Cryptocurrencies: Financial (In)stability and (Un)fairness

By Jon Danielsson, Director of the ESRC funded Systemic Risk Centre, London School of Economics. Originally published at VoxEU

Cryptocurrencies are controversial.  Advocates see them as a better form of money that imparts freedom, useful economic functions, fabulous riches and hedges against bad government policies. The sceptics worry about investor protection and environmental impact.

Cryptocurrencies today do not pose much threat to financial stability, as noted by den Haan et al. (2017) and a recent Financial Stability Board report (Financial Stability Board 2018).

That will change if cryptocurrencies find widespread economic use, either coexisting with or fully displacing fiat money.  They will then have a strong and negative impact on financial stability, equality and social cohesion, as I discuss in Danielsson (2018c).

Financial Stability

Some cryptocurrencies promise to replace fiat money with private money whose integrity is underpinned by algorithms, not government guarantees. This includes the most prominent, Bitcoin, and many of the cryptocurrencies aiming to improve on Bitcoin.

Do such cryptocurrencies pose financial stability threats?

Most observers do not think so. After all, an asset class that amounts to less than $200 billion is quite small compared to the overall asset markets, especially since cryptocurrencies are primarily held for speculative reasons and see trivial economic use outside of that. Cryptocurrencies do not threaten financial stability today.

However, supposing that cryptocurrencies like Bitcoin were to succeed in the marketplace for money and see widespread use in day-to-day economic activities. Would there be financial stability consequences?

Yes. A cryptocurrency-based monetary system (‘cryptosystem’) is subject to the same forces of financial instability as the current fiat system, while further adding new forms of instability.

The same fundamental forces are behind almost every financial crisis, regardless of the underlying monetary system (gold, fiat, or cryptos) – excessive amounts of endogenous risk (Danielsson et al. 2012) that is hidden until it is too late, only to manifest itself once a crisis is underway when it is too late to do anything except react.

All serious financial risk is endogenous, caused by the interaction of the human beings that make up the financial system. They are prone to act as a procyclical herd and are subject to a variety of constraints and biases affecting decisions, and hence outcomes. In boom times, behaviour is more idiosyncratic than during crisis when the self-preservation instincts kick in. This is why booms build up slowly and deflate rapidly – prices go up the escalator and down the elevator.

Fundamental to financial instability is the creation of money. In the current fiat system, the central bank creates base money and the financial system creates higher forms of money such as M1 and M2. The primary damage from financial crises is when the process goes in reverse due to rapid deleveraging.

The same applies to cryptosystems. The mining process only controls the creation of base money (the number of coins), while the supply of money is crypto M1 and M2, and just like with fiat, the creation of such money is under nobody’s control. While some cryptoadvocates argue this would not happen because a cryptosystem would be a full reserve system, that is unlikely. Some people will want to lend out coins and others to borrow, and if such claims get traded, crypto M1 and M2 is created. Similarly, some crypto banks will find it more profitable to operate as the fractional reserve institutions of today.

At the same time, a cryptosystem has additional forms of systemic risk not present in fiat systems. Most of the money in a cryptosystem, crypto M1 and M2, is only claims on coins. In times of crisis when confidence evaporates, that can by itself lead to a panic since if economic agents start to worry their money is not equivalent to coins, they will run their financial institutions.

We can’t resolve such cryptosystem crises because we can’t create new base money (coins), at least if money is like Bitcoin with a fixed mining schedule. While we can certainly conceive of a cryptocurrency with an algorithm that creates new coins during a crisis, such a currency would be an anathema to the cryptoadvocates of today who explicitly do not want the supply of money to be adjusted based on economic conditions.

While fiat systems are affected by the same endogenous risk, they have a safety valve. Because the fiat system can create infinite amounts of liquidity when needed, the central bank can guarantee shock and awe. It can tell the financial markets that no matter what the demand for liquidity, it can meet it, minimising deleveraging, keeping the economy going, and preventing the disastrous failures of the financial institutions without whom the economy cannot function.

