Fed should get real about its role in crypto’s volatility

Cryptocurrencies are faith-based — they have no intrinsic value. There is no sovereign authority backing them. They are the “pet rock” of currency, worth only what someone can get you to believe they are worth.

These are some of the reasons they are so frequently questioned as a reliable investment. And yet they have been steadily appreciating against major sovereign currencies and compete with gold and silver as an inflation hedge. Mainstream commercial and investment banks increasingly are willing to purchase and hold them in safekeeping for their clients, and the Office of the Comptroller of the Currency has confirmed in writing that national banks can take on this responsibility. Why?

Part of the reason is because most major national currencies are also faith-based. Their values depend on the public’s faith in sovereign authority and their central banks’ commitment to preserve their value. However, most major central banks have pursued monetary policies that over time have undermined that goal.

In the United States, the Federal Reserve’s goal has been to maintain an annual inflation rate of 2% or higher. More important, it embarked on a quantitative easing program in 2008 to significantly increase its liabilities — composed primarily of cash and bank reserves — from less than $1 trillion to nearly $8 trillion. This is a phenomenal increase in money-creating capacity.

Importantly also, this money-creating process is governed not by any kind of rule but by a policy committee — the Federal Open Market Committee — that has broad discretion in setting U.S. monetary policy. It is granted a degree of independence from political interference to allow decisions to be made in the public’s long-term best interest, which makes sense.

But that lack of binding rules or constraints also renders U.S. monetary policy subject to the same vagaries that the Fed’s independence was meant to counteract: Events, personal judgment and politics influence monetary policy far more than the Fed likes to admit. This bias is no better illustrated than by the dramatic growth of its balance sheet over just this past decade, a pattern being replicated by central banks across the globe.

The growth in the Fed’s balance sheet has done little to spark general price inflation, but it has sparked asset inflation in everything from real estate to stocks and even art objects. Holding money is no longer as profitable as it once was, and so to hedge against that relative depreciation investors are buying almost anything else. Any one of these asset classes potentially could be a bubble, but with the Fed greatly expanding the nation’s monetary base, these trends reflect rational choices.

Enter cryptocurrencies. In contrast to national fiat currencies, cryptocurrencies have no government sponsor. But also unlike national fiat currencies, they play by a firm set of rules that more systematically constrains their ability to arbitrarily expand in volume. Though they are not widely used as a medium of exchange today, they could develop the capacity to serve that purpose. So while cryptocurrencies are fiat currency — again, pet rocks — their rules-based supply and potential utility as a form of money have made them a preferred intangible asset among investors and speculators.

This rapid — some might say explosive — rise in the value of cryptocurrencies has many of the markings of an asset bubble, doomed to collapse. There appears to be a rush to buy them by investors who poorly understand their origin or their risks, and some investors will even borrow against other assets to fund their purchase, with the expectation that their value will continue to rise. That’s a source of systemic risk that regulators and banks should be aware of.

Nevertheless, they remain a favored investment among some with their controlled growth, their expected longer-run value appreciation and their ability to act as a medium of exchange. And cryptos may not even be the riskiest asset out there — compared to other leveraged assets or the explosive growth in derivatives and synthetic derivatives, cryptocurrencies may appear relatively safe.

Under these circumstances, the banking industry’s role in serving clients who invest or speculate in cryptocurrencies is comparable with many other assets, real and intangible. A bank should understand its risks, and a rational bank may choose to limit its exposure if the crypto market seems too speculative. But so long as it understands its fiduciary responsibilities, understands it risks and applies consistent standards in providing its services to its client, there should be no prohibition against a bank providing such services. Even if banks want to lend against cryptocurrencies and have sensible underwriting standards and the capital resources to accept that risk, bank supervisors should not necessarily block them from doing so. The loss is theirs to bear.

But it’s important for all concerned to understand that the growth of cryptocurrency valuations isn’t happening for no reason. The world’s major central banks have been dramatically expanding the money base for over a decade and appear intent on continuing that pattern. Thus, there is good reason to expect asset inflation to continue — including cryptos.

Should circumstances change and should central banks slow or contract their monetary expansion — or should the market fear such actions — asset values would likely fall, and in some cases collapse. Banks could be caught up in this desperate cycle and could experience significant losses. However, if they are prudent, it is unlikely that their involvement with cryptocurrencies would pose any more of a risk to banks or the financial system than any other inflated asset.

Editor’s note: This op-ed is part of a monthly series called “Deposits and Withdrawals” that offers different viewpoints on hot-button topics. The next installment, also on the subject of cryptocurrency, is scheduled to be published Wednesday.

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