What exactly would the Fed regulate when it comes to crypto? Could it approve its use as an asset class for various investors? Read more to find out!
Abandoning the core principle of politics, US president Joe Biden decided to re-nominate Jerome Powell as the Chairman of the Federal Reserve (Fed). Lael Brainard, who has also been appointed by President Biden as the Vice Chairwoman of the Fed bolsters the US's Central Bank position in tackling the pandemic-induced inflation. And, there's one other thing. Both Powell and Brainard are considered "doves" for the crypto industry as their stance has not been of vehement opposition but that of rational scrutiny.
Given the expected predictions around inflation, several crypto natives are positive about the industry being treated not as a threat but as a potential asset class - one that can also help create a hedge against the rising inflation. That said, there is a crucial point that needs to be highlighted here - the Fed has started to closely monitor stablecoins, something that it must regulate because that is effectively digital USD. But what exactly would the Fed regulate when it comes to crypto? Could it approve its use as an asset class for various investors? Or would it still remain in the dark for most of us? We will explore these questions in this article.
Let's jump right in.
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What Does Jerome Powell's Renomination Mean for Crypto?
What we can draw from this is that the financial regulators are not chasing the industry with chains in their hands to completely lock it down. However, given that there has only been an emphasis on stablecoins and the issuance of CBDCs, it implies that that is one aspect of the industry that they intend to tackle first.
That said, there are several granular pieces to the still persisting ambiguity around these statements that are unclear. Some of them are:
Will crypto be regulated as an asset class or will it be allowed to be used as legal tender in some cases?
These are just three questions off the top of the head - imagine the complexity of regulating an industry that has so many fast-moving parts! One thing, however, is clear for sure: all of their decisions will stem from the objective of the Fed:
To ensure that crypto does not lead to systemic (if it's even possible) financial instability, and
To ensure that it does not mislead users from an investment standpoint
Given that the past few months have been a hotbed of discussions around inflation, it is possible that crypto is used as an offset.
A Seething Problem: Inflation
The Biden administration is on its feet to consider several options and focus extensively on the prevailing issues - the objective is to analyze the granular data and then find solutions. Some of them include releasing petroleum reserves and preparing ports to work longer hours that could potentially shorten the overheating wave. Managing this new wave of inflation is the open-minded Jay Powell, who considers himself a fox - an allude to the economic principle of drawing inferences on disparate and evolving information rather than sticking to one concrete principle. He has previously served under George H.W. Bush and Barack Obama as well.
In 2018, he highlighted the imprecise economic models that central banks relied upon. A natural departure from those models then facilitated the reduction in unemployment rates (going as low as 3.5%) without wage and price inflation taking a hit. The inflation rate, too, was well contained below the 2% target in 2019. All of this came to its head in 2020 when unemployment and pandemic-induced inflation led to a surge of 15% in unemployment rates and a 0.2% rise in inflation. As the interest rates were slashed and a substantial volume of capital was lent out to borrowers, the demand in the markets slowly increased, only to pump inflation even higher as the supply chain issues caused by the pandemic were still persistent.
The $5.9T in stimulus has only accelerated the demand within the market - thanks also to the reduced interest rates and an overall opening up of the American economy post the vaccinations. The inflation target has well overshot the 2% that Fed had projected.
But the most pertinent question of the hour is - where does crypto come in all of this? Granted that Mr. Powell has a more forward-looking approach towards monetary policy - and the relative independence being given to him by Biden as opposed to the pressures from Trump are only going to help him take a well-informed and unbiased stand. Crypto, most certainly, has emerged as a digital hedge because it does not have a direct relation with the economy. If any, the relation is more inverse - as more people feel pressured against the rising prices, the more likely they are going to store their wealth in appreciating assets. Crypto has been one of the most successfully appreciating assets of 2021 - with Bitcoin almost doubling since the start of the year to date.
Bitcoin is widely considered digital gold because it serves the purpose of a store of value rather than showing the potential of being legal tender. Thus, for several financial institutions (and even retail investors) crypto is far more than just the new kid in town.
Using Crypto as a Hedge
A large part of this argument is made by investors who say that, unlike fiat currency, no one controls the supply of Bitcoin. Central Banks then have little-to-no say in how their distribution and issuance is managed, leaving its price-performance dependent entirely on all those who buy it for the market price in the first place. This argument is complemented by the fact that there have not been any noticeable similarities between the rising inflation and cryptocurrency prices. (While one could argue that there is not much data to show that correlation in the first place, the truth is that such correlation does exist.) Let's take this chart for example. It attempts to show Bitcoin's price, the inflation rates, and the short-term interest rates of the U.S.
Stage 1: At this stage, Bitcoin surged over 1,000% while Consumer Price Index (CPI) only rose to 2.1%. The interest rates were also raised during this period in an attempt to cool inflation.
