Systemic Crypto-Asset Risk Analysis
How disruptive are cryptocurrencies? To answer this question, it is crucial to understand their nature and their novel role in the current system. The most difficult aspect for analysts is assessing the level of innovation crypto-assets in fact possess. In their latest paper, the European Central Bank does not deem crypto-asset markets a potential systemic risk to existing financial systems. The bank’s main arguments are twofold: The cryptocurrencies’ comparably low total market capitalisation of about $300 billion in early August 2019 and the EU’s regulatory framework’s flexibility and authority to impose stringent restrictions on participation in EU Financial Markets Infrastructures FMIs.
Since the ECB classifies them as “intangible assets”, meaning that – just as tangible assets – they indeed “ […] are costly to acquire, but help to create future profits, and entail some risk-taking.” Nevertheless, they have several attributes idiosyncratic to them, e.g. “[…] their scalability or non-rival nature, for instance, meaning that the benefits they provide to individual users are not dependent on the total number of users.” There is a crucial message in this last aspect which leads to this article’s reflection about the ECB’s assessment about the systemic risk of crypto-assets.
What the researchers describe referring to the interesting effects of the intangible assets’ behavior under scaling is commonly referred to in engineering or physics as “nonlinear”.
This means that the interplay between their behavior in a system – such as the aforementioned EU FMI – and their impact on the underlying system does not remain steady or constant.
In our example, this is due to the reciprocal feedback amongst the system and the intangible assets over time, which complexity scientists more precisely describe as “complex adaptive”.
The interesting aspect of the feedback is that it varies as it is subject to developments in the system and novel crypto-assets that emerge.
Since the ECB does not take these non-linear dynamics into account, the question surrounding the cryptocurrencies’ capacity to pose a risk for the current financial system remains unanswered. While its researchers acknowledge that currently, there is a risk in the form of money laundering and financing terrorist activities, they underestimate the nonlinear development of the crypto-asset’s impact. In simpler terms, if the “crypto space” grows by 10 percent in one year, its societal impact is not 10 percent larger. Its impact development might for example 1) behave in a way similar to compound interest rates, 2) grow exponentially, or 3) cubed, i.e. even larger than exponentially.
Depending on where cryptocurrencies will find their application niche, they might quickly establish themselves, with subsequent unprecedented impact due to a lack of knowledge of the correct valuation method. Currently, cryptocurrency exchanges like Binance or Bitpanda represent secondary markets where people can trade and deposit IOUs of their acquired cryptos. This approach is comparable to the handling of gold. However, since there are crypto tokens with real use for a certain product that the creator of the respective token modeled, their real value – which is determined by its role and impact on its own system (the product) – is not understood, and neither their correct price.
The right approach might be to have product-based exchanges where users can trade their crypto tokens, however inside their own ecosystem. An example of one such company would be Dent Wireless, a crypto telco that allows its users to trade their mobile data – represented by their DENT coins – on an exchange they built that aims at reflecting the correct price of the coins since users and not speculators determine supply and demand. Otherwise there is a discrepancy, an artificial gap of truth created by having system-external exchanges without a connection to the product. Speculation on these exchanges do not accurately reflect supply and demand of the coins.
As long as we do not correctly measure the value crypto-assets, we cannot and must not make risk-assessments. This, as well as the aforementioned change rate of complexity, that needs to be determined for the crypto space, are crucial factors for system stability/system threat analysis. Wrong measurement can be more dangerous than no measurement.
Author: Patrick Lehner