March 2023 was one of the worst months for the banking industry in recent memory, and while much of the media coverage has focused on the failure of Silicon Valley Bank (SVB) and Credit Suisse, this turmoil has obscured a smaller, more interesting story: the role of cryptocurrency in the recent bank failures. For smaller banks, which in recent years have moved into crypto banking, the collapse of crypto led to massive losses—in fact, the bankruptcy of Signature Bank constituted the third-largest American bank failure of all time. The breakdown of these banks has set off a cascade of losses for investors and bank users across the country. Clearly, in a world where crypto is moving from a niche internet phenomenon to a major player in global finance, what’s bad for crypto is bad for the economy. As an incredibly risky collection of assets, crypto has the potential to cause a massive economic collapse, similar to the 2008 financial crisis. Thus, cryptocurrency must be heavily regulated and separated from the rest of the economy.
Ironically enough, cryptocurrency was founded as a protest against the risky, overleveraged system that caused the 2008 crash. Originally, it was a way to create online currencies (made possible by advanced cryptography, hence the “crypto” prefix). Since then, this supposedly simple system has become incredibly complicated, with crypto now seeming more like an incredibly risky series of stock exchanges and scams, rather than a collection of decentralized currencies. In less than two decades, the financial system has attached itself to these virtual currencies, built on risk, leverage, and unreliable companies. But unlike stocks, cryptocurrencies have no tangible value (while a stock may be volatile, it still represents partial ownership of a real company). No year demonstrated the inherent instability of the modern crypto system as well as 2022. Despite the image of crypto as a niche subfield dominated by jokes and NFTs, the trillion-dollar impact that its collapse had on the economy highlights its growing influence in the financial system.
At its peak, in 2021, the industry was worth $3 trillion, before dropping to $1 trillion by August 2022. The sharp decrease in the industry’s value was caused primarily by recent increases in interest rates that were intended to combat inflation. As a system dependent on the constant influxes of new money and ever-increasing prices, once interest rates started to rise and crypto prices started to fall, the economy faced chaos. First, the smaller and newer companies began to fail. Companies such as Celsius, which promised massive returns on billions of dollars of customer deposits, were forced to file for bankruptcy, losing their customers billions and undoing previous perceptions that crypto is safer than traditional banking. Then, in November 2022, the other hammer dropped in a story of stunning fraud and negligence. FTX, a major crypto exchange that had billions of dollars in deposits, failed after what was essentially a bank run, with panic about the company’s finances causing depositors to attempt to withdraw money that FTX had lost. The charismatic leader of FTX, Sam Bankman-Fried, who had months earlier been seen as a progressive and responsible industry leader, was revealed to be incompetent and negligent. This scandal lost crypto investors billions of dollars, but it also revealed a fundamental truth about many crypto companies: they are gambling in their customers’ investments without a safety net. But in lacking government oversight, it is unsurprising that crypto companies failed their investors.
Past recessions highlight the dangers of allowing simultaneous limited regulation and speculative investments. During the 2001 recession, known as the collapse of the ‘dot-com bubble,’ venture capitalists and investment banks poured money into upstart tech companies without the necessary due diligence to determine whether these companies were actually stable or profitable. But when interest rates rose, this stream of easily available money slowed to a trickle, causing the ubiquitous failure of new startups, and bankruptcy of the companies that had invested in them. A similar, more nefarious dynamic helped to cause the 2008 recession. In this second crisis, the offending assets were “subprime mortgages”, which had been financed by institutional banks and given out in a predatory manner to millions of Americans. The basis of these risky loans was the low interest rate environment in which they were created. But inevitably, rates rose, causing the bankruptcy and collapse of major financial players, and the almost destruction of the U.S. economy.
The common denominator between these two recessions: excessive risk. Meanwhile, regulators fell asleep at the wheel, only responding to the crisis after major damage. If the proper precautions are not taken, the dynamics that caused these two previous disasters may rear their ugly heads again in the context of crypto, causing unknown damage to the American economy.
Cryptocurrencies are incredibly volatile, and their incursion into the American financial system puts the health of the entire economy at risk. To combat this threat, lawmakers must modernize existing regulations to properly combat bad actors and excessive risk. For one, it is currently unclear which regulatory agency, if any, has jurisdiction over cryptocurrency in the United States. The Securities and Exchange Commission (SEC) is the most obvious choice, having recently led a major investigation into Coinbase, a crypto exchange platform. But despite the agency’s efforts to regulate crypto, the SEC’s authority is often challenged due to ambiguity in the legal definition of “securities.” Here, Congress could step in and give the SEC the authority to limit the fraud and manipulation that currently runs rampant in the crypto market. Alternatively, the Federal Trade Commission, which traditionally regulates antitrust cases, could step in to prevent crypto consolidation. In more serious cases, the Department of Justice must also get involved to make it clear that scams and negligence are punished appropriately.
There is also another side to this regulatory coin: the insulation of the broader financial system from the dangers of crypto. In the United States, both the Federal Reserve and Congress could take proactive steps to actively monitor crypto assets, like they have for traditional banks in the past. Until 2018, banks were regulated by the post-Great Recession Dodd-Frank Act, which enacted landmark consumer protection standards and gave financial regulators a much broader mandate when dealing with banks. Since its rollback, however, smaller banks such as SVB or Signature were regulated much more lightly, allowing them to make risky, unexamined investments into crypto. A modern-day Dodd-Frank would both increase normal bank regulation and focus on newer phenomena, such as crypto. By taking an aggressive approach to the incorporation of crypto into the financial system, financial regulators can resolve unambiguity on crypto regulation, and prevent a future economic meltdown tied to this new currency.
In the world of finance, risk and profit are often intrinsically related. And cryptocurrency, for all of its faults, is incredibly, undeniably profitable. Recent events in the crypto world, however, have shown that risk is not always worth the glory. At its foundations, crypto is a system built on digital currencies with no tangible underlying value, so when real-world uncertainty starts to rise, the uncertainty in the crypto world is orders of magnitude higher. Clearly, crypto is fundamentally incompatible with the broader financial system, and it must be regulated aggressively.