Navigating Crypto’s House of Cards

Technology Policy Web3 and Crypto

Navigating Crypto’s House of Cards

Commentary
Posted on: 14th November 2022
Jess Northend
Policy Lead, Science and Innovation Unit

In recent days the headlines have zeroed in on crypto after FTX – one of the largest crypto exchanges – faced ruin. In the latest twist, FTX CEO Sam Bankman-Fried resigned as the firm filed for chapter 11 bankruptcy in the US. Crypto infamously operates outside almost all regulatory perimeters, leaving many to question what the FTX fallout means for crypto’s long-term future – and that of the centralised exchanges that act as the gateway to crypto trading for many retail investors. 

FTX saw a collapse in confidence after reports emerged that an affiliated research company – known as Alameda Research - was holding FTX’s FTT tokens as collateral, rather than independent assets. This swiftly led a separate crypto exchange, Binance – and others - to dump FTT holdings, subjecting FTX to the digital asset equivalent of a ‘run on the bank’. User withdrawals were subsequently frozen as FTX sought financing to prop up the exchange. Binance briefly agreed to bail out FTX, before withdrawing the offer. At the time of writing, FTX is seeking external capital to save it from collapse. 

At the heart of FTX’s woes is the fundamental problem with unbacked crypto – it is a purely speculative asset class. Unlike mainstream finance – which, at its most fundamental level, underwrites investments in productive capacity – crypto is based almost entirely on faith. Few of its supporters are able to point to concrete use cases for crypto innovation in finance that add value to the ‘real’ economy. 

As a result, increasingly complex webs of tokenisation are being spun, with little underlying value – beyond faith that crypto’s overall market cap will continue to climb over the long-run.

FTX’s collapse may result in over 1 million investors in the US alone losing (at least a proportion of) their investments. This includes several institutional backers including BlackRock and the Canada-based pension fund, the Teachers’ Pension Plan. While mainstream finance still has limited exposure to crypto (analysts suggest exposure is likely around 3-6%), the three major US stock indexes all closed down on Wednesday.

Despite FTX’s woes, the technology that underpins crypto – Distributed Ledger Technologies (DLTs) like the blockchain – has huge promise. The success story of this world centres on those building this underlying infrastructure – and real-world use cases – that is likely to form the backbone of our digital future. Policy makers should forthrightly support innovation and entrepreneurship on the broader applications of the technology –security, digital IDs, voting, and logistics could all be transformed.  

As we’ve argued previously, crypto isn’t going anywhere quickly and we’re likely to see future bubbles. In the meantime, policymakers should focus on protecting consumers against its most pernicious elements – by limiting institutional exposure and spillovers, enforcing minimum reserve levels for crypto exchanges, and nudging crypto to clean up its dire emissions record. Alongside action on stablecoins – a core area of concern globally – there’s plenty to keep regulators busy as they try and tame crypto. 

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