Commentary: How to make sense of the cryptocurrency wreckage

Like superstorms, there are few forces better at separating the weak from the strong than global financial markets. But just as the hurricane that struck cryptocurrency markets last year wiped out businesses that ranged from the tenuous to the apparently fraudulent, the collapse also clarified where innovations in currency, payments and markets may endure.

If you have avoided this subject as a colorful fad, you may feel smug at the collapse of bitcoin's price and the arrest of crypto's most colorful entrepreneurs. But the White House announcement Jan. 27 of a "road map" for better regulation underscores the promise that still lies ahead. Crypto markets so far have been dominated by day traders and bloggers, but what remains after the most recent shakeout looks durable enough that institutional investors need to start paying attention. Those elements of the industry that still survived will likely shape the future of finance significantly.

Yes, money moves just fine today. But if you have even passing engagement with the thick web of back-office systems, correspondent banking relationships and contractual commitments that undergird the current flows of global finance, you might agree that even incremental simplification can be transformative.

For more sophisticated, long-term and institutional investors, this creates opportunities in new business models that will take advantage of money that moves cheaply and securely, much like those that emerged when the internet began moving data in the same way. Some digital currencies will succeed better than others, which means the immediate targets will be those firms building the infrastructure for these new flows. For now, think the suppliers of "picks and shovels" rather than betting on the next new railroad.

At the same time, institutional investors will want to take a hard look at their own operations and where these technologies can give them an edge on lower costs and better margins.

Set aside the libertarian impulses of some crypto pioneers or the nefarious motives of criminals. The fundamental promise behind cryptocurrencies and the distributed ledgers on which they move is to transmit value securely, cheaply and without the costs of an intermediary. Of course, the vision at any scale remains distant and fraught with legal and technical challenges, but transformation is heading this way, even if only for some of the trillions in money, securities and titles that change hands every day.

The most likely players will be digital currencies issued by central banks, intended to act in many ways like physical cash that can be transmitted over the internet. China's e-CNY looks like it has a head start on other large economies, having been rolled out methodically for a population that is already comfortable with digital cash. Critics have highlighted the risks to personal privacy, but that has yet to slow adoption within China and among international counterparties ready to test it.

While developing countries have created digital currencies on the promise that cheap and secure payments expand financial inclusion, richer countries also focus on the promise of greater efficiency and more sophisticated "smart contracts" that make automatic payments if a shipment reaches a destination or a market price hits a target. The European Central Bank looks like it's making plans to move ahead, while the U.S. Federal Reserve insists it will not rush.

Central bank digital currencies look like the most reliable form of crypto payment, but they create potential problems. First, it's not clear that central banks are great at customer service or rapid innovation. Second, there are risks of bank runs should depositors have an easy and reliable alternative to insured deposits in a crisis. Third, there are a lot of questions around what this alternative might do to the transmission of monetary policy.

China's version addresses some of these questions by distributing some e-yuan through the banking system, as central banks already do with physical cash. "Tokenized deposits" offer a promising alternative, as banks themselves take advantage of blockchain technology. Backed by insured bank deposits, these "tokens" don't eliminate the intermediaries to most transactions, but they may offer significant improvements in payment efficiency.

Stablecoins are cryptocurrencies that are designed to be backed by an asset that makes their price more…stable. Dramatic collapses in this category last year highlighted the importance of the word "backed": the value of terraUSD was pegged to another cryptocurrency meant to track the dollar via algorithms that ultimately failed and wiped out $45 billion in value in the course of a week.

Alternatives like USD Coin, which are actually backed by dollars and highly liquid Treasury securities, look like much more enduring models, but raise their own questions. In a crisis, for example, can they redeem their coins for cash or bank deposits fast enough? If such coins grow too large, will they lock up excessive shares of safe assets to back their issuance? The Biden administration has already argued that stablecoins should be regulated like deposit institutions.

With governments and banks likely filling up large parts of the crypto space in future, the big question is what role will remain for bitcoin, ethereum and the myriad private and unbacked alternatives that remain. The spectacular collapse of crypto trading platform FTX makes it tempting to write off the whole lot even after the January rebound. Indeed, for all their fervor, bitcoin's champions still send mixed signals about whether their model is either a useful currency or an inflation hedge. (It cannot be both, although I now brace for a flood of vigorous rebuttals from the zealots).

Still, there are plenty of alternatives that offer faster transactions, use less energy and offer possibilities for embedded "smart contracts." Some will endure if they can deliver these features reliably and at scale. Making predictions about the future is hard, as baseball genius Yogi Berra may or may not have said. But every time a market winnows out the "chaff," it's important to pay even closer attention to the value in the "wheat" that remains. Crypto innovation has now matured enough to be a durable part of the market landscape for sophisticated, long-term, and institutional investors. Even if it falls short of the current hype, it remains the most likely next force to transform global finance.

Christopher Smart is chief global strategist of Barings LLC and head of the Barings Investment Institute, based in Boston. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.