A regulatory framework for cryptocurrencies will boost investor confidence

CRYPTOCURRENCIES’ spectacular crash in May has been likened to a bank run. Market capitalisation – the current value of all crypto coins mined – is currently estimated at US$1.2 trillion, down from around US$2 trillion in March, just when it seemed that crypto was firmly on its way to becoming a mainstream asset. Tesla, for instance, had bought US$1.5 billion bitcoin last year, and began to accept customer payments for some items in Dogecoin. Coinbase Global also became the first crypto exchange to successfully list its shares in the US last year, but its stock has since plunged to US$66, compared to its first-day closing price of US$328.

Cryptocurrencies now face a reckoning which has come none too soon. The crash has raised fundamental questions about its role in portfolios. One common argument – its ability to enhance diversification in portfolios – is now in tatters. As if to rub salt into a wound, crypto has in fact fallen far more than traditional equity markets. Year to date, Bitcoin has dropped by nearly 38 per cent, compared to 18 per cent by the S&P 500 and 29 per cent by the Nasdaq. Bitcoin currently stands at about US$29,300 compared to a peak of US$67,800 last November. In other words, in today’s scenario of risk aversion and higher interest rates, crypto tokens are no haven. Their volatility is further exacerbated by wider ownership and active, opportunistic trading by institutions such as hedge funds.

A second argument in favour of crypto is that it is supposedly a viable alternative to fiat currency as it is decentralised, borderless and anonymous. This too has come into question. After all, the flip side of anonymity is an outsized vulnerability to fraud and related risks that are poorly understood. So-called stablecoins, for instance, are supposedly pegged to the US dollar, but investors may have little visibility on the reserve assets backing them. Not all stablecoins, for instance, hold US dollars on a 1-to-1 basis. TerraUSD, for example. relies on algorithms to maintain its US dollar peg, but it failed spectacularly last week, and its value as well as that of its related coin Luna has dropped to virtually nil. Last year Fitch sounded a warning that a stablecoin like Tether, partially backed by commercial paper, may be vulnerable to wider selling pressure or contagion risk that seizes markets now and then.

As if that wasn’t enough, Coinbase recently admitted in a filing to the US Securities and Exchange Commission (SEC) that the crypto assets held by its investors in wallets under custody may be subject to bankruptcy risk. Its customers may be treated as “general unsecured creditors’’, raising the spectre of counterparty risk.  In the aftermath of the crypto meltdown, regulators are on high alert. Apart from the systemic threat to financial systems that crypto may pose, there are too few safeguards for individuals who have flocked to crypto more recently, and hence have suffered disproportionately.

G7 finance ministers last week called for a fast tracking of global crypto regulations. In the US, President Joe Biden has signed an executive order for the government to examine crypto’s risks and benefits, and to come up with a plan to regulate it. For a start, crypto exchanges may well be required to segregate customer assets, long a standard requirement for traditional brokerages. The SEC is beefing up its crypto assets and cyber unit, to better look after investors’ interest. Separately, the Commodity Futures Trading Commission chief also asked US lawmakers for the authority to regulate and protect investors from the ‘speculative fervour’ around crypto and fraud. Singapore regulators are surely watching this space closely. Some degree of regulation will help to beef up investor confidence in an asset that remains nascent at best.