Regulation of Crypto Assets - Need for a new Bretton Woods

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.