The Impending Financial Crisis

I teach a course on 'Financial Crises/Regulatory Responses' with the economist Patrick Bolton. This course addresses the struggle to establish and maintain financial stability, an apex goal of the financial system.  Last week, I told the students that by the time we meet at their fifth reunion, we will likely have experienced a major financial crisis, centering around the growth of crypto finance, a hallmark of the second Trump presidency.  Although initially hostile to crypto, Trump shifted his position after the promise of significant campaign support from the crypto industry, reported to have amounted to at least $150 million. As just reported in the Financial Times, Richard Teng, the CEO of Binance, anticipates a 'golden era' for crypto. So I suspect that we will see substantial, perhaps exponential growth in various crypto assets and platforms, and the spillover of 'decentralized finance,' DeFi, into the global financial system.

My belief in a forthcoming, potentially quite serious financial crisis centered around crypto comes from the course’s consideration of financial crises over the past half century, since the end of the Bretton Woods accords in the early 1970s, especially the global financial crisis ('GFC') of 2007-09 and the Covid crisis of 2020, each of which had a global dimension.

A substantial fraction of global trade and global investment is dollar-denominated. A global bank needs to deal in dollars, to acquire dollar-denominated assets, and to issue dollar-denominated liabilities, including deposits and other short-term credit claims. In the crises, as financial instability spread, short-term creditors pulled out of banks and other short-term credit markets like repo to accumulate cash, not only for safety, but also to protect themselves against similar cash-seeking behavior by their own counterparties. The Fed played an essential, stabilizing role as a lender of last resort ('LOLR'), providing liquidity to the financial system.  Critically, the Fed performed this function not only for US financial institutions, but also globally, via swap-lines with other central banks.  The European Central Bank ('ECB'), for example, could not on its own become a LOLR of dollars to satisfy dollar-denominated withdrawals from EU banks.  But via the swap-lines, the ECB could obtain dollars that it could flow downstream to EU financial institutions within its domain. These arrangements were a critical part of the recovery from the GFC and the Covid shock.

But note: The Fed’s LOLR provision is not risk free.  The Fed typically took back collateral with significant credit risk or market valuation risk.  This was true both in the US context and the global swap-line context.  The argument is that success as an LOLR will itself minimize the Fed’s risk, since avoiding runs and restoring liquidity protect the real economy and thus ultimately minimize losses on the collateral. But the risk of loss is real, particularly evident during the fall of 2008.

What this tells us is that the growth of a crypto-linked financial system, and, most critically, its growing connections with traditional finance, will present burgeoning systemic risk without an obvious resolution mechanism.  One likely crisis vector will be the growth of stablecoins, cryptocurrencies that promise 'stable' conversion-via-redemption into 'fiat currencies,' aka 'money,' like dollars.

It is likely that cryptocurrencies like stablecoins (and other tokens) will become more than a simple payment mechanism.  It is foreseeable that 'real world' assets will be denominated in stablecoins and other cryptocurrencies, that 'real world' liabilities will be issued in crypto, that collateral arrangements will be made using crypto or denominated in crypto. Crypto-based lending will become a credit channel to the real economy.  But crypto has no inherent value. Stablecoins can dive substantially below par. We’ve seen this movie before, with prime money market funds.  As with prime money funds, the stablecoin redemption right is subject to the value of its 'reserves,' in effect, floating Net Asset Value.  As we learned about prime funds in the Covid crisis, the foreknowledge of floating NAV is no guarantee against runs, even where the 'reserves' are specified by regulation and designed to provide liquidity.

In response to some external shock, parties will run to convert crypto to dollars. Liquidity in the crypto financial space will immediately dry-up.  This is the crucial point: There is no LOLR for crypto. There is no guarantor for the convertibility of stablecoins into 'money.'  Indeed, this is a direct implication of the DeFi structures that characterize crypto.  But that doesn’t mean that runs won’t occur and that intermediating parties in the financial space won’t collapse in the face of redemption requests and collateral calls and that crypto-dependent borrowers in the real economy won’t face immediate financing shortfalls.

More broadly, the Fed as LOLR is prepared to take credit and valuation risk because as a government institution, its mission statement includes the maintenance of financial stability, an apex public good.  Avoiding the potentially catastrophic melt-down of the global financial system is ample pay-off for the risks taken by the Fed.  And of course as a central player, the Fed gets to set the rules of global finance in ways that are sometimes obvious and other times subtle. There is no similar institution in the crypto world designed to protect financial stability.  It is a zero-sum environment of all against all.  No regulatory fiat will transform the underlying motivation of the crypto financial players. DeFi is at war with centralization by regulatory fiat.

One lesson of the course I teach is that no innovation at the outset presents a significant risk to financial stability.  As its influence grows, as it becomes linked into banks and other financial intermediaries and provides a meaningful credit channel to the real economy—that’s when the systemic implications of an 'innovation' become strikingly apparent. By then the business is big, and the beneficiaries will fight to hold onto their gains.  Appropriate regulation will be very hard.

Crypto fits right into this paradigm.

As I told my students, the chances for a major financial crisis relating to crypto before their fifth reunion are very high.  I’d be willing to wager some bitcoin on it.

Jeffrey N. Gordon is the Richard Paul Richman Professor of Law at Columbia Law School and co-author of PRINCIPLES OF FINANCIAL REGULATION (OUP 2016). 

Professor Gordon would like to thank his colleagues Todd Baker, Patrick Bolton, and Lev Menand for their help with the piece.

A version of this post was originally published in the CLS Blue Sky Blog, linked here.