•••

Following the collapse of Luna, a cryptocurrency, Vitalik Buterin, a co-founder of Ethereum, tweeted that he supported rescuing minor owners of the stablecoin first. “Strongly support this,” Mr Buterin wrote from his account, “coordinated sympathy and relief for the average UST smallholder.” Buterin also suggested that the Federal Deposit Insurance Corporation (FDIC), a United States government-backed agency that insures the deposits of American banks and credit unions could do this. “The obvious precedent is FDIC insurance (up to $250k per person),” he added.

It’s unclear if Buterin believes the FDIC should, or even could, do this or whether he envisions the cryptosphere should create a similar backing. Either way, lawmakers should not reimburse Luna speculators with public money. If Buterin wants to champion a government-backed crypto-equivalent of the FDIC, they should discuss this independently of, and after, TerraUSD (UST) and Luna’s collapse. But if he proposes that the FDIC step in to make dinky Luna investors whole, this would be a mistake delegitimising the monetary system and worsening the crypto industry.

Franklin Roosevelt, the 32nd president of the US, set up the FDIC during the Great Depression to restore trust in the American banking system. Before this, one-third of all American banks had failed, and bank runs, where many depositors withdraw money believing the bank will collapse, were typical. Legislators passed the Glass-Steagall Act in 1933, which created the FDIC to insure up to $2,500 of individual deposits in member banks with the backing of the US government. Since the FDIC’s inception, the size of individually insured deposits has increased to $250k, and the system works. No depositor has lost any FDIC-insured funds. The agency and its foreign equivalents are fundamental underpinnings of the global monetary system because they provide three benefits:

First, depositors have confidence in the liquidity and security of their funds, safe in the knowledge that if the bank fails, they will be made whole. They can save and spend readily, providing liquidity and confidence to businesses and money markets.

Second, banks can lend freely and communicate directly. Banks can maintain fewer reserves and lend plentifully without the omnipresent spectre of a bank run looming over their heads. If withdrawal led insolvency were always lurking, banks would only ever lend for the short-term against guaranteed protection. Bolstering consumer confidence to prevent bank runs enables banks to make longer-term loans on new projects. This confidence helps entrepreneurs get the capital they need and lubricates the innovation engine.

Third, the government can adequately regulate and support the banking market to protect consumers and prevent banking crises. Without the FDIC government guarantee and the regulatory price tag attached, non-specialists wouldn’t know how to distinguish between safe and risky deposit-takers. Regardless of financial backing, whichever bank offered the highest interest rate would be the one to rake in the funds. A low-interest rate is unappealing even if safe, while a high-interest rate is fun.

These results are suitable for maintaining a functional monetary architecture. If regulators use the FDIC either directly or as a precedent to bail out Luna punters, this delegitimises membership. What good is a government guarantee if extended to the unguaranteed? It isn’t. A haphazard rescue package like this would drag down the utility of banking. As long as the masses have invested, seemingly anything would qualify as a depository institution. When everything is protected, nothing is safe. Savers would seek the highest-yielding accounts without regard for their security. Speculators and depositors would lose money, and the taxpayer would be on the hook for ever-larger sums. This tailspin is neither sustainable nor desirable.

Compensating Luna bag holders from the public purse will create more shysters in the future than otherwise. If folks believe that the taxpayer will ride to the rescue should their naivety lead to loss, they will be less discerning. And like a dank cupboard breeds mildew, this environment would breed a furry layer of Madoff-wannabes, offering colossal ‘guaranteed’ returns. Shooting for the biggest payoff is always the logical path without a downside. Moreover, authorities will infantilise their civilians by saving bad speculative investments in unregulated products. We collectively take another step into the moral hazard swamp by conditioning grownups to act like teenagers, desiring the freedom of adulthood but shirking the essential responsibilities, privatising the gains while socialising the losses.

Indeed, the rally-point of crypto has been that it operates outside the traditional financial system—a metaphoric middle finger to administrations and banks. It’s unclear precisely what Mr Buterin is proposing. He might want the crypto community to have their cake and eat it too. If that’s the case, lawmakers shouldn’t fall for the crocodile tears. As with all new industries, the cryptosphere is learning to walk, run and feed itself. It is evolving. Participants will make mistakes, and they will learn from them. Stepping in now with the cotton wool to prevent any pain would slow that maturation process and, like an overly zealous helicopter parent, prevent the industry from doing some much needed growing up. No matter how naive these smallholders were, lawmakers should not use public money to compensate them.

Instead of public bailouts, governments should join together to pursue Do Kwon and the other co-founders and executives of Terraform Labs, the company behind Luna. They should investigate whether the company misled speculators and whether Terraform Labs operated Luna as a Ponzi scheme by paying out early investors with money from new ones. If the judicial process finds Kwon and his associates guilty, courts should force them to make restitution to the people they duped. The taxpayer should not float punters more chips when they lose money in a backroom poker game. Unless this happens, the cryptosphere will remain a monetary and financial wild west where robber barons deceive and steal, undermining the credibility of legitimate technology.

•••

This article will be in next week's issue of Valuabl. I have made it free for now because I believe it's an important topic.