Do Cryptocurrencies Pose a Macro Threat to the Global Financial System?

Critics of cryptocurrencies, ranging from senior regulators to well-known politicians to renowned economists and investors, have grabbed headlines by highlighting the potential of these instruments to destabilize financial markets. So, it now seems like a good time to assess the merits of this argument, and to examine everything these digital currencies bring to the table – both good and bad.

Kristalina Georgieva, managing director of the International Monetary Fund, opened the IMF’s recent Seoul, Korea-based conference on digital currencies by warning that cryptocurrencies need to be regulated because they pose risks to financial stability. "The challenge is that high crypto asset adoption could undermine macro-financial stability," she cautioned. The effectiveness of monetary policy transmission, capital flow management measures and fiscal sustainability (due to volatile tax collection) could all be negatively influenced by high crypto asset adoption, Georgieva elaborated.

 Aaron Brown

Of course, she is only the latest senior regulator to express these sentiments – and will not be the last. What’s more, she has, among others, some prominent politicians in her corner.

Former U.S. Presidential nominee Hillary Clinton once said that crypto could undermine the role of the U.S. dollar.  “Cryptocurrencies could destabilize entire countries. First smaller countries, but then bigger and bigger ones,” she cautioned.

Meanwhile, Turkey’s President Recep Tayyip Erdoğan once said Turkey is “at war” with digital currencies (partly because it weakens the influence of the country’s central bank), while Xi Jinping, President of China, has complained that “bitcoin cannot be monitored by the state.”

Other prominent critics are European Central Bank head Christine Lagarde, author Nassim Taleb, economist Nouriel Roubini, value investor Warren Buffet, U.S. Treasury Secretary and former Fed Chair Janet Yellen, and JPMorgan CEO Jamie Dimon.

Do they all have a point or are the potential risks of cryptocurrencies destabilizing financial markets overblown?

The Mixed Bag of Crypto: Gains and Risks

The concern about cryptocurrency destabilizing financial markets is ironic, given that bitcoin was invented in 2008 in response to a near-collapse of the global financial system. In the darkest days of 2007 and 2008, there were widespread fears about what would happen if people lost access to their bank and brokerage accounts, if cash machines dried up, if businesses could not process electronic payments, or if governments could not pay their bills. It therefore seemed wise to have an alternative financial system immune from contagion from traditional financial institutions.

Cryptocurrencies have been net stabilizing to date. In countries with ruined financial systems like Venezuela, Argentina, Turkey, Ukraine, and Palestine, crypto has fulfilled its initial purpose: to allow economic life to continue without trust in currency, banks or government finances.

What’s more, in countries like Vietnam, Philippines, India, Pakistan, Brazil and Thailand, crypto serves the economic needs of significant minorities. And in authoritarian countries like Singapore, China and Russia, cryptocurrencies support transactions outside official channels – e.g., they have proved useful to expatriate workers sending money home.

On the other hand, crypto has been associated with many frauds, and has been used by criminals, ranging from ransomware attackers to terrorists to people trafficking in sex, recreational drugs and gambling. But these are micro risks to weigh against the macro advantages.

Like the grouch who complains that the food at a resort is inedible but also that the portions are too small, some crypto critics simultaneously hold that crypto is a Ponzi scam that could never work and that it’s powerful enough to potentially kill traditional finance. If you take only the first view, crypto could cause problems (see the collapse of FTX and other large crypto-related entities in 2022), but not undermine macro-financial stability.

My concern here is with the second complaint. Is a global financial disaster caused by innovations in cryptocurrency the kind of “plausible extreme” event that should figure in stress tests and scenario analysis? Or is the opposite true – i.e., that cryptocurrency offers an important escape route from traditional financial disasters?

For risk managers, if the former is true, it’s most important to know the likely warning signs of an impending crypto-caused disaster.

Breaking Down the Crypto Market

How can risk managers get to the bottom of this? To begin, it’s useful to distinguish the digital assets that make up the cryptoeconomy from pure-transaction cryptocurrencies. Since one of the innovations in crypto is to blur the lines between investors, customers, employees, suppliers and owners (some tokens, for example, mix aspects of security investments and transaction currencies), it’s not easy to tell the difference.

Conceptually, however, we can think of the existence of a cryptoeconomy – one that consumes real economic resources and delivers real services to real people – and the tokens used for transactions in that economy. The tokens are sometimes used in the traditional economy for pure traditional transactions, as well as to raise money for projects, to pay wages and to manage expenses like servers and electricity.

Although cryptocurrencies have been extremely volatile in terms of U.S. dollar prices of coins, the cryptoeconomy itself has grown steadily and quietly. Whether bitcoin and other crypto prices are high or low, developers continue writing code and crypto businesses continue running. Innovations continue to emerge, and customer usage grows.

The volatility is all on the border where people exchange crypto assets for traditional currencies. This is akin to tsunamis, which begin as unnoticeable swells in the deep ocean (with an inability to travel more than 10 miles inland), but can do enormous damage within a one-mile range around a coastline.

