Governments must act on the growth of cryptocurrencies

When cryptocurrencies fluctuate, they don't just affect investors' wallets - they have far-reaching implications for the entire market, writes Luther Lie.

In the past few months, the world has seen an explosion of investments in notoriously volatile cryptocurrencies that have distorted the financial market.

Most recently, Dogecoin, a cryptocurrency that originally started as a joke - slumped 900 percent and then 30 percent in just one month and has soared a total of 12,000 percent this year. On the other side of the spectrum, Bitcoin recently crashed 50 percent in a matter of weeks.

However, volatile returns aren't the only risk associated with cryptocurrencies - there is also fraud. Recently, an Istanbul-based cryptocurrency exchange, Thodex, closed and allegedly took away $ 2 billion in investor money.

This begs the question: How did the financial authorities enable cryptocurrencies to have such a huge impact on the financial market so suddenly?

Cryptocurrencies are digital, private and partly anonymous currencies. Cryptocurrencies are mined by high-performance computers to solve complicated mathematical equations, and then stored and transferred as files in an encrypted "wallet". Many are stored on a decentralized network known as a blockchain. Celebrated as the future medium of exchange, they are issued by private companies to fight the monetary monopolies of the central banks.

They are not tied to any real currency and users can trade peer-to-peer without intermediaries. This means that the value of cryptocurrencies is largely determined by supply and demand, so they function more like a commodity and are not primarily used for transactions like a traditional currency.

The first cryptocurrency to be created was Bitcoin, founded by Satoshi Nakamoto, who was inspired by an article on "B-Money" written in 1998 by computer scientist Wei Dai of the University of Washington.

Dai's idea was to create a medium of exchange in which state interventions "are not temporarily destroyed, but permanently forbidden and permanently unnecessary". Ten years later, Nakamoto implemented this idea and created Bitcoin.

Although it is a financial product, cryptocurrencies are barely regulated. This is in contrast to the highly regulated nature of the financial markets for traditional currencies, commodities and stocks.

At the beginning of the year, the President of the European Central Bank (ECB), Christine Lagarde, expressed the intention of the ECB to regulate cryptocurrencies. She also voiced similar concerns as managing director of the International Monetary Fund, an international body responsible for regulating the foreign exchange market. While there is some appetite for regulation, little progress has been made.

So should cryptocurrencies be regulated or would that undermine their value?

Some have raised concerns about regulating cryptocurrencies, arguing that it could incur transaction costs. Cryptocurrencies avoid these costs as they are traded peer-to-peer with no fees from intermediaries. Real world currencies and stocks that are regulated are subject to a trading fee charged either by banks or brokers.

Another concern is that regulation of cryptocurrencies affects their value. Unlike real currencies, cryptocurrencies cannot be devalued by central banks, and some consider this to be one of their most important assets.

These are legitimate concerns. However, cryptocurrencies should not remain completely unregulated.

Increasingly, cryptocurrencies are owned by retail investors - nearly 20 percent of respondents in an Australian survey said they own cryptocurrencies, and 36 percent of institutional investors in the US and Europe also said they own cryptocurrencies. As with any other financial product, regulators must protect the public - who often do not have the deep financial knowledge to analyze these markets and make informed decisions - from losing large sums of money, whether through incorrect investment forecasts, misleading news, or personal miscalculations .

Of all the respondents who said they owned cryptocurrencies last year, more than 20 percent lost money on their investment.

The wave of personal bankruptcies that would follow large numbers of people losing their cryptocurrency savings - similar to the "too big to fail" phenomenon - could cripple a nation's economy. In such a case, government bailouts would be necessary to save an economy.

The government's response to the Thodex incident suggests the weakness of an unregulated cryptocurrency exchange. While the Turkish central bank has now banned the use of cryptocurrencies, investors' money is irretrievably lost.

Amid the ban, a second Turkish cryptocurrency exchange, Vebitcoin, collapsed.

Cryptocurrencies are also very susceptible to negative externalities. Although the supply of cryptocurrencies is said to be difficult to mine and free from intervention by central banks and intermediaries, it is not stagnating.

In contrast to real currencies, the production of cryptocurrencies is not controlled by a central manufacturer. By monopolizing cryptocurrency mining resources, private companies that issue cryptocurrencies may be able to arbitrarily “control” supply and demand to affect their value.

C.Apart from these weaknesses of cryptocurrencies, regulation would be worthwhile. The huge profits cryptocurrencies offer may sound enticing to public investors, especially during the COVID-19 pandemic, but the fact that they come from an unregulated market meant there will always be big losers at everyone's expense.

Governments cannot allow the financial system to be treated like a horse race with investors "win big or go home". A financial product like cryptocurrencies affects public investors' money, and if it fails, it will not only threaten their very existence, but potentially threaten economies as well.

The views expressed in this article are those of the author alone.

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