Fed Governor says Tokenization Still in Infancy, But Technological Developments have Potential Beyond Crypto

Christopher Waller, Governor of the Federal Reserve, said on Friday that he sees value in the crypto markets and that while cryptocurrencies are speculative assets, they also represent a form of financial innovation.

Speaking at the Global Interdependence Center Conference on “Digital Money, Decentralized Finance, and the Puzzle of Crypto” in California, Waller shared his thoughts on the crypto ecosystem.

According to him, given recent events in crypto, such as the FTX implosion, it is time for discussions related to digital assets.

Waller's speech serves as a fascinating insight into how he views cryptocurrencies; while he is open-minded toward them, he also wants to ensure that proper steps are taken to minimize risks associated with their use within the financial system.

In his speech on crypto, Fed Governor highlighted the significant financial risks associated with digital currencies and banks' involvement in them. He also discussed the profound implications of distributed ledger technology, smart contracts, and tokenization in data privacy.

Waller noted that financial inclusion could be improved through this approach due to its ability to provide more secure access to services than traditional methods while still ensuring customer protection is paramount.

As such, he argued that regulators must take a balanced approach to regulate the sector, introducing measures that will both protect customers from malicious actors while still allowing space for innovation.

Crypto Assets: “The Social Contrivance of Money”

Crypto assets are defined as any digital asset implemented using cryptographic techniques that are being traded. The reason why someone holds a crypto asset is not that it is new or unique, but rather is based on economic relationships that result in objects having value, said Waller in his speech on Feb. 10.

Commenting on the lack of intrinsic value of crypto, the governor said that objects have value because of their inherent properties, and if an object doesn't have any, then its price of it should be zero.

However, “shockingly, it turns out that objects may be valued well above what their intrinsic properties would suggest,” said Wallet pointing to Paul Samuelson's work in 1958 on intertemporal consumption smoothing as per which an intrinsically useless object can trade at a positive price. This concept was referred to as “the social contrivance of money.”

“Such an object's value is driven purely by belief. If I believe someone will pay a positive price for this object in the future, then I may be willing to pay a positive price now, carry it across time, and sell it when I need to consume other goods and services,” said Waller.

But while intrinsically useless objects can trade at a positive price, Waller clarified that there is always a second equilibrium price for this object, which is zero — as beliefs change that there someone will not be paying for this object in the future.

“There are many intrinsically useless objects that still have value,” such as baseball cards and celebrity autographs. “Based on their fundamental properties, these things have little to no intrinsic value, yet can be in high demand and command staggering prices,” continued Waller, adding that one day when no one wants to collect baseball cards, they wouldn't be worth anything.

Supportive of Innovation But Concerned About Banks' Involvement

Crypto assets, according to Waller, are “nothing more than a speculative asset,” much like a baseball card. They are only trading at a positive price based on the belief that someone else will come along and will buy it at a higher price.

“If people want to hold such an asset, then go for it,” said Waller, while warning that “if you buy crypto-assets and the price goes to zero at some point, please don't be surprised and don't expect taxpayers to socialize your losses.”

As such, crypto-assets remain risky while firms dealing in them are in their infancy. Waller then pointed to the brutal 2022, which wiped out many crypto firms like BlockFi, Voyager, Celsius Network, Genesis, and Three Arrows Capital.

From payment platforms and exchanges to crypto lenders and hedge funds, several prominent crypto-related firms have filed for bankruptcy, stated Waller. In addition to this implosion, the dramatic decline in the value of crypto has led to many investors in the crypto industry getting hurt.

With 12% to 20% of U.S. adults owning, trading, or using crypto and losses from crypto mounting, Waller argued that better investor protections should be in place. But it's not only retail investors that are bearing the brunt of the so-called crypto winter “even institutional investors, with significant resources to conduct due diligence of investments, have felt the pain” with at least 15 public pension funds, which manage public employee retirement funds affected by the now-bankrupt crypto exchange, FTX.

“While I don't care if people take on risky investments or engage in risky business ventures, banks and other financial intermediaries must engage in any activity they do in a safe and sound manner,” said Waller, who voiced his support for prudent innovation in the financial system in his speech.

But at the same time, he shared his concerns about banks engaging in activities that present a heightened risk of fraud and scams, legal uncertainties, and the prevalence of misleading and inaccurate financial disclosures.

The governor argued that a bank engaging with crypto customers must be very clear about the customers' business models, corporate governance structures, and risk-management systems to ensure that the institution itself is not left holding the bag if there is a crypto meltdown.

Additionally, banks considering engaging in crypto-related activities face a critical task to meet the “know your customer” (KYC) and “anti-money laundering” (AML) requirements, which he said banks are, in no way, allowed to ignore.

For now, Waller believes the spillovers from the stress in the crypto industry to other parts of the financial system have been minimal. This is partly due to the limited interconnections between the crypto ecosystem and the banking system, he said.

Waller went on to say that in order to protect against financial stability risks from crypto, it is important for regulators to act decisively. However, he also cautioned that in order to prevent stifling innovation, it is important to create clear distinctions between the various aspects of the crypto world regarding if and how to regulate the ecosystem. By doing so, authorities can avoid creating undue limitations on the positive features of the crypto ecosystem, said Waller.

The Technology: Blockchain, Smart Contracts, Tokenization

As for the underlying technology of the crypto-assets, Waller defined blockchain as a database management protocol used to record trades, including permissioned and permissionless distributed ledger technologies. Although fundamental for creating crypto-assets, this technology is not restricted to being used solely in the crypto ecosystem and is being explored to potentially address a wide range of data management problems, said Waller.

As for technology that directly facilitates trading, he stated that crypto includes smart contracts and tokenization as a form of data privacy, which along with blockchain, also have much broader applications.

Further commenting on smart contracts, he pointed out how they are used in peer-to-peer trading and can be used in conjunction with a centralized data management protocol to automate the execution of certain transactions in non-crypto assets.

While noting the potential of smart contracts, Waller suggested that this technology could eventually be applied in a much broader way, from data management and clearance and settlement of securities transactions to even more complex applications.

Commenting on tokenization, Waller said that when this emerging technology is combined with data vaults to store personal information securely, it can be used to trade objects to protect one's identity.

Tokenization is the process of representing a real-world asset as a digital token on a blockchain. This process allows for the creation of security or asset tokens, which are digital representations of real-world assets worth hundreds of trillions of dollars. By tokenizing an asset, it can be represented as cryptocurrency, making it more accessible and easier to trade.

By transforming how we own and trade assets, security tokens have been generating considerable interest from Wall Street. Unlike cryptocurrencies, security tokens are subject to federal securities laws and must comply with regulations governing the sale and trade of securities. With the recent problems in the market and increased regulatory attention, security tokens could turn out to be a major player this year.

Security token offerings (STOs) have also been gaining traction, and in light of the regulatory blowback, they are making a comeback. It could be said that regulatory developments are making security tokens inevitable.

Tokenization actually has the potential to create tremendous value, with the security token market expected to reach the size of multi-trillion dollars by the end of this decade. The endorsement of security tokens by the crypto community, traditional financial institutions, and regulators points to a bright future for them.

“While these technological developments are still in their infancy, they have potential applications beyond the crypto ecosystem that could lead to substantial productivity enhancements in other industries,” said Waller.