If the entire cryptoeconomy crashed and became worthless, $2 trillion of economic value would disappear. This would certainly cause problems, but it would be relatively small in comparison to other financial disasters. For example, depending on how you measure things, the Great Recession of 2008 might have destroyed almost ten times that much wealth – or $20 trillion, from peak to trough.

While a complete meltdown of the cryptoeconomy would pale in comparison, it would be similar to the wealth loss in the 2000 internet crash, when the global economy was much smaller. (That event had only mild macro effects, because it did not involve much leverage.)

Events like the 2022 FTX bankruptcy can lead to some follow-on collapses like the U.S. regional bank failures in early 2023. However, they seem no more threatening to macro stability than losses in the traditional financial system. Indeed, they are less of a concern, since crypto investors are prepared for high risk and cannot get significant leverage from the traditional financial system. (There is considerable internal leverage within the cryptoeconomy, but no reason for that to spill over to traditional financial entities.)

Imagining a Worst-Case Crypto Scenario

Despite the low probabilities of a 100% value loss of such a broad economic sector as the crypto economy, and that such an event would trigger a major traditional crisis, I think it’s reasonable for risk managers to estimate the loss to an institution if all crypto went to zero tomorrow. It’s not a likely scenario in my opinion, but it’s a simple way to see if crypto is worth paying attention to from a micro-risk perspective.

The first macro risk that the IMF's Georgieva mentioned, and the first one to occur to most people, is that the availability of cryptocurrencies reduces the influence of central bank monetary actions. If a central bank tightens by raising interest rates and selling assets, cryptocurrencies allow citizens to continue borrowing and spending, while using their traditional currency to earn the high rates and to buy assets cheaply from the central bank. If a central bank loosens by lowering interest rates and buying assets, citizens may lose faith in the government currency, and then turn to cryptocurrencies as negotiable stores of value.

This is not a theoretical risk – we have already seen countries adopting perverse central bank policies and their citizens turning to cryptocurrencies. Moreover, even in countries with well-managed central banks, some citizens are using crypto to gain leverage outside the traditional financial system, while others are holding some crypto assets as inflation hedges.

Before thinking about the potential consequences if this trend increases and central banks lose influence, consider the interaction with Georgieva’s second macro concern: crypto’s interference with capital flow management. This is also not theoretical. In countries that impose very strict capital controls, this has happened often – and is happening to a smaller extent nearly everywhere.

It does seem likely that countries will have less control over their level of economic activity and capital flows than they have in the past. But not as a result of global, public cryptocurrencies like bitcoin.

The Internet put everyone on Earth in touch with each other, and bitcoin was proof of concept that any two individuals can transact — making creditable, self-enforcing promises and transactions — without knowing or trusting each other. Furthermore, 27 years before bitcoin, Adi Shamir, Ron Rivest and Leonard Adleman (the guys who put “RSA” in the RSA algorithm that underlies Internet security) proved that two strangers could play mental poker over a telephone, without sharing cards or cash or trusting each other.

If you can play poker with someone, you can trade with her.

It’s also important to understand that the vast majority of crypto tokens are not intended for mass adoption; rather, they serve to organize economic activity among groups of a few hundred or a few thousand people. Anyone can, and many people do, create their own tokens with off-the-shelf algorithms. So, even if the government could somehow destroy every existing cryptocurrency, people will be able to run transaction networks outside any government control – as long as the crypto idea survives.

Fortunately, the same feature that makes crypto indestructible also prevents it from being a macro risk in the sense of destabilizing the financial system controlled by central banks. Crypto tokens are local assets accepted voluntarily by individuals. The value of the real economic services they produce can soar or crash, but should not affect anything outside the local network.

Crypto used outside the cryptoeconomy could have contagion effects, but governments retain full power to monitor and control transactions that involve both crypto and traditional assets. If people were forced to accept cryptocurrencies, the way they are often forced to accept traditional currency, it could cause macro problems – but this has not happened yet and does not seem likely to occur (to any significant degree) anytime soon.

The Biggest Threat to Stability

Georgieva’s final point is the one I think demands most risk management attention.

Cryptocurrencies could erode the ability of governments to collect taxes. It’s not tax evasion via cryptocurrency that is the macro threat; many traditional assets used for evasion (cash, gold, diamonds, fine art, etc.) are superior. Rather, the deep problem is that an explosion in the number of currencies makes income and value-added impossible to define.

Without the ability to collect individual and corporate income taxes and VAT on crypto, governments are currently forced to rely on gross taxes on things like wealth, wages, revenues or imports. If individual and corporate taxes and VAT could ever be collected for crypto businesses, it’s not clear these could replace current levels of government tax revenue – but if they could, the transition could easily touch off a major financial crisis.

Diminished revenue puts government debt at risk, and makes unfunded and contingent liabilities an even larger problem. It could force spending cuts that disrupt economies, and the increases in the new taxes could cause further disruptions.

