Interest in cryptocurrencies like Bitcoin and Ethereum has spread. Now, some experts fear that the next crash in these volatile assets could turn into financial wildfire.
While cryptocurrencies have been around for more than a decade, so far they have been viewed as a niche asset, meaning investors who aren’t interested in the potential of digital currencies could safely ignore their price fluctuations. But with values above $ 1 trillion and money managers on and off Wall Street sn -ping up coins, that could soon change, according to regulators and financial experts. Earlier this week, Treasury Secretary Janet Yellen convened a study group on this very issue, specifically looking at the dangers of a subset of cryptocurrencies known as “stablecoins” backed by traditional currencies or other assets.
When cryptocurrency prices last slumped in 2018, Bitcoin fell by up to 80%. But the event h -pened in a financial vacuum. Bitcoin transactions were isolated in then-opaque places like Coinbase, which had little or no connections to public markets or the wider economy. Bitcoin was an upstart who opposed the financial system from the outside. This time around, Bitcoin – the price of which has dropped 50% since -ril – is in the system.
Think of the global financial system as an orchard made up of a multitude of trees and plants interconnected in endlessly complex tangles beneath the surface. Weeds and plants around the edges can be easily pruned before damaging adjacent areas, as was the case with Bitcoin in 2018. But if a certain type of weed is allowed to get out of control, or a new tree is allowed to take root and get tangled, rotting of these new organisms can quickly threaten the entire system. This threat is known as “systemic risk” and some people fear that it is a threat now posed by cryptocurrencies.
“It’s similar to the dot-com bubble in the 1990s,” said John Quiggin, an economist at the University of Queensland in Australia. “While you only have a small number of people speculating in things – if they lose their money, they lose their money. Once you are embedded in the financial system, there are bigger problems. “
There are three main ways that cryptocurrencies have been tied to the broader financial system since 2018.
Crypto has gotten huge
The market value of cryptocurrencies – roughly $ 1 trillion, up from more than $ 2 trillion earlier this year – is suddenly far more than a drop in the financial market. When the sums are this high, implosions typically cause ripple effects. As CNN Money reported at the time, an index of 170 Internet stocks lost $ 1.8 trillion in value during the dot-com crash, an event that sparked a recession across the economy.
The debate over whether cryptocurrencies are big enough to pose systemic risk is now taking place in the highest echelons of central banks and governments. Federal Reserve Bank of Atlanta President R -hael Bostic recently said that digital currencies lack the “size and reach” to present systemic risk. But before the 2008 financial crash, many shrewd regulators and market participants were saying the same thing about “subprime” mortgages. Federal Reserve Chairman Alan Greenspan and others argued that the popularity of high-risk home loans was not systemic.
And so it -peared on the surface. Due to a lack of regulation and sleight of hand by the banks trading the securities, a huge root system of derivatives had grown under the visible market for subprime securities. It was this derivatives market that hopelessly entangled great Wall Street oaks like Bear Stearns and Lehman Brothers – and eventually toppled them.
Derivatives markets are now -pearing below cryptocurrencies and their scope is again unclear. On one exchange alone, Binance, derivatives with a “nominal” value of $ 2.46 trillion, changed hands in -ril alone, according to Coindesk.
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Crypto has deep connections to the stock market
Bitcoin has also developed significant connections to the broader stock market. Coinbase Global, the Bitcoin exchange, competes with Intercontinental Exchange for the largest publicly traded financial exchange by market value with a current value of 46 billion US dollars. In -ril, Grayscale Investments’ Bitcoin Trust, a de facto exchange-traded fund currently only available over-the-counter, managed around $ 50 billion in assets, comparable to ETF giants like the SPDR Gold Trust. Vendors of specialized chips used in Bitcoin mining devices, such as Nvidia, are also exposed to the cryptocurrency.
Another way Bitcoin losses could spread through the stock market is “joint ownership”. In the months leading up to the 2008 financial crash, a debate raged on Wall Street and at the Fed over whether a defeat in the riskiest corners of the mortgage security market could be “contained”. Banks promised that they were “shielded”. Unfortunately, the banks that owned the depreciated mortgage p -er were forced to sell other assets, from stocks to junk bonds to commodities, in order to stay afloat.
“Many of the same participants who own cryptocurrencies have long been speculative stocks and growth, like Nasdaq [stocks]“Said Lorenzo Di Mattia, manager of the hedge fund Sibilla Global Fund, who was one of the first to raise the alarm about the magnitude and scope of the 2008 market shock. Increased sales of one asset class could spread to the other, he warned.
Some institutional investors, such as insurance company Massachusetts Mutual, have voluntarily disclosed purchases, but there are no formal requirements to do so.
In a written testimony to a congressional committee investigating crypto risks to the economy, Alexis Goldstein, a spokeswoman for the Open Markets Institute, a think tank funded by billionaire George Soros, cited an Intervest poll showing that a group of midsize hedge funds had allocated average 11% of their assets in crypto. “Extreme volatility in the cryptocurrency markets could spill over into other financial markets,” she wrote.
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Stablecoins link crypto to the US economy
Perh -s the most dangerous way cryptocurrency markets are tied to the US economy is through a multi-billion dollar hybrid currency that is literally called tether. Tether is a “stablecoin” that was specially developed as a bridge between the world of cryptocurrency and the world of the US dollar. These stablecoins have increased tenfold to around $ 100 billion in a year. By backing coins with conventional financial assets and a little financial technology, these coins have maintained a stable value and are often traded 1: 1 with the US dollar.
But the channel Tether uses to tie itself to mainstream financial markets would shudder anyone who traded during the 2008 financial crisis. Tether has become one of the largest institutional owners of commercial p -er, according to reports in the Financial Times and elsewhere. Commercial p -er is a short-term corporate bond market that is used to cover payrolls and keep companies of all sizes running. If investors suddenly get en masse from the Tether cryptocurrency, they could be forced to give up commercial p -er holdings. This, in turn, could shake confidence in the broader commercial p -er market. It was a crisis in the commercial p -er market that carried the great financial crisis into the heart of the US real economy in 2008.
Finance Minister Yellen’s working group will, among other things, deal with the “risks” [stablecoins] for users, markets or the financial system. “
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How to protect yourself from the next crypto crash
What can you do to protect yourself against systemic risks posed by cryptocurrencies? Don’t assume that your portfolio is completely “shielded” from the crypto crash. That is the assumption that many banks made in 2008 and many retail investors made in 2000.
Instead, prepare just like you would for a regular bear market on the stock exchange – by owning a reasonable mix of stocks and safe investments like bonds, which tend to go up when stocks and crypto go down.
If you are investing directly in cryptocurrency (or other similarly risky assets), most financial planners recommend that these make up no more than 5% of your portfolio.
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