Will cryptocurrency cause the next financial crisis?

Cryptocurrency speculation is all the rage. Aside from the famous bitcoin (which has fallen in value by about a third over the last few weeks, and continues to gyrate wildly), there are thousands of other coins being bought and sold around the world, and new ones launching every day. Probably the most interesting is ethereum, which aside from being a traditional coin is also becoming a sort of platform for organizing all manner of business or other activities.

There are a lot of interesting technology and ideas in the cryptocurrency space. But there is far too little attention being paid to the downsides. Crypto is a godsend to money launderers and other financial scam artists, chews up ungodly amounts of electricity, and raises the risk of shattering financial crises. Crypto needs regulation to be safe.

I'm not an expert in the technical details of cryptocurrencies, which vary widely (see here if you're curious), but as the name suggests, they are a sort of electronic asset protected by cryptography. Instead of a central bank and government controlling things, where most transactions have to be routed through third parties like banks, cryptocurrencies are generally set up through some kind of distributed system where ownership and transactions are processed and protected through cryptographic calculations. The classic instance of this is a blockchain — a encrypted ledger, duplicated across millions of computers across the globe, that contains a record of all transactions and proof of coin ownership.

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That raises the first problem: electricity consumption. The way bitcoin is protected is with a "proof-of-work" system. Each new bitcoin that is created requires completing an ever-more difficult calculations, which also adds new blocks to the blockchain and processes transactions. Because it is so hard to make new blocks, you know the longest blockchain is the most reliable one. Trying to tamper with the bitcoin blockchain would thus require out-calculating the entire rest of the bitcoin community put together. It's a neat idea, but it consumes eye-popping amounts of electricity — something like 130 terawatt-hours per year, or more than the entire nation of Sweden. Ethereum, which currently uses the same proof-of-work system, consumes approximately 50 terawatt-hours yearly — about as much as Romania. All this has fueled massive greenhouse gas emissions, particularly in China.

However, there are possible solutions. Ethereum is in the process of moving to an alternative "proof-of-stake" system (details here) that would reportedly cut its electricity use by 99.95 percent. Many have argued that the bitcoin community should do the same thing.

But even if crypto used only a little electricity, there would still be problems. Crime is the most obvious one: most crypto transactions are in theory pseudonymous and irreversible, making them an obvious way to launder money, evade taxes, or extort ransoms. Other coins have seen classic old-fashioned scams: pump and dumps, Ponzi schemes, short and distorts, and so on. (Beware trading the Simple Cool Automatic Money coin.) There's even a scam unique to crypto: a "rug pull," in which a fraudster (or group of them) sets up a new coin, pumps it, and then abruptly cashes out and shuts down the entire coin trading structure — leaving the marks with no way to sell. Various criminals made off with at least $4.5 billion in crypto crime in 2019 according to one estimate, though that fell to $1.9 billion in 2020.

Crime aside, probably the biggest potential threat is in the construction of new financial structures outside of the supervision of any regulator. So-called "decentralized finance" (or DeFi), allows people to set up financial contracts outside normal Wall Street structures using cryptocurrency — including traditional stuff like insurance or financial derivatives, but also "smart contracts" that can execute on practically any condition you want.

To students of the financial crisis, DeFi bears eerie similarity to the shadow banking system that imploded in 2008 and helped crash the economy. Back then, all the big players in global finance had come to rely on this system for their daily operations. But because it had few regulations or protections that exist in traditional banking (like deposit insurance), when the mortgage-backed security market started imploding, panic spread, funding costs skyrocketed, and the whole system seized up — destroying Bear Stearns and Lehman Brothers. The rest of Wall Street would have followed if not for the government bailout.

Any financial system is vulnerable to panic. One company or market gets into trouble, which causes others to get cautious and stop lending, which causes more fear, and pretty soon the contagion spreads to the real economy. If DeFi grows, then big banks and institutional investors are going to get involved (in fact, they are already doing so), and maybe even come to rely on it. Without government controls, then it's only a matter of time before some kind of DeFi quasi-bank run gets going. Alternatively, even the manic price gyrations in crypto values pose a threat. If enough retail or institutional investors buy in, there could be knock-on damage if they lose their shirts in some random crash (as happened Wednesday).

More broadly, the entire justification for DeFi is somewhat suspect. Crypto boosters trumpet that it allows people to "get access to things like loans, savings, insurance, trading and more" without going through the financial system, but for most Americans, ordinary banks work perfectly well for these purposes — with far more convenience and protection. It's true that many poor people are unbanked, and it may be possible for DeFi services to help on the margin, but this has more to do with poverty than it does with lack of access to financial services.

Fundamentally, there is already way too much financial speculation in the United States. We don't need even more ways for people to make financial gambles on everything under the sun. Finance's share of corporate profits has increased from about 10 percent in the 1950s to about a quarter today, and it has done this by gradually re-gearing the entire economy around short-term payouts to investors instead of wages or investment. Ordinary people are never going to beat Wall Street sharks at the speculation game — what the working class needs is more jobs and higher wages, not an ephemeral chance at some huge payout gambling on meme coins.

Now, that's not to say there are no promising ideas here. For instance, as I have previously written, the credit card payments system is a ridiculously overpriced cartel that effectively scoops an economy-wide sales tax of 1-2.5 percent into the pockets of a handful of financial firms. Constructing a secure, cheap alternative to that would be very useful and provide some badly-needed competition.

To achieve anything good with crypto without the downsides noted above, though, is going to take government rules and protections. Luckily, this appears to be starting already, with new rules from the Treasury Department on crypto transfers and reporting requirements. It's just in time, too; the industry is already scrambling to hire lobbyists and protect their profit streams. The last thing we need is another bunch of financial parasites getting too established to defeat.