Bitcoin regulation could prevent financial meltdown, says report

Researchers have called for crypto markets to be regulated in times of crisis, as they predict systemic risk for the traditional financial system.

In a recent study published on the Oxford University Law Faculty blog, researchers argued that trade in crypto should be restricted in times of crisis, in order to prevent systemic risk to the traditional financial system.

In the report, researchers Hadar Jabotinsky and Roee Sarel suggested that the behavior of cryptocurrency markets is a valuable indicator of systemic risk for the traditional financial system during times of crisis. As the crypto sector becomes more entwined with legacy financial institutions, they noted, the risk that one financial institution will collapse and cause a cascading effect increases.  

“In a nutshell, if, as our findings suggest, investors initially view the cryptomarket is a substitute for the traditional financial markets in times of crisis, then regulating it can help in preventing systemic risk to the “real” financial markets,” they wrote. 

Restricting trade in crypto to save traditional markets

One possibility would be to somehow restrict the trade in cryptocurrencies at a time of crisis. There are parallels for this in traditional markets, but there also disadvantages to this approach, the researchers said. 

Regulators must be careful not to undermine benefits which make the cryptomarket potentially more reliable at a time of crisis, the researchers advise. They highlight security tokens, in particular, as a way that firms could raise cash if traditional markets crash, “which would ease liquidity constraints and reduce the risk of a bank run.”

Any intervention must be time sensitive, Jabotinsky and Sarel said—but they admit that halting cryptomarkets may well be “mission impossible.”

Is crypto a reliable source of liquidity?

Jabotinsky and Sarel were interested in why crypto markets performed a u-turn in March, as the coronavirus crisis turned acute. Their paper, ”How Crisis Affects Crypto: Coronavirus as a Test Case,” discusses cryptocurrency as a “safe haven,” and how regulation may be informed by crypto trading patterns during times of global crisis.

Jabotinsky and Sarel looked at the period of Jan. 1–March 11. They found that the trading volumes and market caps of the top 100 cryptocurrencies increased along with the number of identified COVID-19 cases. However, this positive correlation then reversed; they note competing explanations for their findings.

Their research suggests that initially traders viewed cryptocurrencies as a reliable source of liquidity and an effective safe-haven asset. But this trend began to reverse around February 28, as the number of global cases hit 50,000. They suggest that, during this period, investors began to respond more strongly to the number of deaths than to new infections. The latter—during the same period—began to decrease. 

They argue that this could mean that traders interpreted an apparent lull in the spread of the disease as a positive sign for wider financial markets, prompting them to return to traditional assets. 

But notably, the negative trend did not reverse back, even as the number of new cases again began to rise exponentially in early March.