“Crypto-winter" is the term used by experts to describe the recent instability in the crypto markets, marked in particular by the 70 per cent drop in the value since November of the best-known digital asset, bitcoin. This collapse of valuation also led to a number of failures of crypto related firms, first and foremost one of the big Singaporean players Three Arrows Capital.

Cunliffe draws the following conclusions from these developments, which he believes will be relevant to both regulators and those involved in the crypto market over the next few years:

• Technology does not change the underlying risks in economics and finance.

• Regulators should continue and accelerate their work to put in place effective regulation of the use of crypto technologies in finance.

• This regulation should be constructed on the iron principle of ‘same risk, same regulatory outcome’; to be effective, regulatory frameworks need to apply a common approach internationally and be implemented on a domestic level.

• Crypto – technologies offer the prospect of substantive innovation and improvement in finance. Innovation needs a framework in which risks are managed to flourish.

Technology does not change the underlying risks in economics and finance

Cunliffe believes that new technologies are not able to eliminate risks that are effectively inherent in finance. Crypto technologies could indeed change the management and distribution of risks – including those associated with assets with no intrinsic value, stability of settlement asset, and use of leverage – but it will not eliminate them. A large number of coins that have no intrinsic value pose a risk of total loss. Crypto trading platforms face well-known risks arising from use of leverage. These have already led to various crises which should not be ignored.

Concerning pegged stablecoins, Cunliffe stresses the importance of backing stablecoins with real economy assets so that they can function as currency even in the face of waning confidence. The recent collapse of Terra – an algorithmically-backed stablecoin supplemented by a reserve of Bitcoin - illustrates what can happen when there is a loss of confidence in a ‘currency’ which is not backed by any real economy assets.

Regulators should continue and accelerate their work to put in place effective regulation of the use of crypto technologies in finance

Recent crypto collapses represent a clear sign that regulators need to continue their work and push ahead with the regulation of crypto technologies. In Cunliffe’s view, one cannot conclude that “crypto is over” and that there is no longer anything to worry about. Even if crypto has not posed a systemic risk so far, it could do so in the near future.

He draws a parallel to the so-called "dotcom bubble", in which the valuation of young technology companies was also very speculative and ultimately collapsed. However, in the long run, those technologies led to the current market-leading platforms in internet commerce and a similar outcome is also conceivable for crypto technologies.

‘Same risk, same regulatory outcome’ and the need for international standards

This is an often-repeated regulatory mantra. Regulators should apply regulation to the risks inherent in the provision of a financial service irrespective of how it is provided by focussing on the desired regulatory outcome. Cunliffe maintains this holds true in the context of crypto. If existing regulation might not work in this context, or may not be effective in managing the risks, the same level of risk mitigation has to be achieved by alternative means to get to the “same regulatory outcome”. If it is not possible to mitigate and manage the risk for certain crypto related activities to the extent necessary through regulation, that is to say to the extent such risk is managed in other parts of the financial system, Cunliffe advocates to not let the activities proceed. Such a globally-adopted approach has so far prevented, for example, any launch of a globally-systemic stablecoin.

For the “same risk, same regulatory outcome” approach to be effective for stablecoins and the overall crypto-environment, international standards that are incorporated into domestic frameworks are needed. In the UK, the government will be legislating in the current session of parliament to update the powers of the Bank of England and the Financial Conduct Authority to regulate and supervise stablecoins. A consultation on the regulatory framework should then follow later this year. It remains to be seen what impact this domestic approach will have on the broader regulation and operation of stablecoins.

Innovation and regulation are, in the end, friends not enemies

Cunliffe ends on a positive note regarding the future of crypto and its regulation. In his view, if developed correctly, crypto-based technologies could have huge benefits for finance and create lower costs for end investors as well as higher speed and better transparency. However, to achieve this, more “crypto-winters” have to be avoided to help the deployment and adaptation of the new technologies as well as to build the well-needed trust of the general public.

Regulators as well as innovators should have an interest in the development of appropriate regulation and the management of risk. It is only within such a framework, that they can really flourish and that the benefits of technological change can be secured. Those in the crypto industry will be hoping regulators take heed and engage so that the potential of these new technologies can be realised.

[1]Some lessons from the Crypto Winter − speech by Sir Jon Cunliffe