The Crypto Ecosystem

The cryptocurrency ecosystem that has grown up around Bitcoin and Ethereum includes a diverse range of instruments, institutions, and practices that the original cryptocurrency white papers did not anticipate and often directly contradict. Stablecoins -- cryptocurrencies designed to maintain a fixed value relative to a fiat currency -- exist because Bitcoin's volatility makes it unsuitable for most financial functions. Decentralized finance (DeFi) protocols replicate the functions of banks, exchanges, and insurance companies using smart contracts on blockchain networks. Non-fungible tokens (NFTs) use blockchain to create verifiable scarcity of digital assets. All of these innovations represent attempts to build the financial system that cryptocurrency was supposed to replace -- but on a blockchain substrate.

The irony is deep. Stablecoins are valuable precisely because they are backed by the fiat currencies that cryptocurrency was designed to supersede. Tether, the largest stablecoin, maintains its dollar peg primarily by holding US Treasury securities -- making it, effectively, a money market fund on a blockchain. USD Coin, the second largest, is issued by Circle in partnership with Coinbase, both of which are regulated financial companies subject to the same institutional oversight that cryptocurrency was designed to circumvent.

DeFi protocols have reproduced -- at considerable cost -- the functions of traditional financial intermediaries, generally with less consumer protection, more concentrated governance (protocol voting rights are distributed in proportion to token holdings, which are highly concentrated), and exposure to novel risks including smart contract bugs, oracle manipulation, and flash loan attacks that have drained hundreds of millions of dollars from protocols. The largest DeFi hacks and exploits between 2020 and 2023 totaled over $10 billion in losses.

Crypto has recreated every financial instrument known to traditional finance -- derivatives, leverage, speculative bubbles, insider trading, fraud, and bailouts -- without the consumer protections, disclosure requirements, or regulatory oversight that traditional finance, however imperfectly, provides.Adapted from Hilary Allen, DeFi: Shadow Banking 2.0? (2022)

The failures of 2022 -- the collapse of the Terra/Luna stablecoin system (erasing $40 billion in market value within days), the bankruptcy of Three Arrows Capital, the fraud at FTX (where customer deposits were used to fund proprietary trading at the affiliated Alameda Research firm) -- were not anomalies in an otherwise sound system. They were expressions of the system's structural features: absence of disclosure requirements, unregulated leverage, insider information advantages, and the concentration of protocol governance in the hands of founders and early investors.

The crypto ecosystem has attracted serious technical talent and genuine innovation in cryptography, distributed systems, and mechanism design. It has not produced a monetary system that is fairer, more stable, or more broadly accessible than traditional finance. The problems it was designed to solve -- concentrated monetary power, institutional failure, financial exclusion -- are political and institutional problems. They are not solved by changing the substrate on which financial records are kept.