This crypto winter is warm compared to the next one

How in the world did we allow cryptocurrencies to become a $10 trillion industry before examining the systemic risks it creates? Cryptocurrencies, derivatives, exchanges and the leverage created to support them are now nearly half the asset size of the entire US banking industry.

So we’ve really made a big breakthrough by having a crypto winter now before this unregulated industry grew even bigger and subsumed other financial markets.

What should we have learned from this? As Bill Gates correctly notes, everyone is beginning to understand that the current version of cryptocurrencies relies to some extent on the theory of greater fools. Buyers expect the price to rise solely because they will be followed by more buyers with the same expectations. No such investment scheme has ever succeeded, so the chances that crypto in its current form would just run off the field and boost football were never realistic. Larry David’s ironic Super Bowl ad predicting that crypto would not work was more prophetic than the sponsors expected.

Our “happiness” has been the result of five economic developments. They include (1) a growing skepticism in floating rate cryptocurrencies as prices have fallen; (2) the collapse of several do-it-yourself stablecoin regimes; (3) a growing understanding of the risks inherent in unregulated, decentralized financial technology (Defi) where there is no safety net; (4) concerns about the sanctity of client assets held by crypto exchanges; and (5) the general erosion of the economy now characterized by 8.6 percent inflation, supply chain disruptions, and the effects of the war in Ukraine.

Those who had been fascinated by all things crypto have thankfully now been shocked into economic rationality. It has taken 13 years to seriously evaluate the impact of the collapse of a crypto coin or exchange, but here we are. Crypto buyers were warned and may have assumed the risk that the price of a floating rate cryptocurrency could collapse without any underlying intrinsic value to support it or set a floor. When small investors use chat rooms and social influencers as their primary source of financial advice, and invest money they can’t afford to lose, you don’t have to be a prophet to predict tragic results. Remember: This is a universe of investors who bought Jesus Coin.

Stablecoins were created by a wide variety of tech personalities who are often unfamiliar with financial systems or regulation. They were intended to stabilize the value of cryptocurrencies by “backing” them as money market funds with tradable assets such as US Treasuries. Algorithmic stablecoins claimed to be able to operationally maintain their stable value of $1 without such assets in reserve. But not surprisingly, all this has turned out to be an illusion analogous to a street corner game or three-card monte.

We only now seem to be finding out that in a largely unregulated stablecoin world, “backed” didn’t always mean holders were entitled to their money in a meltdown. So even if a particular unregulated stablecoin had reserves of tradable assets to cover 100 percent of the coins being issued, those assets may be available for everyone creditors in a bankruptcy. Also, most crypto exchange customers likely did not understand that, as Coinbase recently explained, crypto instruments are not always held as securities are held by a stock brokerage and may be subject to claims from general creditors.

Even in the best cases, holders will likely have to deal with endless litigation that will delay any payout as legal processes drag on for years.

For example, the Securities Investor Protection Act does not consider cryptocurrency, which suggests that the determination of the right to crypto assets in a brokerage bankruptcy will involve battles between and among cryptocurrency customers and all potential other creditors. What would happen if only 10 percent of Bitcoins allegedly held by a brokerage for clients are actually present? Can a bankruptcy trustee reverse crypto transactions such as preferences or fraudulent transfers?

As decentralized finance grows, for better or for worse, many innovators have adopted a “better to ask for forgiveness than permission” philosophy. People with uncanny skills in technological innovation often fail to foresee unintended consequences in the real world of finance. Think “Ready, guy, aim.”

The hissing sound you hear is air leaving the crypto bubble. Banking, securities and commodity regulators must install an organized supervisory structure for this emerging financial market before the bubble expands further and truly bursts.

The crypto world hypnotized lawmakers and regulators into a decade of inaction as it grew exponentially. But there is still time for them to come to their senses, modernize financial regulation and regulate cryptocurrencies as the money and securities they pretend to be.

Perhaps then crypto can continue towards a more lasting future. With the economy simultaneously reeling from the aftermath of the COVID-19 pandemic, inflation and global conflict, crypto investors should prepare for a difficult winter for now. But it won’t be nearly as tough as the next one if the crypto-orgy continues without smarter investors and better oversight.

Thomas P. Vartanian was general counsel for FSLIC and is executive director of the Financial Technology & Cybersecurity Center and author of “200 Years of American Financial Panics: Crashes, Recessions, Depressions and the Technology that Will Change it All.” Stephen P. Harbeck served as president and CEO of the Securities Investor Protection Corporation from 2003 to 2018. They handled failure, liquidation and consumer protection in the collapse of hundreds of banks, S&Ls and brokerage firms.