Such credible demonstration is stabilising by itself. Once the markets know the central bank will do what it takes, a crisis can be mitigated; we saw that in action with the ECB’s “we will do whatever it takes” announcement in 2012. The failure of the Federal Reserve to do the same during the Great Depression was the reason a financial crisis and economic recession became a depression. The globally coordinated liquidity creation in the autumn of 2008 is the reason why that crisis did not become a depression.

Ultimately, this means that a monetary system based on the private cryptocurrencies of today would suffer from higher systemic risk than a well-managed fiat system.


If privately issued cryptocurrencies become real competitors to fiat money, someone is going to make a profit.

The current market value of all cryptocurrencies is around $200 billion; the total value of M1 in the G20 economies is $31 trillion. If we fully replace fiat money with cryptocurrencies, a $31 trillion profit will be transferred to a handful of crypto-speculators, equivalent almost to the annual GDP of the US and China combined (at $34.5 trillion). That is the upper bound; private cryptocurrencies may end up coexisting with fiat money, so the market value of cryptocurrencies may end up being somewhere between $200 billion and $31 trillion.

The success of privately cryptocurrencies implies a substantial transfer of a public good to private speculators. It would dwarf the largest historical expropriations of public goods, including the Inclosure Acts in England and Wales when 2,800,000 hectares of common land were transferred to private ownership, the Highland Clearances in Scotland, the confiscation of Native American land in the US and Aboriginal land in Australia, and the more recent Russian and Chinese privatisations.

Would the $31 trillion (or any amount significantly higher than the current $200 billion) switchover from M1 to cryptocurrencies be of the same nature? The wealth transfers in the examples above happen at the instigation of the sovereign, which deliberately enriched some citizens and impoverished others. By contrast, current transfers to crypto-speculators are entirely voluntary. I buy Bitcoin at my own volition.

However, for cryptocurrencies to displace fiat money, the sovereign has to acquiesce, to make the deliberate decision that Bitcoin is to be used along side, or instead of, dollars. The reason is that fiat money is legal tender, and the sovereign needs to permit the displacement of fiat.

Consequently, the transfer of up to $31 trillion to a handful of private speculators would dwarf any historical antecedents to become the largest expropriation of a public good in human history.

This is strongly disputed by crypto-advocates, who find such notions Marxist and that it does not recognise the just return to an entrepreneur taking risk. Such counterarguments miss the point. There is widespread support for the idea that the entrepreneur should benefit from the fruits of their labour, accomplished in a competitive marketplace, not by expropriation.

Unlike entrepreneurial wealth, the crypto-fortunes would be created by inclosing a public good and it would be fundamentally unfair to transfer the public money supply to crypto-speculators.


While I think that cryptocurrencies do not make much sense and are destined to end up worthless, (Danielsson 2018a, 2018b), suppose I am wrong. The success of privately issued cryptocurrencies like Bitcoin would come at a considerable cost. It would increase financial instability and wealth inequality, while bringing no discernible benefits.

If we are to transit from a fiat monetary system to a crypto-based one, the only right way is for all created coins to be under public ownership from the outset.

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  1. Jim A.

    For all that the proponents claim the cryptocurrences are modern and futuristic, they remind me of nothing so much as the wildcat banks of the 19th century.

    Of course the “base currency,” is not really controlled by the crypto algorithms because the number of different crypto currencies is not controlled. The demand for different crypto currencies are governed by the same boom-bust cycle that other markets are prone to.

  2. paulmeli

    The question is, is it even possible for cryptocurrencies to replace fiat currency?

    I say no, the question is moot.

    Cryptocurrency is a kind of payment system, indexed to fiat currencies.

    Fiat is a flow-based system. Flow is mostly generated by the State.

    Cryptocurrency is functionally a stock-based system (flow from creation is infinitesimal, dribbling out of computers at a snails pace). More like savings than spending. Economies aren’t powered by savings.

    Roughly 65% of the World economy is a direct function of money creation. The remaining 35% is dependent upon it.

    Then he let’s the cat out of the bag…

    If we are to transit from a fiat monetary system to a crypto-based one, the only right way is for all created coins to be under public ownership from the outset.

    Still won’t work. Cryptocurrency is finite as compared to fiat currency, the system path would be deflationary, oriented towards zero, which is much shorter than the one to infinity. Austrian thinking.

