Financial stability has been a hot topic among institutions lately and not just because of the pandemic, supply chain issues, record inflation or the ongoing war in Ukraine. The continued adoption of cryptocurrency has made it another important factor, so much so that the IMF recently dedicated an entire section of its financial stability report to crypto-related tech. Today I’m going to tell you a bit about the IMF and break down what its recent report says about cryptocurrency and what it could mean for the crypto market.
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What Is The IMF?
If you’re unfamiliar with the IMF, here’s what you need to know. The International Monetary Fund, or IMF, was created as part of the Bretton Woods agreement in 1944 when 44 countries came together to agree that all their national currencies would be pegged to the US dollar at a fixed rate, which would in turn be backed by and redeemable for gold at a fixed price.
The IMF was originally created to make sure the exchange rates between the US dollar and the other currencies remained stable, alongside other roles that are nearly identical to those of the World Bank. Oh, and FYI, the World Bank was created alongside the IMF at Bretton Woods.
After the Bretton Woods agreement ended in 1971, when the United States abandoned the gold standard, the IMF turned its focus to international financial stability. In short, the IMF makes sure, by any means necessary, that any national economic issues don’t become international economic issues.
Following the 2008 financial crisis, the IMF added gender equality, income inequality, money laundering, and climate change to the list of things it concerns itself with because, why not?
Today the IMF consists of 189 countries, which collectively decide what the IMF does. A country’s voting power is proportional to how much money it pays to the IMF in the form of a membership fee. The IMF uses money to finance its operations as well as issue loans and the like.
Because most of the IMF’s money comes from western countries, the IMF’s mission is implicitly and explicitly aligned with the economic interests of said western countries, namely the United States and the European Union. Case in point: The IMF’s headquarters are in Washington, D.C., right across the street from the headquarters of the World Bank.
Like all other unaccountable international organizations, the IMF has its fair share of critics, and the primary point of criticism has been all the conditions that come with the loans the IMF issues to developing countries. These conditions include things like cutting health care and education spending, increasing raw material exports to western countries, allowing western corporations to set up shop in the country, and, in the case of Argentina, discouraging the adoption of cryptocurrency.
Now if that last point didn’t give it away, the IMF is anti-crypto. I suppose that’s not surprising given that its purpose is ultimately to ensure the current fiat-based financial system continues to operate without obstruction.
El Salvador’s adoption of bitcoin as legal tender in September last year put cryptocurrency higher on the IMF’s list of priorities, and it seems that the IMF has been coordinating with its member countries to crack down on the crypto industry to prevent it from becoming a serious competitor to the status quo.
As such, this is one of the many things the IMF discussed in its recent financial stability report, which I’ll be breaking down today. The report is broken up into three parts, and most of it is honestly quite technical, pretty boring, and not really related to cryptocurrency. As such, I’ll just be summarizing what was said in the sections that explicitly mentioned cryptocurrency, as well as the third part of the report, which pertains to cryptocurrency regulation.
War in Ukraine And Crypto
Now sit back and relax while I unpack the IMF’s most recent crypto rhetoric. The first section of the IMF’s report is titled “The Financial Stability Implications of the War in Ukraine,” which is pretty self-explanatory in the summary at the start of the section. The IMF notes that the economic effects of Russia’s invasion of Ukraine are likely to accelerate crypto adoption, particularly in developing countries. I would say this so-called cryptolization is already in full force in both Ukraine and Russia because of the war, with regular citizens on both sides stacking sats to protect their purchasing power and using stable coins for day-to-day transactions as well they should.
The inflationary effects the war is having on other countries appear to be causing crypto adoption as well. But it’s important to note that inflation was already accelerating well before the war began. On page seven, the IMF notes that crypto could be used by Russia and other countries to bypass sanctions, but this is much easier said than done and might even be impossible to do if you need any proof.
Chainalysis, a blockchain analytics firm, recently released a report that confirms there is not enough liquidity, i.e money, in the crypto market for Russia to evade sanctions and that’s just Russia. The IMF, ironically, cites Chainalysis as a source later in the report when discussing how decentralized exchanges, privacy coins, and privacy preserving technologies could be used to avoid sanctions.
The IMF also notes that bitcoin mining could be another way that rogue countries evade sanctions, which is probably why the US Treasury Department recently sanctioned a Russian crypto mining company. This begs the question of whether buying BTC that was previously or recently mined by this Russian crypto mining company would result in sanctions or if any BTC transactions processed by this crypto mining company would constitute a sanctions violation
On page 33, the IMF admits that there’s a possibility that central banks will begin buying cryptocurrencies as part of their foreign exchange diversification strategies away from the US dollar, something which has accelerated since western countries seized the overseas assets of Russia’s central bank.
At the end of the first section of the IMS financial stability report, the authors provide policy recommendations for all the issues they discussed earlier when it comes to cryptocurrency. In addition, the IMF recommends that countries take steps to follow the recommendations of the financial action task force, or FATF, which would effectively end the crypto industry as we know it.