To understand this risk, it helps to realize that the official economy measured by GDP is a small froth on an ocean of human transactions. Even the froth can be hard to measure, but most analysts put official global GDP at around $100 trillion. Unofficial goods and services are impossible to measure, but some plausible values are $40 trillion for unpaid labor and $20 trillion for underground economy.

By far the largest omission are the most important things in life. People earn trust, reciprocate affection, repay loyalty — but not with or for money. While no dollar value can be placed on these things, most people place them far above material possessions.

The boundary between official money transactions and unofficial and non-monetary transactions changes over time and varies from person to person. But many things that are bought and sold in the official economy have highly inefficient markets.

Media content, for example, is sold via annoying commercials and paywalls that can bias content and fail to extract most of its value. Healthcare transactions are so intractable that most developed countries have elected to replace market transactions with nationalized healthcare. Violent services like military and police, moreover, can’t be offered to the highest bidder.

Only about 30% of U.S. GDP is in sectors that seem to work best with universal money — primarily real estate, manufacturing and construction. The rest seems vulnerable to reorganization with specialized cryptocurrencies.

The scenario in which government revenues are threatened is if some of these and other sectors move to a cryptocurrency model. What’s I’m talking about here is a strictly crypto organization – one in which the tokens used could not be exchanged for each other or for traditional currency. When a crypto organization allows such an exchange, it loses the advantage of a carefully designed algorithm that uses game theory and cryptography to mediate exchanges according to subtle rules appropriate to the sector, rather than just allocating things according to who offers the most money.

Let’s now take a second to consider a couple of hypotheticals. Imagine a world with non-convertible national currencies – i.e., hundreds of currencies that cannot be exchanged for one another. Now envision a crypto world with hundreds or more cryptocurrencies for specialized purposes, with only very limited abilities to exchange one token for another, or any token for traditional cash.

My personal guess is this will happen, but over decades, with plenty of warning. However, that does not mean risk managers can afford to ignore it. The joker in the deck, as usual in risk, is leverage.

Currently the S&P 500 pays 1.38% per year in dividends. Using a standard Gordon model approximation, that implies that 50% of the present value of future cash flows from these stocks occurs more than a half a century down the line. (Log(2) / log(1.038) = 50 years in the future.) Other major asset classes have shorter horizons: for example, real estate at a 5% cap rate earns half its purchase price back in present value in 14 years.

Many bonds return capital in only a few years and some commodities can be used within days. But all of these prices are dependent on either selling to someone or collecting from someone who gets her money from the general economy.

If stocks fall, they can take most of the economy with them. If you knew that the U.S. government would be unable to borrow money in 2074, the value of its debt today would be much diminished, since its financing strategy is to continually borrow more money to pay interest and principal on existing debt.

All this means is that changes anticipated to occur over many decades can have large effects on market prices today. If you think 70% of the global economy will migrate away from traditional money in 50 years, securities that offer payouts only in traditional currency become significantly less valuable today.

As sectors move from cash to crypto, there will be many bankruptcies. As governments lose tax base, there will be defaults, inflation and spending cuts. Total economic growth might be strong now, but the portion supporting traditional money may erode, making that traditional money less valuable.

Parting Thoughts

What risk managers should think about today is a change in market opinion about the likelihood that much of the existing economy will move away from traditional money, even if that move takes many decades.

These sorts of sentiment shifts tend to be self-sustaining. A critical mass of investors can, for example, change their perspective, pushing prices in a direction that seems to validate their thesis, attracting both momentum investors and additional investors who had been thinking along the same lines. The more investors begin to favor crypto assets over traditional securities, the shakier those traditional securities and the traditional financial system look, further speeding the change.

I consider this kind of shock to be plausible enough to be worth a serious scenario analysis. If necessary, an organization must be prepared to move away from traditional money and markets. Having backup plans that don’t rely on the traditional financial system or the value of national currencies is therefore a sound policy.

There are an infinite number of things that might happen in the future, and we cannot even imagine any significant fraction. A central risk management principle is preparing for the things you can foresee gives you the discipline and resources that might help you survive what actually happens.

Crypto technology is a plausible major earthquake to traditional finance, and the fact that a tectonic shift is likely decades away does not mean crypto cannot kill your organization tomorrow. Indeed, if the anticipation of this shift causes equity investors to demand, say, 0.1% higher returns today, it could cause many companies to fail. 

You may feel the probability of that earthquake is high, as I do, or low. But it’s hard to argue the probability is zero, or too small to worry about. 

Aaron Brown worked on Wall Street since the early 1980s as a trader, portfolio manager, head of mortgage securities and risk manager for several global financial institutions. Most recently he served for 10 years as chief risk officer of the large hedge fund AQR Capital Management. He was named the 2011 GARP Risk Manager of the Year. His books on risk management include The Poker Face of Wall Street, Red-Blooded Risk, Financial Risk Management for Dummies and A World of Chance (with Reuven and Gabriel Brenner). He currently teaches finance and mathematics as an adjunct and writes columns for Bloomberg.