    1. jsn

      Crypto is an attempt to replace the expired gold standard with a waste carbon in the atmosphere standard: it is suicidally insane.

      “Mining” of crypto currencies is a massive energy sink that converts real energy resources into waste heat and CO2 in the atmosphere to “back a currency.”

      1. Not From Here

        Carbon releases due to mining gold are up too (see today’s Links)(plus nasty chemicals like mercury back into biosphere). Both media represent a rarefied commodity secured by extremely destructive behavior. We need a Whuffie in today’s world

  3. Mike Robinson

    The essential fallacy of bitcoin is that it is not coin – it is barter currency, whose “value” is said to be dependent on the computational infeasibility of producing new tokens.   In other words, “they are ‘rare.'” But this also means that they cannot satisfy the first-requirement of a currency system: liquidity.

    “The Gold Standard” faced a similar conundrum:   there simply wasn’t enough of it, and people realized that the metal didn’t matter anyhow.   The ability to conduct transactions, wherever and whenever we needed to, did.   All we needed to do was to agree that the currency had value (which we did), and then to manage it properly (which we didn’t).

    Well, that’s our fault.   The present problem with our fiat-currency systems as deployed in the world today is that there are vastly too many currency-units of various flavors out there:   far too many to correspond to the total set of things on this planet that could be bought or sold.   But this is not an intrinsic failure of fiat currency.

    Block-chain technologies do raise tantalizing prospects that one day will revolutionize our electronic-only trading systems and greatly reduce the possibility of fraud.   But first, tokens must become commonplace … as easy to generate as a new security-certificate for a new “https” web-site.   Eventually, we did perfect “public-key encryption (PKI),” although it took a while.   Eventually we will perfect block-chain, too.   And the true public benefits will be, as with PKI, “mundane, but essential.”   We’re just not there yet.   Stay tuned.

    1. paulmeli

      The present problem with our fiat-currency systems as deployed in the world today is that there are vastly too many currency-units of various flavors out there: far too many to correspond to the total set of things on this planet that could be bought or sold

      How can that be true when Western economies are operating at 75% capacity and resources (largely human) are going un-sold, sitting idle?

      Also, there is not enough $ in the World to monetize the stock market or pension funds. Those monies haven’t been created yet.

    2. Wukchumni

      The problem with the gold standard wasn’t a lack of money, as the USA had 4 different fiat paper currencies circulating along with the gold and silver certificate banknotes…

      The problem was the aftermath of WW1 and old gold standard countries in Europe could no longer afford to play the game, as about 80% of all above ground all that glitters was in the hands of the USA, as a result of armament sales to the allies.

      Only England really tried to keep things going by keeping on the standard.

      Belgium, France, Germany & Italy all had gold coin based economies-along with some fiat currency before the war, and not one of them ever issued a gold coin for circulation in the interwar period.

      1. paul

        With gold, you could presumably dig up more. Bitcoin is designed to be finite (and hoardable) so when it reaches its maximum volume the few holders can use it to obtain assets with it to rent them out to return their ‘investment’, to be paid in the bitcoin of this realm.

        This will force producers and consumers to deflate prices,profits and spending to subsistence (probably just below as a discipline) in order to keep receiving their ever diminishing share required.

        Rather than ever bigger wheelbarrows required for your daily bread, you will be searching for small enough memory chips to address your holdings.

        I think that’s how it is supposed to work.

        All they have to do is to eliminate competing, established currencies,the endemic fraud and prevent people transferring their faith to another wunderkurrency.

      2. paulmeli

        You do realize it was Nixon in 1971 that took us (and the World) off the gold standard, Domestically the US went off the gold standard in 1933.

        The end of Bretton -Woods and the rest of the World could accept $ or pound sand.

        If I recall we also didn’t participate in the war reparations in gold that drove Germany to start WWII (a continuation of WWI). Now Germany is doing to Europe with finance what it couldn’t do with bombs.

        1. Wukchumni

          The gold standard that ended in 1971 being limited to only Central Banks exchanging US$ for all that glitters @ $35 an ounce. Meaning in essence that the gold standard post 1933 was limited to a few dozen entities, that’s it.

