The next crypto crash could hit equity and bond investors too

Interest in cryptocurrencies like Bitcoin and Ethereum has spread. Now, some experts fear that the next time these volatile assets collapse, it could turn into a financial wildfire.

While cryptocurrencies have been around for over a decade, they have so far been seen as a niche asset, meaning investors who weren’t interested in the potential of digital currencies could safely ignore their price fluctuations. But, with values ​​exceeding $ 1,000 billion and fund managers on Wall Street and off Wall Street, that could be about to change, according to regulators and financial professionals. Earlier this week, Treasury Secretary Janet Yellen convened a study group on this issue, looking in particular at the dangers of a subset of cryptocurrencies known as “stablecoins,” which are backed traditional currencies or other assets.

The last time cryptocurrency prices fell, in 2018, Bitcoin fell 80%. But the event took place in a financial vacuum. Bitcoin transactions were isolated on then obscure sites such as Coinbase which had little or no connection to public markets or the economy at large. Bitcoin was an upstart that resisted the financial system from the outside. This time, Bitcoin – whose price has fallen 50% since April – is inside the system.

Think of the global financial system as an orchard of a wide variety of trees and plants, interconnected beneath the surface in infinitely complex entanglements. Weeds and plants on the margins can easily be pruned before they damage adjacent areas, as happened with Bitcoin in 2018. But if a certain type of weed is allowed to grow uncontrollably , or if a new tree can take root and become tangled, the rotting of these new organisms can quickly threaten the entire system. This threat is called “systemic risk” and some people are concerned that it is a threat that cryptocurrencies now pose.

“It’s similar to the dot-com bubble of the ’90s,” said John Quiggin, an economist at the University of Queensland in Australia. “While you only have a small number of people speculating on things – if they lose their money, they lose their money. Once you are integrated into the financial system, the problems are bigger. “

Since 2018, cryptocurrencies have been linked to the wider financial system in three main ways.

Crypto has gotten huge

The market value of cryptocurrencies – around $ 1,000 billion, up from over $ 2,000 billion earlier this year – is suddenly much more than a drop in the financial ocean. When the sums at stake are this large, implosions generally have a ripple effect. 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 triggered a recession in the economy.

The debate over whether cryptocurrencies are large enough to constitute a systemic risk is now taking place at the highest levels of central banks and governments. Federal Reserve Bank of Atlanta chairman Raphael Bostic recently said digital currencies do not have “the scale and scope” to pose systemic risk. But before the 2008 financial crash, many smart regulators and market players said the same about “subprime” mortgage securities. Federal Reserve Chairman Alan Greenspan and others have argued that the popularity of subprime home loans is not systemic.

And that’s how it appeared, on the surface. Due to a lack of regulation and sleight of hand on the part of the banks trading the securities, a vast root system of derivatives had developed under the visible subprime market. It was this derivatives market that irreparably entangled the great Oaks of Wall Street like Bear Stearns and Lehman Brothers, ultimately pulling them down.

Derivatives markets now appear below cryptocurrencies, and their scale is once again unclear. On one exchange, Binance, derivatives with a “notional” value of $ 2.46 trillion, changed hands in April alone, according to Coindesk.

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Crypto Has Deep Ties To The Stock Market

Bitcoin has also developed important links with the wider stock market. Coinbase Global, the Bitcoin exchange, competes with Intercontinental Exchange to be the largest publicly traded financial exchange by market value, with a current value of $ 46 billion. As of April, Grayscale Investments’ Bitcoin Trust, a de facto exchange-traded fund currently available only over-the-counter, had around $ 50 billion in assets under management, comparable to ETF giants such as the SPDR Gold Trust. Vendors of specialized chips used in Bitcoin mining equipment, such as Nvidia, are also exposed to cryptocurrency.

Another way that Bitcoin’s losses could trickle down to the stock market is through ‘common ownership’. In the months leading up to the 2008 financial crash, a debate raged on Wall Street and the Fed as to whether a rout in the riskier corners of the mortgage market was “contained.” The banks promised they were “isolated”. Unfortunately, the banks that owned the devalued mortgage securities 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 are also long-term speculative and growth stocks, like the Nasdaq [stocks]”said Lorenzo Di Mattia, manager of hedge fund Sibilla Global Fund, which was one of the first to sound the alarm bells about the magnitude and scope of the 2008 market shock. the sale of one or the other asset class could spill over into the other, he warned.

Some institutional investors, such as Massachusetts Mutual insurance company, have voluntarily disclosed their purchases, but there are no formal requirements to do so.

In written testimony to a congressional committee exploring crypto risks to the economy, Alexis Goldstein, spokesperson for the Open Markets Institute, a think tank funded by billionaire George Soros, cited an Intervest investigation showing that a mid-sized hedge fund group had allocated an average of 11% of their assets to crypto. “The extreme volatility of cryptocurrency markets could spill over to other financial markets,” she wrote.

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Stablecoins Connect Crypto to the US Economy

Perhaps the most dangerous way the cryptocurrency markets are linked to the US economy is through a multi-billion dollar hybrid currency that is literally called Tether. Tether is a “stablecoin”, specially designed as a bridge between the world of crypto and the world of the US dollar. These stablecoins have increased tenfold to around $ 100 billion within a year. By backing the coins with conventional financial assets and using a bit of financial engineering, these coins have maintained a stable value, often trading 1: 1 against the US dollar.

But the conduit that Tether uses to tie into traditional financial markets is one that would thrill anyone who traded during the 2008 financial crisis. Tether, according to reports from the Financial Times and elsewhere, has become one of the biggest owners. institutional “commercial paper”. Commercial paper is a short-term corporate debt market that is used to meet the payroll and keep the lights on by businesses of all sizes. If investors suddenly bail out Tether cryptocurrency en masse, they might be forced to get rid of their commercial paper holdings. This in turn could undermine confidence in the larger commercial paper market. It was a tightening of the commercial paper market that sent the Great Financial Crisis to the heart of the real US economy in 2008.

Among other things, Treasury Secretary Yellen’s task force will study the “risks [stablecoins] pose to 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 from the systemic risk posed by cryptocurrencies? Don’t assume that your wallet is completely “delimited” by the crypto crash. This is the hypothesis formulated by many banks in 2008 and by many private investors in 2000.

Instead, prepare yourself the same way you would for a steady bear market in the stock market – by owning a wise mix of stocks and safe-haven assets like bonds, which tend to rise when the markets fall. stocks and crypto fall.

If you invest directly in cryptocurrency (or other similarly risky assets), most financial planners recommend that you do not make more than 5% of your portfolio.

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