlds. The actual experience would depend on control and privacy issues and the nature of regulation.
Regulation as a necessity
We believe that financial markets are a public good. Strong regulation is an essential element of fair financial markets. Otherwise, the incentives to “overexploit the commons” (cheat) are too strong.
The underlying theme of all our research has been the need for regulatory frameworks and footprints that recognize the borderless and digital nature of crypto-enhanced commerce, but leave continued room for innovation. This means protecting the public from cheaters, but not discouraging the participation of true innovators.
Here are our main predictions for the future of regulation:
- Crypto trading is here to stay. The supply of the technology is too widespread and its demand too ubiquitous to be reversed.
- With the financial impact of recent failures and negative externalities on investors running into the billions of dollars, it will take years to know the real impact on markets and public policies.
- The current regulation is quite clear. Market participants simply need to ask themselves whether their stablecoins are deposits or securities.
There will be more new fraud until the latent public demand for the benefits of crypto-enhanced commerce is met by honest actors and by more uniform, less arbitrage-prone regulation.
Following the failures of FTX, Luna, Three Arrows, and Celsius, we had follow-up issues at major banks exposed to the crypto payment rail, including Silicon Valley Bank, Silvergate, and Signature Bank. The regulatory intervention in these banks last spring appears to have been partly motivated by regulators’ desire to exert more control over the sector. This appears to have been the turning point where conditions changed.
The devastation of the crypto-based private trading market has been widely reported. Billions of dollars have been lost. Fraud and scams are inevitable when humans come together to find new ways to make money. You would think we would have learned our lesson. But why do you think that, looking at human history? It is said that greed and fear are the main drivers of financial wealth.
If you look at these incidents, you will find that they follow the same path as many financial failures of the past. Insufficient or non-existent checks by lenders, shareholders and other stakeholders. Short-term borrowing and long-term lending. These factors are all present in these failures as in most human activities. This is the only thing we can be certain of and must guard against.
Greed is about to replace fear in the cryptocurrency world. As regulators try to protect the public, fear is decreasing and the willingness to participate is increasing. Here are some examples:
- The creation, in 2022, of the European Union Markets in Crypto-Assets (MiCA), a framework to maintain financial stability.
- Allocation of Responsibilities for Cryptocurrencies Between the Securities and Exchange Commission and the Commodity Futures Trading Commission
- Bitcoin and Ethereum Exchange Traded Funds (ETFs) Approved and Launched
- And the entry of traditional suppliers such as Blackrock and JP Morgan
Why, after all the market devastation, does growth seem set to continue? The reason is that bitcoin and other crypto-based trading instruments continue to demonstrate latent and inherent demand. The bitcoin blockchain itself has not been the source of a scandal (rather, the operational ecosystem surrounding it has) and, in fact, its intrinsic value has continued to reflect a store of value. In other words, regulation is beginning to protect a market that is ready to move from early adopter to true mainstream.
Central Bank Digital Currencies
Central bank digital currencies will continue to slowly develop to meet some consumer demands. This will take a long time. It seems that some central banks are downright reluctant to engage in the CBDC space. Many in traditional finance have been vocal in their criticism as privacy and control issues have been politicized. Time will tell what the future developments of CBDCs will be, but we are not hopeful that there will be any major developments in the near future. As with all things government, this will be a slow and painful process.
Criminal use is increasing
In 2023, the FBI’s Crypto Fraud Report noted the growth of cryptocurrency crime. Complaints in the United States have increased by almost half since 2022. Losses in 2023 amounted to $5.6 billion, an increase of 45% compared to 2022. They point out that the characteristics of cryptocurrencies that are attractive to many users are also the same reasons why criminals are increasing their use.
Despite this increase in criminal use, we remain optimistic about the growth of cryptocurrency trading, fueled by political reasons. In many countries, these instruments will represent a way for citizens to avoid a risky banking system and currency, while continuing to participate in the global economy.
But, for all that is explained above, buyers should beware.
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- This blog post represents the views of the authors and not the position of the LSE Business Review or the London School of Economics and Political Science.
- Featured image courtesy of Shutterstock
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