          At the very same time is was illegal for an American to so much as own a gold bar/ingot of any size…

          If anything, the USA was what kept 1920’s Germany going, by loaning them money. See the Dawes Plan

  4. KPC

    Thank you for this.

    May we also add that these private “e-money gigs” are having a material adverse impact with respect to energy consumption leading to greater levels of contamination and instability in public and private electric systems to nation state level of scale and scope?

    This goes directly to the very heart of global climate change, managing this issue in a thoughtful and proper manner and helping human beings have a better quality of life.

    Again, thank you.

  5. Thomas P

    An additional risk lies in mathematics or better computers. What if we decide that bitcoin or some similar currency is a global currency base and then someone come up with an algorithm or a quantum computer that makes mining it trivial, especially as he is unlikely to tell anyone? He could be honest and just use it to get a huge income from mining, but as I understand it, this would also give direct control of the block chain and would allow stealing unlimited amount of coins. Just a suspicion that this was going on may lead to a crash in confidence.

    And by coincidence, the most recent SMBC:

  6. OpenThePodBayDoorsHAL

    The author states that crypto would have a “strong and negative impact on financial stability, equality and social cohesion”. Um, we have those with the current system, thank you very much.

    Debt-based money has some big plusses, one of which is its connections to the supply and demand for money. Unlike government-issued scrip (which presumably needs to be issued in quantities determined by statistics and formulas), debt-based money is created when there is demand (for loans).

    But (absent Jubilee) the condition arises when there is already too much debt outstanding, and debtors lose the capacity to service additional debt. This for a time is of course ameliorated by super-low interest rates. Artificially low rates (currently driven by the accounting parlour trick by central bankers called QE) however fool economic actors into believing many economic activities are, well, economic. The result is top-down monetary Communism, with highly irrational activities propped up as zombie industries (one current example is fracking but you might also mention Netflix).

    And the next problem arises when loan demand is not for productive economic activity but rather for consumption and speculation. This raises costs across the board but without also raising the productivity to meet those higher costs through business innovation and technology.

    And how to get money into people’s hands absent loan demand? This was Bernanke et als problem. Answer: they used the stock market as the transmission channel. Companies borrow to buy back stock, the stock goes “up”, and people holding the stock have additional money. (Problem problem though: more than 80% of stock market gains go to 10% of people). So you just get more inequality.

    Importantly, the high priests of money are stuck with their failed theory that there must be inflation for an economy to operate optimally. This would be risible were it not so destructive. Costs of goods and services, from agriculture to widgets, going down over time is what is known as progress. When you make the buying power of money chase and negate those gains you flatline your standard of living.

    Lastly, the high priests who (in their incredible hubris) believe they can presciently forecast in advance trillions of economic decisions by billions of people in order to magically arrive at the “right” price of money in the future cannot even measure the thing they are supposed to be “managing”. As one of their uber-priests said:

    “The problem is that we cannot extract from our statistical database what is true money conceptually, either in the transactions mode or the store-of-value mode. One of the reasons, obviously, is that the proliferation of products has been so extraordinary that the mix in our money and near-money data is continually changing. As a consequence while of necessity it must be the case at the end of the day that inflation must be a monetary phenomenon, a decision to base policy on measures of money presupposes that we can locate money. And that has become an increasingly dubious proposition.”

    – Alan Greenspan
    FOMC notes, April 2000

    Quick summary on crypto. The quote that applies is Bill Gates’: things change less in two years and more in 10 years than you think. You will be able to own (outright, not through intermediaries) any asset type (bank currencies, equities, fixed income, precious metals) you wish securely using just your phone. You will be able to use them however you please (investments, payments, purchases at merchants). You will be able to make conversions between any of these assets in any amount and at any time with no fee and no spread. This will only require trivial quantities of electricity, not the crazy V1 usage of things like Bitcoin.

    I would let you draw your own conclusions on whether this will be a boon or a bane of mankind. I say boon, with huge disruptions between here and there.

    1. skippy

      I think your complaint about too much debt is grounded not in, the debt itself, due to the fact that contracts proceed it – this holds true for both Fiat and Gold standard systems. So whilst many fiddle with the money side they completely over look what enables too much or the quality thereof.

