Crypto Wager

G20 to Set Global Crypto Regulations: IMF Report Offers Insight into Expected Requirements

by Ryan Shea

Key Take-aways

·      Global regulators have been actively pushing back against the crypto industry. It is clear they are not letting last year’s crisis go to waste.

·      The G20 is set to create global crypto regulations in September, with the FSB, IMF, and BIS offering advice through their respective papers.

·      For crypto enthusiasts, the IMF’s recommendations make for unpleasant reading. The future being mapped out is one festooned with rules and regulations and in time it is very likely governments will be issuing their own cryptocurrencies. However, all is not lost.

·      Maintaining monetary credibility in the fiat world is a necessary condition for governments wishing to limit the adoption of  private cryptocurrencies.

·      Critically though, monetary credibility is threatened by fiscal trends, especially due to population ageing.

·      Either credible commitments to lower government debt burdens now and in the future will be made making further crypto adoption unlikely or that they won't, in which case it is likely to thrive. That is crypto’s wager.

The regulatory pushback against crypto continues. In the past two weeks, the IMF published a paper  Elements of Effective Policies for Crypto Assets[1], the Fed issued a statement warning the commercial banking sector of the liquidity risks associated with crypto-assets[2] and the Canadian Securities Administrators published a notice detailing new rules and guidance for crypto trading platforms, which includes a ban on clients being able to buy stablecoins “without prior written consent”[3]. Coming hot on the heels of the decision by the SEC to order Paxos to stop minting Binance’s stablecoin (BNB)[4], and the charging of Terraform Labs and their CEO Do Kwon with fraud[5], it is beyond doubt that global regulators are not “wasting” last year’s crypto crisis – as I warned would be the case at the time[6].

Furthermore, according to the statement[7] released after this month’s G20 finance ministers and central bank governors meeting, the FSB, IMF and BIS will all publish papers and recommendations seeking to establish standards for a global crypto regulatory framework later this year. The most important of these documents, expected in September, will be...

“… the IMF-FSB Synthesis Paper which will support a coordinated and comprehensive policy approach to crypto-assets, by considering macroeconomic and regulatory perspectives, including the full range of risks posed by crypto assets.”

Given what is clearly coming down the pipe, and given the prominent role being played by the IMF, it is worth taking a closer look at their recent report to gain some insight into what regulatory requirements are likely to be forthcoming.

IMF Report Highlights Risks to Financial Stability and Consumer Protection

The executive summary of the IMF paper contains a list of “purported”[8] benefits of crypto assets, such as more efficient (namely, cheaper and faster) cross-border payments, increased financial inclusion, greater portfolio diversification and increased transparency and traceability of transactions. However, the main thrust of the paper relates to crypto’s potential risks. Those identified by the IMF include…

“… macroeconomic risks, which encompass risks to the effectiveness of monetary policy, capital flow volatility, and fiscal risks. There are also serious concerns about financial stability, financial integrity, legal risks, consumer protection and market integrity, and contestability. Some risks are inherent to the technology underpinning crypto assets, while others stem from the lack of policies or their enforcement.”[9]

Having outlined how these risks could manifest themselves the report makes the following nine key recommendations – see graphic below.

What they are proposing is an all-encompassing approach that seeks to provide crypto assets with legal certainty, a general principle of law that will bring much-need clarity to the sector. Once established, this constitutes the basis to enact regulatory and tax frameworks which they argue should be applied as comprehensively and widely as possible. This latter aspect is rather important as the IMF recognizes regulatory enforcement is challenging because many crypto asset service providers are located in offshore jurisdictions but market their services globally, ie. unlike tradfi entities many crypto entities are not geographically-bounded. Indeed, the “inherent  borderless nature of crypto assets” is one of the reasons why the IMF considers an outright crypto ban would not be the “first-best” option because it would be costly to enforce and may stifle innovation and drive crypto asset activities underground. Personally I think the IMF have been a little disingenuous here – a blanket ban on crypto would not only be costly to enforce, it’s practically impossible as it would require nothing less than pulling the plug on the internet[10].

IMF's Recommendations on Crypto: No Legal Tender Status, Except for CBDCs"

One of the most prominent recommendations the IMF makes is that crypto assets should not be given legal tender status because it would serve to further increase crypto adoption thereby magnifying the risks identified elsewhere in the paper. To-date only two countries have done so - El Salvador and the Central African Republic both made Bitcoin legal tender - and given the IMF’s stance this list seems set to remain very short.

The IMF did, however, make one important exception: a crypto asset “backed by a public institution, such as the State itself, a central bank, or a monetary institute”. In other words, a central bank digital currency (CBDCs).

