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Regulators have cryptocurrencies in their sights

When cryptocurrency prices surged last year, this created hordes of newly-minted digital millionaires. Now we are seeing some real-world consequences.

This week Fidelity, the asset manager, revealed that its clients donated $ 10bn to its charitable arm in 2021: including $ 331mn of crypto asset donations, mostly bitcoin. This was a 12-fold increase on 2020.

Some of this giving might have reflected more generosity (or guilt). But pre-emptive “tax optimization” strategies probably sparked it too, since investors are waiting for “clarity from the Internal Revenue Service * on what crypto taxation looks like in the future,” Jacob Pruitt, head of Fidelity Charitable, tells me.

Either way, the pattern shows that the once anarchic, anti-establishment crypto world is increasingly mingling with the sober sphere of tax planning and stodgy mainstream financial entities. Is this a good thing? Many Fidelity investors (and their targeted charities) would say “yes”. But for regulators, the issue has been provoking rising anxiety ahead of this week’s meeting of G20 leaders.

To understand why, take a look at an important report that the Financial Stability Board, a global committee of regulators and central bankers, issued ahead of the G20.

The report notes that the crypto world has hitherto not posed any systemic financial risk. For while its market capitalization more than tripled in size in 2021, to reach $ 2.6tn, this “remain[s] a small portion of overall global financial system assets ”. And “episodes of price volatility” have “so far been contained within cryptoasset markets and have not spilled over to financial markets and infrastructures”. Phew.

But the FSB report shows regulators fear that this benign picture is starting to change. “Cryptoassets markets,” it warns, “are fast evolving and could reach a point where they represent a threat to global financial stability.”

What worries the FSB might be summed up in four L-words: legality, leverage, liquidity and leakage.

The first of these is relatively easy to describe: the pseudonymous, borderless nature of crypto has made it a breeding ground for money laundering and other nefarious practices. This week, for example, a crypto research group called Chainalysis suggested that criminals held $ 11bn of crypto from known illicit sources in 2021 – a fourfold rise on 2020.

However, leakage is a more subtle issue. Until recently, most FSB regulators and central banks seemed to view crypto assets as being akin to poker chips in a digital casino – that is, tokens that periodically sparked wild dramas at the betting table but did not have much impact on the “real” world beyond the casino walls, since they could not be used outside unless converted.

But the FSB now thinks that contagion or leakage risks are rising. One reason is that the issuance of so-called stablecoins – crypto tokens backed by real assets, such as dollars – has surged from $ 5.7bn in late 2019 to $ 155.6bn in January.

Another reason is that mainstream investors and institutions are now incorporating crypto into wider portfolio strategies. This means that any future crash in crypto prices might ricochet into other asset classes if investors needed to liquidate portfolios.

The two other “Ls”, leverage and liquidity mismatches, could further exacerbate such jolts. The latter poses a problem because the cyber entities issuing stable coins may not have enough liquid assets to actually redeem investor claims, the FSB notes. That creates the risk of runs, of the sort we have often seen in the banking world (and witnessed with credit vehicles during the 2008 financial crisis).

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Meanwhile, the leverage issue is provoking concern because of anecdotal evidence that debt is increasingly being used to turbocharge crypto bets. To cite just one example: FTX Trading, a crypto company, recently listed bitcoin products on the Austrian exchange with 20 times leverage. And while the anecdotal evidence also suggests that leverage has recently fallen, in line with the bitcoin price, that “L” word tends to spark a Pavlovian reaction from regulators today, given the role that concealed leverage played in the 2008 crash.

Of course, crypto enthusiasts would argue that worrying about crypto seems a bit ironic, given all the other leverage issues that the FSB has sometimes downplayed. Fair point: many mainstream financial asset classes are riddled with leverage and potential liquidity mismatches, due to years of excessively loose monetary policy. A crash in Treasury prices would be more destabilizing than one in bitcoin.

However, whether or not you approve of the FSB’s concerns, the key point that investors need to understand is this: regulatory scrutiny is rising – fast. Indeed, the G20 is likely to embrace the FSB’s calls for new data reporting requirements and other prudential controls.

And while it might take time to implement these proposed reforms (and global implementation will inevitably be uneven), those would-be crypto millionaires need to brace themselves for a new world. In 2022, in other words, we will hear a lot more about crypto tax planning; not all “charity” is purely charitable.

* This column has been amended to correct the name of the IRS

gillian.tett@ft.com

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