Rethinking the Future of Crypto: Challenges, Missed Opportunities, and the Path Forward
Crypto has long depended on crafting new narratives to draw in fresh investors, but these narratives often reveal conflicting ideas about what crypto assets are or should be.
The initial vision of creating a decentralized payment system through cryptography hit a major setback in 2017 when blockchain networks became overwhelmed, causing transaction fees to spike. This led to a shift towards the concept of “digital gold,” which triggered a crypto boom. At its height, nearly 20% of U.S. adults and 10% of Europeans were investing in crypto, driving the market’s total value to €2.5 trillion.
However, this notion of crypto assets being an easy way to wealth, or a reliable store of value unraveled during the “crypto winter” that began in November 2021. Prices plummeted, wiping out around €2 trillion in value within a year. This left many investors unprepared, with estimates suggesting that about 75% of Bitcoin users incurred losses on their initial investments.
Evolving Narratives: From Decentralized Payments to Centralized Speculation
Cryptocurrency was initially built on the promise of replacing trust with technology, promoting the idea that “code is law,” where self-regulation would eliminate the need for intermediaries. This would, theoretically, enable financial transactions to operate without trusted third parties.
Yet, this idealistic narrative often masks the reality. Unbacked cryptocurrencies have not taken on the traditional role of money and have strayed from their decentralization goals, increasingly relying on centralized solutions. Over time, they have morphed into speculative assets and tools for bypassing financial regulations, such as capital controls and sanctions.
Blockchain’s Technical Limitations
One of the primary reasons cryptocurrencies haven’t fulfilled their promise as an alternative form of money is their technical inefficiency. Public, permissionless blockchains used for crypto transactions are often slow, expensive, and inefficient. They are hindered by the “blockchain trilemma,” where balancing security, scalability, and decentralization is impossible.
Cryptos like Bitcoin, which rely on proof-of-work (PoW) validation, also have significant ecological drawbacks. As public authorities prioritize environmental commitments, the large carbon footprint of PoW cryptos may become an issue. Beyond environmental concerns, PoW systems are impractical for large-scale use, with Bitcoin only processing up to seven transactions per second, often accompanied by high fees.
While alternative methods to address blockchain’s technical flaws have emerged, such as off-chain transactions via third-party platforms, they compromise core crypto principles like security and immutability. Additionally, the lack of central governance in public blockchains poses operational risks, such as the inability to manage incidents or correct code errors.
Volatility and Instability
A major issue with unbacked cryptos is their extreme price volatility. Without intrinsic value or backing reserves, they are prone to wild fluctuations, making them unsuitable as stable payment methods. For instance, Bitcoin’s volatility can be up to four times higher than that of stocks or gold.
The Increasing Centralization and Its Risks
The shift away from decentralization toward more centralized structures, often without regulatory oversight, has resulted in substantial costs and contradictions within the crypto ecosystem.
Reintroducing Traditional Financial Sector Vulnerabilities
Centralized crypto intermediaries, many of which remain unregulated, have brought back classic financial sector vulnerabilities. Stablecoins, which play a key role in decentralized finance (DeFi) markets, exemplify this. Problems with prominent stablecoins have contributed to significant downturns in the market, and their inherent risks—similar to those found in money market mutual funds—have led to liquidity issues, runs, and broader market instability. The collapse of the crypto exchange FTX further highlighted the dangers of inadequate risk management and mishandling of funds, shaking investor confidence in the ecosystem.
Similar vulnerabilities have been exposed by regulatory actions, such as the U.S. Securities and Exchange Commission’s recent charges against Binance, which accuse the company of deceptive practices and evasion of the law. These cases underline that the technology behind crypto does not eliminate financial risk—it merely shifts it. Whether recorded on paper, in a centralized system, or on a blockchain, financial risks like credit, market, and liquidity risk persist, and poor management can lead to failure.
Ties to Traditional Financial System
The second contradiction lies in crypto’s growing ties to traditional finance. Many banks, big tech firms, and even public sector entities are exploring ways to integrate crypto into their operations. Companies like Meta and Twitter are looking to offer crypto-based payment systems, while banks such as Silvergate and Signature have faced significant risk exposure from crypto-related deposits, with both banks recently experiencing failure. These cases demonstrate the reliance of crypto service providers on traditional financial systems for fiat money settlement.
