Opinion: Cryptocurrency may have found its ‘Goldilocks’ moment; understand

Sixteen years ago, I used to joke that the financial system needed a “Goldilocks crisis”—a shock that was hot enough to force investors and regulators to wake up and see the rising risks in credit markets, but not so hot point of making the entire system burn out.

Unfortunately, at that time, the crisis did not occur; instead, credit derivatives and subprime mortgage loans continued to explode until they triggered the 2008 crisis, which nearly “burned” the financial ecosystem (until central banks arrived with the extinguishers of quantitative easing).

But the intriguing question today, amid another boom in financial innovation, is whether that Goldilocks moment has arrived for digital assets. The cryptocurrency industry has recently exploded as dramatically as credit derivatives — and many investors are as clueless about its workings as they were about secured debt obligations in 2006.

But this month we experienced “one of the biggest catastrophes cryptocurrencies have ever seen,” as Ran Neuner, a prominent cryptocurrency enthusiast, recently admitted. Most notably, Terra and Luna, the two so-called “algorithmic stable coins”, imploded, generating losses of $50 billion in three days. Wow!

Some now claim (or hope) that this shows that cryptocurrency is set to burn out completely, as the industry has failed to live up to its promise to offer a reliable wealth reserve or truly efficient payment mechanisms.

Maybe it will. The $2 trillion global cryptocurrency market has already shrunk by around 30% in value, and if a crisis now hits the $80 billion tether stablecoin (which is entirely possible), it will shrink even further. But if you think (as I do) that the crypto revolution has a core of potentially valuable ideas around blockchain technology, it’s silly to demand a Chinese-style ban.

Yes, Luna has always looked crazy, as respected cryptocurrency experts such as finance professor Alex Lipton warned last year. But Lipton still thinks blockchain can transform industries like foreign exchange businesses and carbon markets, while some stablecoins have payment utilities.

The $50 billion question is whether key actors and policymakers can now embrace reform to eliminate the bad, while retaining some of the good. Can a Goldilocks pattern occur?

It is not clear. But there are five key questions investors should look at to determine the answer.

The first is whether industry language becomes less confusing. Consider “stablecoin” (stablecoin). This word is currently used to trade a variety of different practices, from algorithmic currencies (which are actually more like a synthetic derivative) to USDC currency (which is more like a narrow mini-bank). This obfuscation needs to change.

Second, regulators need to expand their oversight. In the United States, tokens that act as derivatives or mutual funds are best overseen by the Commodity Futures Trading Commission or the Securities and Exchange Commission. Currencies that function as mini-banks are best monitored by the Office of Comptroller of the Currency (OCC). (Circle, which issues USDC coins, is now in active discussions with the OCC for just that.)

Third, if regulators get involved, they should require stablecoin issuers to provide detailed, audited statements about their assets and impose large reserve requirements. That sounds obvious. But notably that is not what Tether, the largest stablecoin issuer, has done.

Fourth, regulators must require cryptocurrency exchanges to maintain basic listing standards. And finally, clarity is urgently needed regarding custody, as exchanges are not only acting as platforms to close deals, but often also hold client assets.

This oft-ignored concentration of power mocks the decentralization mantra that supposedly drives the cryptographic dream (and, as I recently noted, is just a contradiction in the mythology of the creation of this sector).

But it also creates a practical risk: failure can trigger panic in the market. Some small jurisdictions outside the US have custody rules that protect investors if an exchange fails. Not so at the federal level in the United States, as Coinbase executives were forced to admit to investors last week. This definitely needs to change.

These ideas are not even remotely revolutionary; similar principles have already been imposed on other innovative areas. Indeed, many were clearly presented in a report issued by the President’s Working Group on Financial Markets seven long months ago, which called for “urgent” legislation to address the rising risk.

But since then Congress has notably failed to act, despite it being a rare topic of bipartisan interest. Most major cryptocurrency players also shrugged off the issues. For example, even though the issuer of Tether was fined for accounting misconduct, investors continued to use the coin.

Hence this question about Goldilocks. If industry and policymakers react now (belatedly) to being burned for adopting a sensible framework, the world can finally see if cryptocurrency can become anything more than a fringe wild casino, with real uses. Otherwise, expect more scandals, shocks and suffering for investors. In my opinion, the jury still doesn’t know which scenario prevails.

Translated by Luiz Roberto M. Gonçalves