Managing Systemic Risk in the Crypto-economy
Our co-founder and BizDev Lead, Talal Tabbaa, recently gave a talk at the Blockchain Summit in Dubai, UAE. The talk revolved around the risks associated with the scale of certain elements within the crypto-economy, as well as the extreme interconnectedness and its implications on the overall health of the system. The presentation can be found here.
This piece covers what was presented and adds a bit more detail on what the community can do to self-regulate.
What is Systemic Risk?
Systemic risk is the risk of collapse of an entire financial system or market caused by idiosyncratic events and financial intermediaries.
How does Systemic Risk play out?
Systemic risk can play out in a different number of ways. The most common outcomes being; the domino effect, financial contagion and loss of trust.
It can play out in a number of ways. The domino effect is when the collapse of a single entity sends shockwaves through the system, taking down unstable organizations with them.
In addition, in some cases, seemingly healthy organizations are impacted by the overall economic climate, as a result of over interconnectedness. This is known as financial contagion.
Finally, we can look at Bitcoin itself as the offspring of the Loss of Trust between capital providers and lenders, where the original crypto-anarchists / enthusiasts turned to cryptocurrencies as the result of a justified disillusionment with the state of consumer banking in the years following the collapse.
When has Systemic Risk Materialized?
We don’t have to look too far back to see an example of Systemic Risk materializing. During the 2008 Global Financial Crisis, a portion of home mortgage markets (primarily subprime) triggered the most severe financial crisis in the United States since the Great Depression.
While various elements played a role in this, one of the key drivers was the proliferation of complex mortgage-backed securities and derivatives
with highly opaque structures, unnecessarily high leverage, and completely inadequate risk management.
The problem was compounded further by conflicts of interest and dangerous incentive structures including within rating agencies, underwriters and lenders.
What causes Systemic Risk? How do we measure it?
Using this framework, we can measure and identify potential sources of Systemic Risk. For example, the 2008 financial crisis was a result of ‘Too Big to Fail’ institutions.
Note. Some literature refer to ‘Systemically Important Financial Institutions’ (SIFI) and ‘Too Big to Fail’ Institutions as the same thing, but for the sake of our analysis we shall keep them separate.
What does this have to do with the Crypto-economy?
- Systemically Important Financial Institutions
Concentration risks across the crypto ecosystem, whether its mining pools, exchanges or wallets — given the ecosystem is still in its infancy, it is expected that these concentration risks would emerge.
That being said, it is imperative that we diversify our offerings with regards to products and self-regulate with regards to institutions.
Exchanges now face / impose risk in the form of potential fraud / bad actors, technological vulnerabilities, liquidity risks and market risks.
Even today, the top-5 mining pools control over 60% of all mining power.
2. Too Interconnected to Fail
Cryptocurrencies serve a multifaceted role. They are used to store value, to send value, as a speculative investment tool and as a crowdfunding mechanism.
If we are using ETH as a speculative investment tool, it becomes less suitable as a currency (due to volatility) and then unsuitable for payments. While this example is, again, due to the ecosystem still being in the early days, it is important that we begin designing different tokens, for different roles and regulating them accordingly.
Furthermore, in some cases, crypto-currencies are used beyond their architectured purpose, for this reason, we are beginning to see projects fail to get off the ground — especially those with completely unreasonable token economics.
3. Too Big to Fail
As we previously pointed out, concentrations exist across cryptocurrencies, crypto-exchanges as well as mining pools. What makes the issue especially worrying is the global scale and interconnectedness of these entities.
It does well to remember that Mt Gox. was processing more than 80% of bitcoin trades at its height.
What will the consequences be for the traditional economy?
At current levels and volumes, it’s unlikely that a crypto-bubble correction / burst will have any significant implications or impact on the traditional economy.
This is primarily driven by two overarching dimensions:
- Limited Scale / Magnitude
The current crypto-economy in its entirety is one third of Amazon’s market capitalization.
2. Limited On-chain / Off-chain Linkages
While VCs and other institutional investors have begun to look at crypto-currencies as a new high risk investment area, the reality is, many have yet to take long term positions or commitments.
For this reason, any crypto-bubble burst, is unlikely to heavily impact these institutions, as they are not that invested or exposed.
What will the consequences be for the crypto economy?
This is where it gets interesting / terrifying, depending how invested you are.
- We use the same cryptocurrencies for different functions, examining the usage of ETH:
A. Remittances, payments, etc. → Real world equivalent →Currency
B. Speculative investment → Real world equivalent → Equity
C. Fund raising → Real world equivalent → Convertible note
Given ETH is being used as a speculative investment tool, volatility is quite extreme, meaning it is no longer suitable for remittances and payments.
In addition, given its volatility, crypto-startups with significant funding locked in ETH, have their funding at risk, due to regular corrections in the market.
i.e. a crypto-company may raise funds on a market high, and subsequently see its funding slashed due to market corrections.
We are beginning to see concentration risks emerge across geographies, exchanges and mining pools. The downfall of one key player could lead to a domino or financial contagion effect, bringing down the entire market for some time.
In addition, there are also concentration risks among products and infrastructural elements. Given that a handful of user application (e.g. wallets), development tools (e.g. libraries and frameworks), and protocols are adopted across the board, any identified weaknesses are exploited at a large scale.
What does this mean for crypto-startups and crypto-investors?
With a lot of investors taking a more conservative approach these days, with a bulk of ICO funding coming from investors seeking to diversify their portfolios after astronomical early gains — the main risk imposed by a crypto-bubble burst are on the solvency of crypto-startups.
Currently, crypto-startups are afforded two key luxuries:
- Strong bull market — any funding raised has only appreciated in value (relative to fiat)
- Lax Regulation — regulators have taken a laissez-faire approach, only providing overarching guidelines, but there intervention is a matter of when, not if, they are likely to choose one key offender and make an example of them, setting the relevant case-law / additional frameworks as they do.
- Crypto-accepting vendors — Law firms, PR firms, advertisers and other vendors have started accepting crypto for payment, either in the form of alt-coins from crypto-startups, or BTC / ETH.
The reality is, these three elements have allowed crypto-money to stay within crypto, while still servicing the needs of the startups.
Coupled with lax regulation, this is a slippery slope and is likely to attract bad actors (such as money launderers).
How do we prevent this catastrophe, or at least mitigate risk / impact?
We recommend a simple three-step solution to reduce the risks associated with the issues above — Separation, regulation and, monitoring & administration.
At Jibrel we’re working on step 2. Below we discuss what all three elements mean.
If you issue a token that represents gold you are holding and you are freely trading that token, you are basically a Gold ETF, and should be regulated as such.
If the token you issued represents listed equity, you’re a stock broker.
These tokens will need to get classified by the assets or functionalities they represent.
Once these tokens are classified as the assets they represent, they will need to get regulated accordingly, but without imposing bottlenecks on the sustainable growth of the system.
That’s why we’ve developed Smart Regulation — “Governance without Governments” — a decentralized self regulating system, that reflects and enforces existing real-world regulation, on-chain.
Monitoring & Administration
Finally, like with any system, a large part of the success lies in the ability to comprehensively monitor and administer the system. Thanks to the benefits of Distributed Ledger Technology (DLT) or ‘blockchains’ — this should be the easiest step to implement, but buy-in on self-regulating the crypto-economy is very important — from all stakeholders; miners, exchanges, crypto-startups, traders and enthusiasts.
There is an immediate need to translate real-world regulation, across asset classes and jurisdictions, into self-enforceable blockchain powered code. That’s exactly what we’re doing at the Jibrel Network.