Resist calls to tighten crypto regulations after FTX. Just let it burn

One of the main supposed advantages of cryptocurrencies is that they provide financial tools to those who do not trust the banks or the governments that regulate them. Such a position may seem reserved for eccentrics, but there are, in fairness, legitimate reasons to be suspicious of the competence of lenders and, particularly in some parts of the world, the motives of their supervisors.

Decentralized finance, or DeFi, does what it says on the tin and cuts out the middleman. If, for example, you own Bitcoin, you will have a public Bitcoin address associated with a private key that you can use to make and receive payments. Which is great until you forget the key and your bitcoin is lost forever. It happens. A lot.

Cryptocurrency exchanges, as you can imagine, allow people to trade cryptocurrencies. But they also make it easier to hold them. You can open an account with the exchange. Technically, you don’t own Bitcoin, Ether, Dogecoin or whatever. You own a claim on the exchange for the amount they hold on your behalf.

It’s much more convenient, but it’s also exactly how a deposit of boring old fiat currency works at a boring old lender. If you have a deposit in a bank, it means the bank owes you money; if you have a deposit in a cryptocurrency exchange, it means that the cryptocurrency exchange owes you money. Who would you rather lend your money to: Some guy called Bankman-Fried who doesn’t seem to know how to brush his hair, or NatWest?

Exchanges also allow you to trade directly on the exchange, which makes them a bit like brokers. Some even offer leverage. And, as we now know, FTX had what looks like an uncomfortable relationship with its trading arm Alameda Research – a setup reminiscent of the former proprietary trading desks of major investment banks.

As DeFi grew and the value of cryptocurrencies soared, it attracted more speculators who were less concerned with the philosophical underpinnings of the technology and more about making money. The result was less emphasis on the “From” and more on the “Fi” and the system grew to look like what it sought to disintermediate.

It now seems that the whole edifice is collapsing under the weight of its own contradictions. So if DeFi is starting to look like traditional finance and smell like traditional finance, should it be regulated like traditional finance?

Yes, according to Sir Jon Cunliffe. In a speech on Monday, the Deputy Governor of the Bank of England argued that crypto exchanges should be more regulated before they become a risk to the financial system. He specifically cited the fact that services like FTX bundle services that traditional financial institutions have to separate.

Michael Barr, vice chairman of oversight for the US Federal Reserve, and Gary Gensler, head of the Securities and Exchange Commission, have been making very similar noises across the Atlantic in recent days. The FTX collapse is the kind of event that leads to demands that something be done: increased regulation is something, so it should be done.

It is better to resist such constraints. It is worth bearing in mind that thousands of retail investors have, in some cases, lost huge amounts of money. Small adjustments may be needed to ensure better consumer protection. However, the FTX implosion is the best possible warning that these are not “widows and orphans” assets.

The key question here is whether turbulence in the cryptosphere poses a systemic risk that threatens broader financial stability. Fingers crossed, but so far the signs are good. One of the largest cryptocurrency exchanges in the world has, for all intents and purposes, instantly vaporized. Some other crypto companies are suffering from the fallout. The value of most cryptocurrencies has taken a hit. But the contagion seems contained.


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