Indeed, the ninth recommendation “to strengthen global cooperation to develop digital infrastructures and alternative solutions for cross border payments” includes several references to CBDCs. This is hardly surprising because, as I have argued before[11], their widespread introduction is an extremely high probability event.

For crypto enthusiasts, the IMF’s recommendations make for unpleasant reading. The future being mapped out is one festooned with rules and regulations and in time it is very likely governments will be issuing their own cryptocurrencies – a digital form of public money many worry will consign financial privacy to the dustbin of history[12]. No matter how objectionable such an outlook may be to many within the crypto community, the simple fact is that there is nothing that can be done to stop governments from moving in this direction because they set the rules that we are all compelled to live by (i.e., laws). But that doesn’t mean all is lost, far from it.

Elephant In The Room

There is one aspect of the report that I have skipped over until now but it’s an important one, in fact I would go as far as to say it is the most important one.

At the outset of the report, the IMF notes that after years of being niche products crypto assets are now being held and used more widely. The reason why crypto adoption has increased and, in their view could continue to increase meaning “doing nothing is untenable”[13], is not explicitly spelled out. Nevertheless, later in the report it is clear the IMF understands all too well what has been driving crypto adoption and it is not the “purported” benefits cited above, which they dismiss as being only “tenuous”[14]. To wit:

“A lack of credible domestic institutions and policies is the most common root cause of substitution pressures into foreign fiat currencies, and the same is the case for the pressures to substitute into crypto assets. A weak monetary policy framework (MPF), combined with large fiscal deficits and government pressures for central bank financing, are likely to undermine monetary credibility and instigate currency substitution (Adrian et al. 2021; IMF 2020). Therefore, the most effective way to limit substitution into crypto assets is to develop effective monetary frameworks and fiscal and monetary policies that maintain monetary credibility”.

After last year’s crypto winter, when crypto prices dropped precipitously (in inflation-adjusted terms Bitcoin fell approximately 70% peak-to-trough - a magnitude of decline that is in keeping with prior crypto bear markets – see chart below) some global policymakers clearly feel that the threat from crypto has receded. For instance, during a recent Bloomberg interview, Augustin Carsten, head of the BIS (one of the three institutions that will be making policy recommendations to the G20) stated that crypto had “lost the battle against fiat currency”[15] because “[o]nly the legal, historical infrastructure behind central banks can give great credibility” to money.

Historic BTC/USD Drawdowns

This is a strong statement by a leading global policymaker, but that doesn’t necessarily make it true.

Currency Debasement

When unleashing Bitcoin on the world 14 years ago, Satoshi Nakamoto put forward the following argument as to why a privately-issued decentralized cryptocurrency could be useful. To wit,

“The root problem with conventional currency is all the trust that's required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.”

In its most extreme form, debasement takes the form of hyperinflation. Economic historians have documented numerous instances of hyperinflation[16]. Unfortunately, hyperinflation is not a historic relic, Venezuela, Sudan, Lebanon, Syria and Zimbabwe are all currently experiencing triple digit inflation rates. Obviously, singling any of the currencies of any of these countries for comparison is a bit of a cheap shot. Instead, let’s look at the performance of the US dollar and Sterling, which were the two dominant global reserve currencies over the past century.

Unlike Bitcoin, which as I noted in a recent research note does not pay interest rates natively[17], fiat money held within the commercial banking system does pay interest so to be a fair comparison we need to take this additional return into consideration when calculating their historic drawdowns. What we find is that even the “crème de la crème” of fiat currencies witnessed repeated and substantial declines in their inflation-adjusted values (between 40-50%) - see chart below. Critically, since 2009 -  when either by luck or good judgement Bitcoin was born - both have seen their inflation-adjusted values fall by over 20%.

Historic Fiat Money Drawdowns

The most notable aspect of these episodes of fiat depreciation is that they coincide with periods of fiscal profligacy as evidenced by surging government debt-to-GDP ratios – see chart below.

Government Debt (% GDP)

This positive correlation between fiat money’s loss of purchasing power and surging government debt is entirely consistent with the IMF’s statement above, namely that monetary credibility depends not just on monetary policy but also fiscal policy. This is an aspect of money that is very often overlooked even - it saddens me to say - by professional economists who should know better. In essence, fiat currencies are backed by the ability of the government to repay its debts out of future tax revenues (net of future expenditures). Obviously, the higher the level of government debt the less likely this condition will be satisfied.

