Reviews | Crypto is money with no purpose

Prior to the FTX crash, crypto lobbyists and many politicians were loudly complaining that crypto trading was being unfairly denied full participation in banking and finance by overly cautious regulators. We should thank our lucky stars that someone used common sense.

Admittedly, crypto trading is very similar to the forms of financing we are all familiar with. It is made up of things called “exchanges”, “brokers”, “lenders”, “deposits”, and “hedge funds”. The financial press breathlessly reports on their every move. Crypto also carries the particular mystique of blockchain, which has allowed traders to treat critics like anti-innovation Luddites.

Yet, in the most crucial respect, the crypto market is not at all like traditional finance. Finance and financial services exist for a purpose that crypto trading lacks. As Nobel Prize-winning economist Robert Shiller once wrote, “Finance is not about making money per se. . . it exists to support other goals, those of society.

Finance helps businesses, individuals, and governments collect, save, transmit, and deploy money for socially and economically useful purposes. Banks allow savings to be pooled and turned into loans for orchards, solar farms, automobiles, small businesses and homes. The securities market serves the needs of large corporations and government to raise capital and helps make the banking process more efficient by spreading risk widely. Insurance and derivatives markets help manage risk. Participants in finance seek to maximize profit, of course, but within the context of a larger social and economic objective.

Contrast that with the aimlessness of the crypto trading system. Crypto trading is a game that uses finance as a subject. It emulates finance the way the board games Risk and Monopoly emulate warfare and real estate investing. But it’s a devilishly complex and dangerous game born in the age of big data. The “finance” emulated by crypto gambling is the type that society wants the least: highly leveraged and opaque. It uses all the weapons of modern financial engineering and all the tricks of commercial culture to increase returns. This is the kind of finance that creates crises.

Crypto trading is also gambling. Players bring money – a fiat currency – into a casino or online game of chance, bet on the results, and convert the winnings or losses into cash. The closed-loop crypto trading system works the same way. Crypto trading cannot serve the productive purpose that defines finance. It does not perform any intermediation function to help develop the economy or improve society. Crypto trading is, as George Costanza of “Seinfeld might have said,” funding next to nothing.

If crypto trading were to be integrated into traditional finance, the risk of systemic contagion would be real. Crypto coins would be part of investment, retirement and retirement portfolios, which are essential parts of people’s financial support structure. Unexpected connections and hidden leverage would recreate the kinds of systemic vulnerabilities that led to the 2008 financial crisis. All of this would be exacerbated by the “stateless” status of much of crypto trading and the inability of current regulatory structure to deal with offshore and virtual crypto trading providers.

More importantly, crypto trading would inevitably benefit, like other parts of the traditional financial system, from the ever-growing role of the Federal Reserve as a lender of last resort.

None of this sounds like good politics. Instead, crypto trading should be separated from the traditional financial system as completely as possible. Banks, brokerage firms, investment advisers, fund managers and pension funds – any entity or affiliate that is part of the regulated financial infrastructure – should be prohibited from participating in, supporting or adding a leverage to crypto trading in any way. This will likely slow or even reverse the growth of crypto trading. Considering the game’s many downsides, that’s a good thing.

No crossing means no crossing. While individuals should be allowed to play in both fields, institutions must choose whether to participate in traditional finance or crypto trading. We cannot have struggling crypto trading companies or facilitators causing real crises by liquidating assets held in banks and brokerages to cover losses. Nor can we have affiliated entities operating on both sides of the divide, as there is a long history to suggest that risks cannot be effectively separated in jointly controlled enterprises.

When you have a hammer, everything looks like a nail. This is why everyone in Washington seems to think that federal financial services regulators are the natural supervisors of crypto trading. It’s wrong. Crypto trading should be regulated for what it is – a form of gambling that mimics finance – not what its proponents tell you.

This means that the separate crypto-trading system should be excluded from financial services regulation by the Securities and Exchange Commission, Commodity Futures Trading Commission, bank agencies and the Consumer Financial Protection Bureau. Consumers will not be unprotected. State laws specifically regulating crypto activities, such as New York’s Binary License Act, will continue to apply, as will fraud and consumer protection laws. The jurisdiction of the Federal Trade Commission over any unfair and misleading advertising or other practices engaged in by crypto traders and their facilitators shall not be affected. Where these laws prove inadequate, state legislatures and Congress can add targeted consumer protections specific to crypto trading. Expanding the scope of state gambling laws to cover crypto trading is also a possibility.

The best part about separating crypto trading from traditional financial services? The Fed will not need to act as a lender of last resort for the crypto markets. With no connection between the crypto trading system and the real financial system, there will be no contagion and no systemic risk to manage. The Fed’s reaction to the next crypto crash will be one big yawn. It’s good when the alternative is metastasized crypto trading causing the next financial crisis.

Mr. Baker is a Senior Fellow at the Richman Center for Business, Law and Public Policy at Columbia University.

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