      I would point at the amount of equity in the markets and the questionable quality due to the currant trends becoming dominate – it is a form of money at the end of the day. With that in mind I don’t see how crypto or a return to a gold standard fixes that problem.

      Seems like some are attempting to fix a political problem with an A – political patch….

      1. OpenThePodBayDoorsHAL

        Great points. Per The Maestro it is difficult/impossible to define “money” and increasingly it does seem to include equity (viz Japan’s CB owning a huge percentage of the country’s stock ETFs and the formerly venerable Swiss CB owning large chunks of Apple). Money is probably not a simple noun but rather a quality: moneyness. But I’m not sure “equity” (in the broadest definition) being “money” is necessarily a problem. Gold worked that way for centuries. At the user level: I want to store my labor so it can be transported across space and time. If I can store it in fractional ownership rights to discounted enterprise cash flows (stocks) and then use it in transactions, great! Monopoly sovereign suppliers of money that operates in isolated national silos of course will not be amused.

        1. skippy

          I get that albeit what I’m on about is contra to some ideologues philosophical preferences regardless of information to the contrary – think Bill Blacks offerings vs economic doctrinaires.

          When I talk about equity I’m pointing at its creation as a creature of the incentivization the share holder value meme created, and the ability of principals – large share holders to take price then convert it to some asset with intrinsic value whilst the sundry are left to swing in the breeze. Don’t even know how one could call it classical capitalism e.g. nary a hint of any productive capital expenditure or formation in productive enterprise with a wafer thin slice of social anything.

          Oh and I am completely pro state money and functional finance vs the sound money camp or anything that attempts to challenge state money e.g. I’ll take laws before arbitrary market functions when it comes to recourse i.e. not afraid to be called a totalitarian on that issue.

    2. paulmeli

      Importantly, the high priests of money are stuck with their failed theory that there must be inflation for an economy to operate optimally.

      Has there been a period in recent history where this wasn’t true? Virtually every financial crisis has been debt- based. Anything that reduces our debt burden must be a good thing.

      From where I sit, inflation is an overshoot, and in my mind. less destructive than undershoot.

      I’ve lived a while, and inflation has never hurt me. We have more purchasing power today than we had 100 years ago (an hour of labor will buy more today than 100 years ago). The problem is one of distribution – the top 90% are outpacing inflation, the rest of us aren’t. zero inflation or deflation would be worse – it would require higher unemployment to achieve.

      1. OpenThePodBayDoorsHAL

        Mises Institute has the surprising data: America “suffering through” episodes of 50% price deflation (that Oops were also the periods of the nation’s fastest growth in the standard of living):

        And the “inflation is low!” meme is worth questionning. The people who construct The Chapwood Index go to the store and retrieve the actual prices on 500 items, and they say it’s running at a very destructive 10%:

        1. OpenThePodBayDoorsHAL

          Further note: the period in the Mises data also included several very severe and disruptive debt and banking crises. The point is that when the dust settled the money still bought you more and more. Point Number 2: the “dust settled” very quickly, not the endless Chinese water torture bank debt crises we get nowadays. Last week a prominent German federal bank board member proposed that all Italian citizens be obligated to turn over 20% of their net wealth into “solidarity bonds” (to be owned by foreign banks). And this is a full decade after the crisis began in earnest.

  7. eg

    Cryptos aren’t currencies at all, as modern fiats operate.

    They are commodities.

    The category errors just keep on piling up, one upon another atop this fundamental misunderstanding.

  8. Henry

    It seems that cryptos are another example of our immune system trying to defend against the parasites, as our current main defense, democracy, is clearly failing. Whether they will succeed in bypassing the rentier class or be subverted to be used as another tool to maintain the feudal system is yet to be seen. Similar to the battle that is occurring over access to information. See ( to understand the context of this thought.

    It would be nice if cryptos also did a better job of unambiguously transferring ownership from one entity to another and had some method for guarantying that the item with be there in the future or insure for that possibility by automatically tying the transaction to some real current asset, but even if they work no better than our current system and just reduce or eliminate the rent extraction from daily transactions they will be hugely successful. Now that could also be accomplished through public banking (see Ellen Brown’s work), but that pathway would require democracy to be functioning and I’m skeptical that is going to work at this point.

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