Now, the 20% loss experienced by fiat money over the past 14 years is clearly better than the 70% loss experienced by Bitcoin and other cryptocurrencies last year. But, the problem facing fiat currencies is that debt-to-GDP ratios not only remain high by historic standards but the outlook is far from appealing – that’s putting it mildly – when one considers the massive unfunded liabilities arising from the rapid ageing of populations. For example, the OECD estimates that debt-to-GDP ratios will rise 3X over the next 40 years due to the impact of ageing alone[18].

Of course, these are projections and nothing is set in stone. Politicians implement policies to improve their future fiscal positions either by raising taxes (any wonder why they are keen to introduce CBDCs, which could be used to automatically collect taxes at source via smart contracts[19]?) and/or expenditure cuts[20]. Prior fiscal consolidations were facilitated by the huge retrenchment in military spending that occurred naturally as a result of the cessation of the two world wars. Unfortunately for governments in the advanced world, this time around it will necessitate spending reductions on such political hot potatoes as pensions and healthcare. These are things people – especially those closer to the finish than the start line of life – care about greatly. What’s more, these people will also constitute a large and rising share of eligible voters. The political challenge from implementing such policies should not be underestimated – it is huge.

If it it turns out that fiscal consolidation on the required scale is politically unfeasible the alternative – the only alternative – to avoiding a default is for the government to coerce the central bank into deploying printing press. This phenomenon is known by economists as fiscal dominance and it is mentioned in the IMF paper[21] as a mechanism that could increase pressures towards currency (and crypto) substitution.

Obviously, governments are well aware of such pressures and introduce barriers to ensure the burden of inflating the debt is distributed as widely as possible in order to limit the negative social consequences of its actions. Historically, such barriers[22] have included capital controls and bans on the private ownership of gold[23].  However, with the advent of cryptocurrencies, people now have an additional method to avoid financial repression, that – as I noted above – is nigh impossible to ban. This is crypto’s real threat to the fiat money system and the IMF clearly understands that.

Crypto’s Wager

What the paper illustrates is that ensuring the monetary credibility is maintained in the fiat world is a necessary, perhaps even sufficient, condition for governments seeking to limit the adoption of (read: mitigate the threat from) private cryptocurrencies, like Bitcoin, because it undermines their raison d’etre. Doing so, however, requires a credible commitment to lower government debt burdens now and in the future. If you believe that such commitments can and will be made then crypto adoption is unlikely to flourish. If not, then crypto is likely to flourish. It is really that simple. This is crypto’s wager.

My judgement is that cryptocurrencies will not only survive but thrive because the fiscal challenges facing pretty much all of the major economies in the world are of such a magnitude that it is highly improbable governments will be able to avoid deploying the printing press, resulting in the further erosion of fiat money’s purchasing power. Of course, given I work in the crypto sector one could accuse me of talking my own book, but it would appear that I am not alone in holding such concerns about fiat money’s ability to hold its value when one looks at the following chart courtesy of the Financial Times.

If the very institutions tasked with ensuring the purchasing power of fiat money are ramping up their purchases of an asset that does not facilitate their daily business activity – it cannot be used to make electronic payments and is not easily transportable – and whose only advantage is that its supply cannot be expanded easily, making it printing press resistant, it is a non-too-subtle signal that the global fiat money is in trouble.

Given their natural inclination towards conservatism, it makes sense that central banks’ first choice would be to purchase an fiat money hedge they are very familiar with and have the infrastructure in place to handle. For regular people who don’t have vaults in their basement, it does not take much an imaginative stretch to think they might consider cryptocurrencies instead, especially Bitcoin which has has many commonalities with gold[24] with the added benefits that it can be used for electronic payments and is highly geographically mobile[25].

In short, the IMF is right that fiscal policy matters greatly in supporting monetary credibility and given current and expected fiscal dynamics that means Augustin Carsten is wrong in concluding that crypto has lost the battle against fiat currency[26]. It is not a battle, it is a war and is only just beginning.

Sand In The Hand

It is true governments make the laws and hence set the rules, and they can mandate people to own and use public money by making it the only means by which taxes can be paid, but if they can’t ensure that fiat money is able to hold its value then people can, and will, seek out alternatives. This is because society dictates what it considers and uses as money not the government – it is beyond their mandate. Crypto adoption over the past 14 years has been driven by concern that in the future “A nickel ain’t worth a dime” to quote the great Yogi Berra. Nothing about the future outlook suggests these worries will recede, quite the opposite.