Stage 2: During this stage, the tables turned as Bitcoin performed poorly while inflation rose to about 2.4%. The interest rates were boosted as well. This is counteractive to the larger argument - why would investors not decide to choose this asset class when the prices were consistently going up? Lack of awareness?
Stage 3: This is where our argument of crypto at the time of inflation comes true. The previous stage's rising inflation could have propelled investors to get into crypto. Moreover, the lowering of interest rates in 2019 could have spooked some investors of incoming inflation, thereby moving to Bitcoin.
Stage 4: This was the time when the pandemic had just started to wreck the markets and disrupt supply chains. However, the inflation during this period was low, whereas Bitcoin's gains were as much as 600%. This is where the argument in support of Bitcoin against inflation completely fails.
While several of these investors are jumping on the bandwagon and abandoning gold, the truth is that Bitcoin is relatively new to be used more than a speculative asset. It has only been around for just over a decade and has hence seen very limited economic cycles. In fact, 2021 is probably the first year when it is actually being considered by the more prominent players on Wall Street. Rising consumer prices coupled with declining gold prices have surely propelled investors to look for new assets - however, the speculation around it cannot be ignored.
Some investors argued - the underlying speculation notwithstanding - that the recent run to its record-setting ATH of almost $69K was driven by a surge in both retail and institutional investors to look for alternative investments. Because the crypto market has ballooned this year, the various options available within crypto were naturally a favorable option.
Out of all the investors surveyed, it was found that most investors were looking to increase their exposure to this asset class by acquiring various investment products, if and when approved by the SEC.
A large portion of the surveyed investors was focused on acquiring Bitcoin and Ethereum as their primary exposure to digital assets.
Most Asian investors were far more inclined towards investing in digital assets followed by European and American investors respectively.
How Would The World of Digital Assets Look Like in the US?
The most pertinent question of all time is that if there is a raging interest in digital assets, then how would that scenario change in the coming months? As mentioned previously, DeFi is a complex ecosystem that has several moving parts to it. Regulating this system requires a fundamental knowledge of not only the ecosystem but also of the various stakeholders that are involved within. To differentiate a miner, a liquidity provider, a staker and a lender is crucial before deploying regulations around each. And that is where problems really come up.
The complexity of the industry could imply two things -
The regulatory body understands what each stakeholder does and create regulation accordingly
The regulatory body creates a blanket regulation that fails to distinguish between two entities that are markedly different in both structure and function
Thus, when it comes to regulation it seems like we have a steep and slippery climb. Now, coming to the question of how the Fed could use crypto assets, we have already understood that there is not enough data that tells us that crypto is a useful inflation hedge. For any central bank relying on such a speculative asset when it is accountable to billions of people and has the potential to have a cascading effect on the economy of the entire world, it just does not make sense. Other problems exist too.
Cryptocurrencies do lack solid fundamentals. If the central bank cannot limit/de-limit its supply, it surely must find ways to regulate it in ways that favor the larger economy.
Because of the anonymity around crypto transactions, they can also be used for all the wrong reasons. And this is where the SEC would have to step in - who have been echoing their promise to protect investors from fraudulent activities. Over $600M have been lost to DeFi scams in just 2021!
All of this is bound to leave the regulators with a scorned look at this space - it surely is exciting, innovative, and forward-looking, but it is speculative and full of challenges. Perhaps one of the biggest challenges that the industry faces is the existence of fiat-backed stablecoins such as USDT and USDC. The protocols that issue these coins have previously been in trouble for not having adequate reserves. Now, this is where it gets interesting for the Fed.
Would they completely regulate these protocols and check for their fiat reserves? If they do and find that they do not have as much as they say, they are sure to put a check on them. That itself poses a systemic risk to the entire DeFi - which runs on the back of stablecoins.
While issuing CBDCs are certainly an alternative, the United States especially has been behind when it comes to adopting it. In addition to all the benefits it provides, a CBDC could also work as a potential solver for all the unbanked. Fortunately, though, all recent explorations into CBDCs have seemed to spare algorithmically-backed stablecoins.
It is hard to tell what the future would exactly look like. We have seen that several arguments that might look to us as favorable for Central Banks are barely arguments at all because of a) the relative newness of this industry and b) the Fed's current lack of understanding of how this rapidly growing industry works. One thing is for sure, however, that there does not seem to be a disregard for crypto. Several institutional investors who have already poured their money into the industry complement this fact.
The main reason behind the re-nomination of Mr. Powell was that President Biden felt that his core philosophical beliefs with regard to the economy align perfectly with that of Mr. Powell. For a country that embraces capitalism and innovation, it is possible that crypto is currently in the right hands and we should expect positive things in the future.