Stephen Cecchetti is the Rosen Family Chair in International Finance at the Brandeis International Business School. Kim Schoenholtz is Clinical Professor Emeritus at NYU’s Stern School of Business.
In the aftermath of FTX’s collapse, authorities should resist the urge to create a parallel legal and regulatory framework for the crypto industry. It is far better to do nothing and let the crypto burn.
Actively intervening would lend undeserved legitimacy to a system that does little to support real economic activity. It would also provide an official stamp of approval for a system that currently poses no threat to financial stability and lead to calls for public bailouts when crypto inevitably breaks out again.
Finance is a matter of trust. The loss of trust due to growing failures is already driving the demise of crypto. The market capitalization of the myriad “coins” is down about 75% from its peak in November 2021.
It’s hard to imagine confidence in crypto recovering from the scale and scope of FTX’s failures. Until very recently, FTX was a top exchange and was widely touted as a guide in an industry plagued by quacks. However, FTX has intentionally chosen to locate in a jurisdiction beyond the legal and regulatory jurisdiction of countries with the largest financial systems.
Additionally, reports now reveal that FTX lacked transparency, misused client funds, engaged in related party relationships, had weak corporate governance and accepted phantom guarantees, as well as other dangerous practices.
Simply put, the crypto system as it currently exists is not sustainable. In the absence of clear and easily enforceable property rights, relying solely on private investors to monitor and discipline the behavior of opaque intermediaries has never been safe and effective. There is no prospect of a technological solution to these age-old problems.
The big question therefore is whether authorities should create a new regulatory and supervisory framework that protects property rights and enforces the principles of security and soundness. Worried about further losses from the crypto meltdown, many people are calling for new rules to protect consumers.
Ironically, however, attempts to create a separate structure to regulate and oversee crypto will only make the financial system less, not more, sure.
This is true for two reasons. First, it will encourage banks to both buy crypto assets and lend against them as collateral, making the banking system vulnerable to falling market values. In contrast, even the ongoing collapse of crypto stocks and institutions has had virtually no impact on the well-being of traditional financial markets and businesses.
Second, new rules would result in a migration of financial activity from traditional finance to the even less regulated, but newly sanctioned world of crypto. Crypto and traditional finance are simply combinations of a database and computer code. It would be simple for a bunch of technicians to convert any set of conditional cash flows from one to the other. For example, imagine someone chooses to issue claims on their company as a crypto token rather than conventional equity to take advantage of looser rules on disclosure, accounting, custody, etc.
If new rules are needed, they are those that limit the exposure of traditional leveraged intermediaries to the crypto world.
Banks, dealers, insurers and pension funds should not be allowed to buy and hold crypto or accept it as collateral. Essentially, crypto today is just a multiplayer online video game (like World of Warcraft). If virtually all transactions remain internal to the crypto world with no ties to the real economy, the process could just as well happen on Mars, leaving traditional finance untouched.
The overriding goal of policymakers should be to keep crypto systemically irrelevant. The best way to do that is to let it implode under the pressure of its dangerous and unhealthy business practices. Meanwhile, authorities should constantly report that the crypto is plagued with failures and fraud.
Rather than create a new legal and regulatory framework that legitimizes crypto, we should just let it burn.