Worse, just like grabbing a handful of sand regulators are likely to find that the harder they squeeze the more sand slips through their fingers because, ironically, many of the IMF’s proposed recommendations to regulate crypto will only serve to make them more attractive. Uncertainty about crypto’s legal/regulatory treatment has been, and continues to be, a key impediment to institutional adoption. Providing legal certainty will therefore remove one of the obstacles to wider crypto ownership. Introducing CBDCs will lead to the same result because once the general public starts using them they will quickly begin to appreciate how they much financial privacy is sacrificed in their usage.

About the only recommendation the IMF is making that will serve to impede greater crypto adoption is the refusal to give private cryptocurrencies legal tender status but even that is a bit of a red-herring. Currently, large swatches of the payment system already uses non-legal tender (debit and credit card payments are, for example, not legal tender) and, to repeat what I said above,  society dictates what it considers and uses as money not the government. Even the Bank of England acknowledges as much[27].

When the alternative is being paid in a fiat currency whose purchasing power is declining, perhaps shop owners won’t lose as many customers as central bankers think. Indeed, when pondering the long-run implications of private cryptocurrencies, I often wonder if governments have already lost control of money, they just haven't realized yet.

Until next time.

Ryan Shea, crypto economist

[1]    See: https://www.imf.org/en/News/Articles/2023/02/23/pr2351-imf-executive-board-discusses-elements-of-effective-policies-for-crypto-assets

[2]    See: https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20230223a1.pdf

[3]    See: https://www.osc.ca/sites/default/files/2023-02/csa_20230222_21-332_crypto-trading-platforms-pre-reg-undertakings.pdf

[4]    See: https://paxos.com/2023/02/13/paxos-issues-statement/

[5]    See: https://news.bitcoin.com/terraform-labs-and-ceo-do-kwon-charged-by-sec-with-multibillion-dollar-crypto-fraud/

[6]    Earlier this month, Nic Carter detailed how he believes that the Biden administration is coordinating a campaign – dubbed  Operation Choke Point 2.0 – to deny crypto firms access to tradfi banking services – see: https://www.piratewires.com/p/crypto-choke-point

[7]    See: https://www.mof.go.jp/policy/international_policy/convention/g20/g20_20230225_1.pdf

[8]    Their words.

[9]    Page 5 – see footnote 1 above.

[10]  This may come as somewhat of a surprise to IMF managing director Kristalina Georgieva, who speaking on the sidelines of the G20 meetings, said policymakers “should not take off the table banning those assets” – see:  https://news.bitcoin.com/imf-calls-for-more-crypto-regulation-says-banning-should-be-an-option/

[11]  See: https://trakx.io/cbdcs-crypto-killers-part-1/

[12]  The only form of public money the non-bank sector can own presently is bank notes and coins.

[13]  Stephen Cecchetti, a well-known finance academic, wrote a column in the Financial Times last year arguing that governments should do nothing on the regulatory front and “just let crypto burn”. His argument was that introducing crypto regulations would convey legitimacy upon the sector. The IMF, it seems, takes a rather different view – see:  https://www.ft.com/content/ac058ede-80cb-4aa6-8394-941443eec7e3

[14]  Seemingly, the IMF is not above a little FUD.

[15]  See: https://www.bloomberg.com/news/articles/2023-02-22/crypto-has-lost-battle-against-fiat-currency-bis-chief-agustin-carstens-says?utm_campaign=socialflow-organic&utm_source=twitter&utm_medium=social&utm_content=crypto

[16]  See: https://www.cato.org/sites/cato.org/files/pubs/pdf/hanke-krus-hyperinflation-table-may-2013.pdf

[17]  See: https://trakx.io/interest-ing-times-part-i/

[18]  I included OECD estimates of these unfunded liabilities in a previous research note – see: https://trakx.io/london-calling/

[19]  For those familiar with the Laffer curve, CBDCs will have the effect of pushing out the right hand side of the curve.

[20]  Yes I know structural reforms to boost economic growth can also be deployed, but they are rarely implemented at sufficient scale because the political payoffs are typically well-beyond a politician’s time horizon.

[21]  See: Page 19.

[22]  Economists call such measures financial repression.

[23]  Between 1933 and 1974 it was illegal for US citizens to own gold in bullion form without a special licence – see:  https://en.wikipedia.org/wiki/Executive_Order_6102

[24]  I discussed these similarities in a recent research note – see: https://trakx.io/interest-ing-times-part-i/

[25]  Cryptocurrencies are also fungible, unlike other assets household’s tend to own to hedge against inflation such as  works of art or real estate.

[26]  I suspect he knows it as well and that his comment was more PR than substance.

[27]  See: https://www.bankofengland.co.uk/explainers/what-is-legal-tender