In addition, the IMF recommends that countries begin aggressively regulating ‘non-bank financial intermediaries’, which presumably includes things like DeFi protocols and various crypto apps.
Finally yet importantly, the IMF recommends that countries develop central bank digital currencies to fight against crypto adoption.
Biggest Financial Stability Risk
The second section of the IMF’s report basically has to do with all the government debt that’s been accumulated in response to the pandemic. Although this section isn’t directly related to crypto, it’s important to break it down because it’s arguably the biggest stability risk the financial system currently faces, at least as far as the IMF is concerned. As some of you will know, government debt is typically sold to investors, usually foreign banks and governments, who want to earn a safe interest rate on their idle capital. Pension funds also tend to buy government debt as they’re often obligated to do so for financial stability reasons.
However, during a pandemic, demand for government debt from foreign sources and the domestic private sector wasn’t enough to meet the supply the government needed to spend, and that left the buyers of last resort, commercial banks and central banks.
In the case of the United States, the Federal Reserve bought almost $5 trillion dollars of debt during the pandemic, mostly government debt and mortgage-related debt. The graph is terrifying, to put it mildly.
While all this government debt buying by central banks isn’t always a problem in developed countries, it can be a very big problem in developing countries. This is because the interest rate on a government debt determines the interest rate for other types of debt in the country of origin. It’s the risk-free base rate that’s used to determine all other interest rates of similar maturity, Tor example, if the interest rate on a 30-year government bond is 5%, then you could expect to see a 30-year mortgage at 5% plus a reasonable credit spread.
The interest rate on different durations of government debt is determined by supply and demand, with low demand resulting in higher interest rates and high demand resulting in lower interest rates. So what happens when foreign investors and domestic private sector investors see that the central bank and commercial banks are the primary purchasers of a certain government’s debt?
Logically, it leads to even lower demand for that government’s debt from these parties because they sense that something isn’t quite right. That leads to higher interest rates for that government’s debt. Normally, this wouldn’t be a problem because foreign and domestic private sector investors would eventually start buying that government’s debt again when interest rates are high enough to whet their profit appetite and the resulting demand would bring interest rates back down. However, because of all the debt that governments have piled on in response to the pandemic, allowing interest rates to rise too much could cause them to default on their existing debt. It also makes it extremely difficult for companies to borrow, which has a negative effect on economic growth. In developing countries the effects of this are even more severe because interest rates are often high under normal economic conditions. This is simply because there’s more risk associated with buying the government debt of a developing country.
The possibility that developing countries could soon start to default on their debts was the main topic of discussion at a recent meeting and subsequent debate between some of the most powerful people in finance, which aired on CNBC last week. The cast list for this included FED chairman Jerome Powell, European Central Bank President Christine Lagarde, and IMF managing director Christina Georgiava, who admitted while laughing that they didn’t think about the consequences of printing too much money in response to the pandemic.
In any case, it looks like the IMF spheres are slowly starting to come to fruition as Sri Lanka appears to be on the brink of a default. Even though the country only has around 50 billion dollars of foreign debt, this could lead to a domino effect because lenders need that money to pay back their own billions of debt.
Fintech And Crypto
Anyhow, the third section of the IMF’s report is the one that concerns cryptocurrency, which apparently falls under the Fintech umbrella. I suppose that makes sense. In any case, the authors begin by acknowledging the obvious, and that’s that the pandemic has accelerated the adoption of alternative financial technologies, particularly decentralized finance protocols in cryptocurrency.
The general theme is that these alternative financial technologies are fine so long as they don’t compete directly with the banks, in which case the authors consider them to be a risk to financial stability. I can’t say I’m surprised.
The first case study the authors examine in this regard is what they call “neobanks,” which they define as branchless banks whose suite of services are only accessible online or via a mobile app. The authors take issue with the fact that neobanks target people who have a hard time getting access to financial services. As far as the IMF is concerned, these people carry inherent financial risks, which makes neo-banks risky by extension. In addition, because neo-banks are often nothing more than a more accessible front-end for the existing financial system, neobanks therefore put the financial system itself at risk. That is some next-level sophistry. I’m almost impressed.
The second case study the authors examine is Fintech companies that offer mortgages in the United States. Now this is news to me. The authors take issue with the fact that Fintech companies are growing faster than banks and explicitly state that, quote, ‘Fintechs directly compete with banks, raising financial stability challenges’. The authors then finally pivot to decentralized finance, and they eloquently explain that there are three fundamental technologies that make this possible. These are:
- blockchain to keep a record of transactions,
- smart contracts for secure complex transactions,
- stable coins as a unit of account.
