The Bank for International Settlements (BIS) published a short paper exploring options to address the risk of cryptocurrencies, or as it likes to call them, crypto assets.

He argues that cryptocurrencies present many of the risks of TradFi, but while they are similar, the risks tend to be overstated. These include extensive use of leverage, liquidity and maturity mismatches, and significant information asymmetries.

We would add a comment on maturity mismatches. For example, cryptocurrency lenders have deposits that can be withdrawn instantly, but lend to borrowers for months or years. TradFi may have similar discrepancies. However, because cryptocurrency is interconnected, even on a social/Twitter level, “bank runs” and herd movements are much more frequent, exaggerating the problematic nature of maturity mismatches.

The BIS report highlights that DeFi is often not decentralized because the founders have significant stakes in tokens or others can acquire great influence. It also points out the critical roles of centralized cryptocurrency exchanges as onramps to cryptocurrency. Another observation we have is that decentralized wallets are increasingly enabling direct on-ramps with credit cards which, over time, may partially erode the on-ramp role of exchanges.

Four Ways to Address Crypto Risks

While the BIS report highlights three routes that directly address crypto risks, the report also mentions a fourth. That is to make TradeFi more attractive by lowering the cost of payments or through central bank digital currency (CBDC). However, we would argue that payments is just one application, although it is understandably the one that is most on the radar of the central bank community.

The three direct routes to control the risks of cryptocurrencies are to prohibit, contain or regulate them.

The BIS acknowledges that forbidding it may not be acceptable to free societies. Also, prohibitions can be circumvented and this could inhibit innovation.

For containing crypto BIS stands for Boundary Cryptography, so minimal overlap with TradFi is maintained. As an example of contention, the BIS cites the Basel Committee’s crypto rules for banks; the final version was announced in December. Another example is the SEC’s refusal to allow a spot Bitcoin ETF. However, even if TradFi is protected, there is still the issue of investor protection. And the BIS points to the risk that the credibility of regulators will be undermined if steps are not taken to protect crypto investors.

And that action is likely to be regulation. A common approach is to map crypto activities to conventional activities to apply the same risks and rules. But mapping is not always easy. For example, some jurisdictions will regulate stablecoin issuers as banks, some as payment systems, and some as banks. A second challenge is identifying the entity in a decentralized world. However, it views the starting point as the entity that has control over the protocol.

With the collapse of cryptocurrencies, particularly the collapse of FTX, the cryptocurrency community is poised for extensive regulation. However, politicians may not always be as conservative as central bankers. For example, in the UK, the Treasury this week stressed that it wants to balance innovation with investor protection and avoid “foreclosure of the future”.