Bitcoin: Have the Lessons of the Financial Crash been Learned?

The Chicago Mercantile Exchange (CME) has a sense of humour. Why else pick Halloween to announce its plan to launch a Bitcoin futures contract before the end of the year, ‘pending all relevant regulatory review periods’?

CME’s announcement is another indication that lessons from the financial crisis have been lost in the rush to jump on the cryptocurrency bandwagon. And before things get completely out of control, it is worth remembering the fable about boiling frogs: Drop a frog into hot water and it will leap right out; put a frog in a pot of cold water, slowly raise the heat and the frog will not perceive the danger until it is too late to jump.

The frog metaphor is a reminder that, although people believe they are good at adapting to change, they often fail to recognise and respond to gradually developing threats.

Analysis of antecedents to the financial crisis suggests that in the rush to profit from sub-prime mortgages, credit-backed securities, credit default swaps and derivatives based on innovative market indices, few understood these exotic products or the risks they created. However, lack of understanding did not stem the tide of investment into them.

Like the frog, the guardians of financial stability failed to respond to the developing threat until it was too late; by 2005, a systemically important, but widely distributed, shadow banking sector had developed.

Almost every step, from debt origination to the sale of credit-backed securities, to debt servicing and speculation on debt-based derivatives could take place outside the direct view of regulators. Mainstream financial institutions were investing in complex, opaque debt securities and derivatives based on credit-backed products, many linked into the unregulated shadow banking sector.

Regulators were lost in the dust of the stampede to profit from debt products. Operating in narrowly focused silos, they failed to detect the growing systemic risk caused by interconnections between institutions. They also failed to respond as excessive leverage created illusions of new wealth and credit rating agencies blessed as low risk successive additions to the growing mountain of debt.

Silos were not the only regulatory weakness. Investigations into the Equitable and Madoff failures concluded that regulators lacked the skills and capabilities needed to supervise these complex entities.

Fast forward to 2017, and Blockchain technology is introducing new business models, new products and new ways of operating. Few understand how these are constructed and maintained or the risks they create.

Regulators, where oversight even exists, are dispersed, certainly varied in approach, and most likely under-resourced and under-skilled. Cryptocurrencies such as Bitcoin and Ethereum are just the most obvious. Only a few critics have warned about Bitcoin’s wild gamble and some implausible projects currently underway.

Many understand FinTech innovations could disrupt the models on which the financial system operates but they are excited by the opportunity to make money from them, and few are interested in the new risks these introduce.

Prudential regulators, including the US Federal Reserve and Bank of England, have concluded the cryptos pose little systemic risk to the financial system because these are small-scale niche businesses. However, regulators have failed to acknowledge that the many digital businesses which service cryptocurrencies have extensive linkages into the global financial system.

So, Bitcoin is being pushed at a naïve public, and hype about profits has grown steadily. A digital currency trade fair in London had standing room only; an event in New York filled a ballroom. Excitement is stimulated by media reporting Bitcoin’s skyrocketing price; BBC Radio 4’s Today programme concluded the CME has brought Bitcoin into the mainstream.

Think again, for a more sober investigation suggests the CME project is built on sand. Crypto Facilities Ltd which produces the Bitcoin Reference Rate (BRR) Index has elected to file abbreviated accounts with Companies House so it is difficult to substantiate their claim that they have facilitated $150 million in trades since the Financial Conduct Authority licensed it as an appointed representative for MET Facilities LLP beginning 27 August 2014. The company did not receive Financial Conduct Authority approval to operate as a derivatives broker until 6 April 2017. Also, the accounts the company filed suggest it was insolvent at the end each of its first two years in existence.

CME claims ‘[the BRR is] governed by an independent oversight committee of industry experts’. Three of the seven committee members are CME and Crypto Facilities insiders, the others include an academic whose paper validates the BRR methodology, two Bitcoin market makers and a Bitcoin enthusiast who has been reported as lobbying in Canada for little or no regulation of cryptocurrencies.

Minutes posted by CME of the three one-hour committee meetings held to date disclose that the first occurred after BRR launched; two were by telephone and one committee member has failed to attend any meetings.

The BRR Index includes only four exchanges, three US-based and one in Luxembourg. Only two of these are among the global top ten, so another issue may be a lack of adequate activity coverage.

Cryptocurrencies present opportunities for criminals. Although the extent of criminal activity is unknown, Europol reports that Bitcoin has been payment in most recent ransomware attacks and cryptocurrencies have enabled growth in ransomware.

Significant investment is going into FinTech – including start-ups seeking to profit from the Bitcoin bandwagon. As the breadth and depth of cryptocurrency activity increases, the concomitant risks increase. A growing number of hedge funds are speculating in cryptos and new derivatives based on them. Much of this speculation is highly leveraged.

CME’s new futures contract is just one of many links connecting high-risk cryptocurrencies into the global financial system. There should be immediate concerns about the systemic risks presented by Bitcoin and many other Fintech projects which are creating conditions that closely resemble those preceding the financial crisis.

Kathryn Vagneur has had a long association with RUSI. A specialist in 'fixing broken companies', her academic research explores governance and resilience, especially weaknesses in the system of oversight in the financial services sector.

The views expressed in this Commentary are the author’s, and do not reflect those of RUSI or any other institution.