This was published on the 8th Dec 2021 in Times of India
It is crypto season around the world. Some countries are banning private
cryptos (China), some enthusiastically embracing it (El Salvador), some moving
towards wary acceptance (US) and yet some more are cautiously examining the
landscape without foreclosing options (India).
As a fascinating new frontier of technology, the potential of crypto assets are
immense — financial inclusion, tokenisation of illiquid/physical assets (like
property and art), cheaper/faster payment systems. Alongside the immense
potential, there are emerging areas of risks such as money laundering, terror
finance, disturbing global financial stability, that need careful
consideration.
Cryptos are large, and growing
Source: IMF
Through 2021, the total market capitalisation of crypto assets nearly doubled. At $2 trillion, it is still smaller than mainstream asset markets like equities and credit globally. But the pace of growth, despite intense volatility in the asset, demonstrates its rapid socialisation and acceptance.
Cryptoisation: Potential loss of sovereignty
Independent conduct of fiscal and monetary policies are a key feature of
national sovereignty. It is not uncommon, however, for countries with weak
macros to lose control over some or many aspects of the two.
There are dozens of African and Latin American countries, for example, where
the US dollar has been (and is still) the default primary currency in use.
Zimbabwe and Venezuela, in recent times, represent examples, where there are
widespread questions on the ability of the state to govern, hence monetary and
fiscal policies are outsourced to foreign or supra-national entities.
In some ways, it is similar to private residents raising private
militias for security, as a result of a breakdown of confidence in the state’s
monopoly over violence.
But “dollarisation” of domestic economies has a serious impact on monetary and
fiscal policy settings. Domestic central banks lose the ability to influence
interest rates and manage liquidity in the economy, if the dominant currency is
issued by a foreign government. Further, the domestic central banks lose their
seigniorage revenues — difference between the 0% interest on each currency note
issued and the same deployed by the central bank into interest-bearing domestic
financial instruments (like bank reserves, government securities etc). In
effect, dollarised countries end up importing the monetary policy of the US Fed
and losing seigniorage revenues to the US Fed.
Private cryptos as “currency” are rightly feared to have similar potential
impact. Just as “dollarisation” effectively results in the economy importing US
monetary and fiscal policy, “crypto-isation” will mean importing the monetary
policy engendered by a privately owned currency. The larger the developed
ubiquity of cryptos as a medium of exchange, the less influence will domestic
monetary policy tend to have on monetary aggregates like interest rates, money
supply, capital flows.
Cryptos are structurally global: Challenges to localised regulation
Most private cryptos, like the popular Bitcoin, have a public blockchain
ledger. Transactions on Bitcoin are untethered from a specific financial
institution or country, a peer-to-peer transfer can be made as long as someone
has an internet connection and a Bitcoin wallet. There is no central repository
in any one country that can be used to shut down or regulate Bitcoin activity.
The near-tautological incapability to control cryptos engender governments to
completely ban them. Bans too, because of the same characteristics, are
difficult to enforce. Ergo, global coordination is a sine qua non for effective
regulation of cryptos.
National regulations have signalling effects, but not always in the right
direction
Recently, rumours of the new crypto bill in India proposing to ban private
cryptos sent crypto prices tumbling across all Indian exchanges, completely
disconnected from price movements elsewhere in the world.
The Kimchi Premium, referring to the persistent premium of Korean-traded
Bitcoins over US-traded ones, reflects both limits to the global free-trading presumptions
as well as potential of local regulatory interventions on cryptos. But while
local regulations can influence prices in a specific country/market, crypto
exchange trading happens primarily through entities in offshore financial
centres.
Source: IMF Global Financial Stability Report, 2021
In other words, independent national regulatory actions merely drive capital flows and trading outside to offshore financial centres. China, in a series of measures starting in 2017, has banned private crypto ownership and trading in mainland China.
But the impact of that has been a shift of Chinese crypto activity from
exchanges to per-to-peer Decentralised Finance (DeFi), which it allows users to
trade sans any exchange or intermediary, making it harder to ban/control.
China remains the largest centre of crypto activity in Asia, although the bulk
of it is now in the form of DeFi. DeFi, given its architecture, has less
oversight possible from regulators; and doesn't have the same KYC/AML
obligations of regulated exchanges (and market participants). Net effect: A
national ban has moved cryptos towards riskier, less-monitorable avatars.
Need for Crypto Bretton Woods
The end of World War II, with its horrific human and physical costs, led to the
creation of Bretton Woods institutions. The aim was to promote international
economic cooperation to rebuild a better economic architecture via new
institutions, rules and globally accepted common norms.
Eight decades on, the report card can be judged to be quite positive. Expansion
in global prosperity (even if unequal), especially in Asia, massive increase in
global trade, cooperative mechanisms like FATF to tackle financial crimes, it’s
an impressive record.
Cryptos present a new requirement for a Crypto Bretton Woods today. It’s a
feature of the asset that it spans geographies, is nimble enough to find new
variations, and if left unregulated, can wreak havoc at weaker economies. Above
all, it has natural immunity against isolated national regulations. It also
holds great promise as a technology frontier. A new set of globally coordinated
rules are urgently needed, so that we harness the promise while mitigating the
real risks.
