Nobel Prize winner Johnson: The crypto crisis is coming

By Simon Johnson

Compiled by: Bitpush

After passing a major piece of digital currency legislation (the GENIUS Act), and with more bills pending (the CLARITY Act has already passed the House of Representatives), the United States is poised to become a major hub for cryptocurrency-related activity, even—if President Donald Trump takes his word for it—the “crypto capital of the world.”

But those who support the new legislation should be careful not to backfire.

Unfortunately, the crypto industry has gained so much political power—primarily through political donations—that the GENIUS Act and the CLARITY Act are designed to prevent reasonable regulation. The result is likely to be a boom-bust cycle of epic proportions.

Historically, a major advantage of U.S. financial markets compared to other countries has been their relatively higher transparency, which enables investors to better understand risks and make more informed decisions. The U.S. also has strict anti-conflict of interest regulations, requires fair treatment of investors (including safeguarding their assets through appropriate custodial arrangements), and places limits on the risks many financial firms can take.

This framework didn't emerge by accident, nor did it emerge purely through market competition. Rather, it's the result of smart laws and regulations created in the 1930s, following the Great Depression (a major disaster), and has evolved in a rational way ever since. These rules are the primary reason why it's so easy to do business in the United States, bring new ideas to market, and raise capital to support all kinds of innovation.

Any individual entrepreneur, or even a potential emerging industry like cryptocurrency, might complain about these rules, claiming they are unlike anything the world has ever seen. But the risks posed by financial innovation affect the entire financial system, not just individual investors. Regulation is focused on protecting the whole.

Many major economies—including the United States—have learned this the hard way. Over the past 200 years, they have experienced severe financial turmoil and even systemic collapse. One of these collapses was a major contributor to the Great Depression, which began with the stock market crash of 1929 and spread to many banks (and other investments), destroying the wealth and dreams of millions of Americans. Avoiding a recurrence of these mistakes has long been a key policy goal.

But the GENIUS Act doesn't advance that goal. Instead, it creates a framework for stablecoins issued by U.S. and foreign companies. Stablecoins are an important emerging category of digital assets designed to maintain a stable value linked to a specific currency or commodity (the U.S. dollar is the most popular). Stablecoins are useful for investors actively trading cryptocurrencies, allowing them to move in and out of specific crypto assets without having to go through the traditional (non-crypto) financial system. We should expect significant demand for stablecoins, including from non-financial companies (such as Walmart and Amazon) looking to circumvent existing payment systems.

Stablecoin issuers have a business model similar to that of banks: they earn an interest spread by investing their reserves, and under this legislation, the interest they pay on stablecoins would be zero. This creates a strong incentive for stablecoin issuers to invest at least a portion of their reserves in riskier assets to generate higher returns. This could become a major source of vulnerability, especially if issuers are licensed by lax state-level agencies.

Indeed, from a systemic perspective, the GENIUS Act’s primary shortcoming is that it fails to effectively address the inherent run risks of stablecoins because it prevents regulators from enacting strong capital, liquidity, and other safeguards.

When any stablecoin issuer—whether domestic or foreign—gets into trouble, who will step in, and with what authority will they prevent the problems from spreading to the real economy, as they did in the 1930s?

Simply applying bankruptcy laws to failed stablecoin issuers would inevitably impose severe costs on investors, including lengthy delays in recovering remaining funds. This would almost certainly exacerbate runs on other stablecoin issuers.

It is worth noting that if the GENIUS Act is really aimed at maintaining the US dollar's status as a global reserve currency and boosting demand for US Treasuries as its supporters claim, why does Section 15 of the Act allow foreign issuers to invest their reserves in assets such as their own (high-risk) government debt - even if these debts are not denominated in US dollars?

It's foreseeable that regulators around the world will acquiesce to, or even encourage, such operations. This will lead to a truly absurd situation: so-called "stablecoins" burdened with dollar redemption obligations, while their reserves largely consist of non-dollar assets. This absurd asset mismatch will inevitably become apparent if the dollar appreciates significantly (spoiler alert: liquidity crises, solvency concerns, and bank runs will ensue).

Even greater dangers lie ahead—especially if the Senate passes any version of the CLARITY Act. This legislation would allow conflicts of interest and self-dealing to flourish at a level not seen since the 1920s. Even more serious are the national security concerns: both the GENIUS Act and the CLARITY Act could, to some extent, facilitate the continued use of stablecoins (and cryptocurrencies more broadly) for illicit financial transactions.

The United States could become a global hub for cryptocurrency, and its emerging legislative framework will surely enrich a wealthy minority. But as Congress eagerly caters to the crypto industry's demands, it exposes the United States and the world to the very real risk of a repeat of the financial panic, which could cause severe economic damage, mean widespread unemployment, and wipe out wealth.