Bank Regulator Sees Cryptocurrency Innovation Creating ‘Fool’s Gold’

Acting Comptroller of the Currency Michael Hsu warns that red-hot crypto and 'decentralized finance' markets strikingly resemble the tech-driven innovations that nearly brought down the global financial system in 2008.

Michael Hsu has made no secret of his concerns about positive actions taken in regard to cryptocurrency activities by his predecessor at the Office of the Comptroller of the Currency, who came from that business. In an early interview with reporters Hsu, Acting Comptroller of the Currency, said that he would be reviewing certain past decisions, including those dealing with crypto. But in a speech to a key industry group, he called into question — forcefully — the point and logic of much of what’s been happening in crypto recently.

“Innovation for innovation’s sake… risks creating a mountain of fool’s gold,” Hsu, a career financial regulator, told members of the Blockchain Association. The lobbying group’s board consists of some leading crypto firms, including Binance.US, Ripple, Kraken, and Anchorage. So Hsu was in the lion’s den, but didn’t blink.

In his speech Hsu compared many elements of crypto’s current state to developments in U.S. finance in the runup to the 2008 financial crisis that brought on the Great Recession. He recalled his experience on the Securities and Exchange Commission’s staff during that time.

“We had a front row seat to the rapid scaling up and industrialization of innovations in derivatives, securitization and trading,” said Hsu. “We saw innovations that brought genuine improvements to clients and risk managers; but we also saw innovations that would imperil the firms that promoted them and amplify the 2008 crisis. I see similarities with emerging risks in the crypto and DeFi space today.” [Emphasis added.]

(“DeFi” refers broadly to peer-to-peer financial services conducted on public blockchains that are intended to eliminate middlemen like banks.)

Why Target Crypto Now:

Acting Comptroller Hsu said the crypto and DeFi fields are still at a point where a potential crisis can be prevented — if industry leaders and innovators scrutinize what they are doing and why.

“Breakneck” doesn’t begin to describe the pace of current activities in the crypto world as a whole. In his speech Hsu outlined three broad areas of concern and then provided three points to guide crypto companies developing products and services.

(Read More: New OCC Chief Targets Fintech/Banking Deals & Crypto for Scrutiny)

Three Reasons Why Hsu Sees a Crisis in the Making

Hsu drew on a 2010 book about the financial crisis, Gillian Tett’s Fool’s Gold: The Inside Story of J.P. Morgan and How Wall St. Greed Corrupted Its Bold Dream and Created a Financial Catastrophe, to outline his concerns. He also made it clear that his own experiences watching the near-meltdown has affected how he sees these new activities.

First, he pointed out that “innovation is exciting because it often begins with trying to solve an intractable problem and, in doing so, unlocking great potential.”

The creation of the credit default swap, he noted, started with the goal of hedging the risk of borrower defaults, a reasonable objective.

But a dozen years later, so much financial engineering had occurred that the swaps had spawned all kinds of new and ever-more-opaque financial instruments. Similarly, as crypto and DeFi have grown larger today they are also becoming less understandable.

Likewise, some arguments made for crypto and DeFi are questionable, in Hsu’s view. For example, “many believe that crypto/DeFi can dramatically increase financial inclusion,” he said. He noted that some observers in traditional financial services may find the idea laughable. But he said discontent could support such evolution. “Crypto/DeFi is able to pose a threat to the status quo because many people feel ignored, taken for granted, or exploited by banks,” said Hsu.

Second, concepts begun with good intentions before the crisis became perverted.

“The original idea — to create an instrument that could improve risk management and thus lower the cost of credit — has been turned onto itself, cloaked in impenetrable math and jargon, and supercharged with yield and fees to ensure growth,” said Hsu. “It was innovation for innovation’s sake.”

Hsu worries that crypto/DeFi are moving the same way. For example, multiple crypto exchanges have recently started offering “stablecoin savings accounts” with APYs of between 4% and 14.5%.

“How are the returns generated? It is hard to get straight answers that don’t quickly devolve into cryptospeak.”

— Michael Hsu, Acting Comptroller of the Currency

Third, Hsu worries that a sudden unraveling could occur in crypto/DeFi much as the financial crisis spread. This could especially play out if the growing base of crypto buyers becomes more and more mainstream and susceptible to scams and downturns.

“Until recently, most users have been hardcore believers in the technology and thus are both understanding of the risks and willing to forgive them,” said Hsu. As mainstream consumers, “with regular expectations of safe and sound money” come to represent the majority of buyers, they will dominate and drive reactions.

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Three Lessons to Keep Crypto Risks in Check

Hsu outlined three ways to avoid the risks he foresees.

First, “financial innovation should be anchored in purpose.”

Innovators ought to be able to say why some identified problem should be solved through innovation. Regarding providing for more inclusion through crypto/DeFi, Hsu said that while he is in favor of improving inclusion, he has yet to hear anybody satisfactorily explain how esoteric blockchain technology will assist.

“How is it helping to expand access to banking services and credit?” he asked. “How is it making housing more affordable and building long-term wealth?”

Second, people who see things going on that don’t make sense should speak up.

Hsu says many who could have spoken up before the financial crisis didn’t because they were making money.

Third, the industry should be able to explain how it makes a profit — or doesn’t.

“How is money being made and lost in crypto/DeFI?” said Hsu. “For the industry to grow in a responsible way, there needs to be a straightforward way to answer this question. It cannot be cloaked in jargon if it is to build trust and reliance over time.”

More is coming beyond these strong words, clearly. In an earlier speech, Hsu noted that a Presidential working group, including banking regulators, the Treasury Department, the Commodity Futures Trading Commission and the SEC is to issue a paper on stablecoins in the fall of 2021.

“Innovation is important,” Hsu said in that speech, “but safeguarding trust is paramount.’

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