Moreover, the crypto industry seeks to access the regulatory protections of traditional finance, as seen when Circle, the issuer of USD Coin (USDC), attempted to gain access to the Federal Reserve’s overnight repurchase facility. This reflects a broader strategy in which crypto, while presenting itself as an alternative to traditional finance, increasingly relies on its infrastructure and protections.
Public Sector Response: Supporting, Regulating, or Innovating?
The public sector’s approach to crypto-assets can be summarized into three main strategies:
1. Resisting Public Backing for Cryptocurrencies
First and foremost, it is crucial to resist the urge to provide public backing for crypto-assets. While allowing stablecoin issuers to hold reserves at central banks might seem appealing, such a move could have serious unintended consequences.
Giving stablecoins access to the central bank’s balance sheet would essentially delegate the issuance of central bank money to private entities. If stablecoin issuers were able to place their reserves in risk-free central bank deposits, it would remove investment risks typically borne by stablecoin holders. This could also create a payment method that closely mirrors sovereign money, undermining monetary sovereignty, financial stability, and the integrity of payment systems. For example, large tech companies could use their extensive customer bases to drive the widespread use of stablecoins, displacing government-backed currencies. Hence, central banks must remain cautious, preserving control over their balance sheets and national currency systems.
2. Implementing Comprehensive and Appropriate Regulation
Second, regulators should avoid promoting the notion that regulatory oversight can make crypto-assets entirely safe. Instead, the principle of “same activity, same risk, same regulation” should be applied across the board. Regulation should not be used to legitimize flawed crypto models to attract crypto-related businesses.
While some governments are attempting to apply existing financial regulations to crypto-assets, the European Union (EU) has pioneered a tailored framework through the Markets in Crypto-Assets (MiCA) Regulation, which applies to all EU Member States. This regulatory structure draws from existing regulations, like e-money rules, and ensures the extension of key provisions, such as the travel rule, to cover crypto transactions.
Despite progress, more action is necessary. All crypto-related activities, including decentralized finance (DeFi) services like crypto-asset lending and non-custodial wallets, should be regulated. It’s also important to recognize the risks posed by unbacked crypto-assets, which are often speculative. Enhancing transparency, raising awareness about these risks, and addressing the ecological impact of cryptos, especially considering climate challenges, should be key priorities.
Global regulatory cooperation is also essential, as highlighted by the collapse of FTX, which expanded with little oversight. The Financial Stability Board’s (FSB) recommendations on regulating crypto markets need to be swiftly finalized and adopted globally. Additionally, the Basel Committee’s prudential standards for banks’ crypto-asset exposures, including conservative capital requirements for unbacked cryptos, represent positive steps. The EU and other jurisdictions adhering to Basel standards should incorporate these rules into law by the 2025 deadline. However, regulation alone will not be enough.
3. Innovating with Digital Settlement Assets and Central Bank Digital Currencies (CBDCs)
Finally, the public sector should actively foster the creation of stable and trustworthy digital settlement assets. Central banks are already innovating to ensure continued confidence in all forms of money, particularly in the digital age. Currently, physical cash is the only form of central bank money available for retail transactions. As the use of cash declines, its role as a stable monetary anchor diminishes. A central bank digital currency (CBDC) could provide a secure, digital standard and facilitate the seamless exchange between different types of private digital money, ensuring the integrity and unity of the monetary system while preserving monetary sovereignty.
The development of tokenized financial markets may also prompt central banks to update the technological infrastructure for wholesale transactions. This could involve creating a connection between distributed ledger technology (DLT) platforms and central bank systems or developing DLT-based settlement services with central bank digital currencies for large-scale transactions. Central banks are already engaging with the private sector to explore these possibilities.
In summary, the crypto industry’s efforts to grow by intertwining itself with the financial system exposes its vulnerabilities and contradictions, revealing the significant risks and challenges still present in the ecosystem.