The 'crypto boom' may well be regulators' worst nightmare

The 'crypto boom' may well be regulators' worst nightmare
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Goldman Sach’s decision to explore trading of bitcoin and other cryptocurrencies comes as no surprise, given the surge in digital currency prices that far outweighs other asset valuations. Bitcoin has traded over $5,000, up several hundred percent in one year.

The temptation of triple-digit annual returns in digital currencies creates an irresistible urge for Wall Street — and even Main Street investors: One fueled by greed. People chase supernormal profits that appear to present the opportunity for disproportionate returns. No wonder that some 15 new hedge funds have been launched recently to capitalize on what’s being called a “crypto boom.”

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Goldman reportedly has told its clients that bitcoin is worth keeping an eye on because of the amount of money pouring into it. But bitcoin, the biggest and best known of the digital currencies, is an extremely volatile asset.

 

As the Wall Street Journal reported, bitcoin doubled in price and then fell by a third, all in the third quarter of 2017, a stomach-churning ride even by “the virtual currency’s Wild West standards.”

But where there is talk of booms, there are also predictions of bust. One need only remember collateralized debt obligations (CDOs), created by bundling mortgages and other debt instruments, that once looked like a promising investment — until that bubble burst and resulted in the 2008 financial crisis.

Although cryptocurrencies are a drop in the bucket compared with mortgage assets, the pattern is similar — exotic instruments that promise higher returns but are poorly understood even by those who trade in them. We have seen this movie before, and it ends badly.

The ghosts of 2008 may have prompted JPMorgan Chase CEO Jamie Dimon to call cryptocurrencies a “fraud” and to threaten to fire anyone at his firm who traded them.

From a policy perspective, reining in bitcoin may not be as easy as putting regulations in place or even banning digital currencies altogether. For one thing, there is the challenge of trying to regulate something that was created specifically to obviate and bypass regulation.

The best hope here is the Securities and Exchange Commission (SEC), which recently ruled that digital coins fall into the category of “securities,” putting them under the SEC’s authority.

But there is a broader, global issue in regulating cryptocurrencies. Unless governments collectively regulate them, these digital coins will go to the markets that welcome them, and investors will no doubt flock to embrace them there, at least in the short term.

Not surprisingly, China, with its centrally planned economy that is dependent on regulation, is imposing a ban on bitcoins and similar digital currencies. Japan, meanwhile, is issuing licenses for exchanges that deal in cryptocurrencies.

Central banks in countries like Russia and Singapore reportedly are experimenting with digital currencies. The Bank for International Settlements, in a recent report, said central banks may even have to decide whether to issue their own retail or wholesale cryptocurrencies — a “Fedcoin.” The Federal Reserve, meanwhile, has been closely following digital currencies.

There is still a great deal of confusion surrounding cryptocurrencies. While many people have heard of bitcoin and numerous other forms of these digital currencies, few can explain them (as evidenced by the number of articles on how to explain cryptocurrencies).

A simple explanation is that these decentralized currencies operate strictly peer-to-peer for transactions, and can be exchanged for traditional currencies. Cryptocurrencies exist within a level of opaqueness that is difficult for financial authorities to penetrate. That means digital currencies could potentially be put to nefarious uses, such as in money laundering or drug trafficking.

While naysayers point to their bubble-like explosion in valuation, supporters say they are potentially as revolutionary as the internet. The real revolution may actually be the blockchain technology used by bitcoin and other financial, business and even government transactions. This technology uses encrypted entries into a shared database, which helps promote security of these transactions.

Beyond the ability of regulators to impose limits on cryptocurrencies, and even Wall Street’s desire to set its own standards, the real cautionary tale is the lack of understanding of cryptocurrencies. In the words of Warren Buffett, “Never invest in a business you don’t understand.”

In the short term, bitcoin’s meteoric rise in value will likely continue to attract attention. But given the volatility of this asset — especially the outsized risks that are associated with this kind of reward — it is a regulatory nightmare in the making.

Before too many naïve investors get burned, lawmakers and regulators worldwide need to clarify their policies and define their strategies to deal with the “crypto boom.”

Mohanbir Sawhney is the McCormick Foundation chair of technology, the clinical professor of marketing and the director of the Center for Research in Technology & Innovation at the Kellogg School of Management at Northwestern University.