The authors acknowledge that DeFi has the potential to change the financial world, but imply that the financial risks outweigh the financial benefits. After explaining the basics of DeFi, the authors reveal some interesting statistics about it that I never knew about. Specifically, that 90% of the cryptos being borrowed in DeFi protocols are some kind of stable coin, and 75 of the cryptos being used as collateral in DeFi protocols are actually cryptos, mostly BTC and ETH. What’s funny is that the authors state that borrowing a cryptocurrency is the equivalent of shorting it, not realizing that this is exactly what’s been done with fiat-denominated stable coins when they’re borrowed against volatile crypto collateral.
The authors also make an equally interesting prediction, and that’s that we will soon see DeFi expand to support things like mortgages, which seems far-fetched until you realize that many DeFi protocols are starting to incorporate real-world assets as collateral.
The authors then talk about the risks of liquidation and warn that DeFi protocols could become insolvent in the event of a crypto market crash, yet they fail to provide an example. That’s because it hasn’t happened, at least not yet. This is all thanks to the brilliant design of these DeFi protocols, and an example here is Aave, which has been a pioneer in this crypto niche.
Now back to liquidations. The authors drop another interesting statistic about DeFi, and that’s that liquidity provision on DeFy platforms is highly concentrated, something I also didn’t know. To be exact, half of the total deposits on the average DeFi protocol come from fewer than a dozen wallets, and the authors rightfully point out that this presents some serious risks. Then again, I suspect it’s not all that different from centralized finance, with massive asset managers like Blackrock that are connected to every single asset market.
The next element of DeFi that the authors examine is cyber risks, and this subsection is surprisingly short. The authors also failed to mention that most of these so-called defy hacks are really just massive arbitrage trades involving flash loans that typically involve taking advantage of oracle inefficiencies.
As jokes aside, the authors judge DeFi as being ‘efficient, but risky’, specifying that DeFi has the highest cost efficiency of any financial technology but is risky because DeFI protocols don’t require KYC to use and because they don’t have access to the money printers of central banks. The relative lack of regulation also means that DeFi has a competitive edge over other financial technologies and institutions. It’s safe to say the IMF doesn’t like this one bit.
As far as regulatory recommendations go, the authors call for stricter oversight of neo-banks. Unironically, they advocate for suppressing innovation in the Fintech space to protect traditional banks and demand scrutiny of stablecoin issuers and crypto exchanges for their alleged facilitation of DeFi. As for DeFi itself, the authors straight up suggest that authorities regulate this crypto niche at the code level. This is unprecedented and potentially unconstitutional because code could count as free speech under the first amendment.
The authors even go as far as suggesting that authorities become involved with the decentralized autonomous organizations that govern these DeFi protocols to enforce regulations at the blockchain level.
Admitting that all these regulatory attempts could fail, the authors conclude that one of the only other options would be to prevent institutions from interacting with DeFi protocols altogether to ‘slow the pace of growth’ so that adoption can be delayed while regulators find a way to control it.
The scariest part is that we could see similar recommendations made for proof-of-stake cryptocurrencies. Now for the big question, what does all this mean for the crypto market?
What It Means For Crypto?
Well, I think it’s pretty clear that the IMF isn’t all that concerned about cryptocurrency so long as it doesn’t interfere with the control the IMF and its constituents have over the current financial system. From where I’m standing, the IMF is an international version of the president’s working group on financial markets in the United States, which is essentially tasked with making sure there’s never a big crash in asset markets, hence why it’s colloquially referred to as the ‘plunge protection team’.
The fact that cryptocurrency is very difficult to control doesn’t sit well with these fiat-focused institutions. Centralized control is the only way that the current financial system can continue to exist, and the need for this centralized control only increases as the system becomes more unstable. Things like the pandemic supply chain issues, record inflation, and the ongoing war in Ukraine are only adding to the inherent instability of the financial system, effectively shaking its foundations while cryptocurrencies seep in to fill the cracks.
The bad news is that this means every crypto technology that competes directly with the institutions that make up this crumbling financial system is likely to be a target. And even though DeFi is first in the line of fire, almost every other crypto niche stands behind it.
Something like the SEC’s recent attempts to secretly change the definition of an exchange to crack down on defy is likely the first of many shots we’re going to see fired across the crypto bow from the United States and elsewhere. The possibility of a regulatory crackdown on crypto code itself seems to be very real as well.
The good news is that the IMF seems to have its hands full with more immediate issues like governments defaulting on their debts. To quote the IMF’s managing director, Crystalina Georgieva, ‘we act like eight-year-olds playing soccer, everyone chasing the same ball, not paying attention to anything else’.
Second, cryptocurrency very much seems to be a secondary concern. Even though defy is on the IMF’s to-do list, it seems to be far enough down that list that there’s time for the crypto industry to find a solution to the incoming wave of regulation. The crypto lobby is leading the fight on this front.
[This article is a transcription of a video made by Coin Bureau]
Original video: https://youtu.be/5zo7oXDeCxI ]