Could Crypto cause a real world crash?

The Value of Cryptocurrencies has grown exponentially from being worth $16 billion five years ago to currently $2.3 trillion. What if the value of these assets crash? Could it cause a wider contagion in the real-world financial markets?

The sub-prime mortgage market that was considered the trigger for the financial crisis in 2008 was only valued at $1.2 trillion before the crash.

In a speech by Sir Jon Cunliffe, Deputy Governor for Financial Stability, he outlines the risk Cryptocurrencies could pose to the world economy. Click here

Sir Jon’s conclusion is that “Crypto technologies offer a prospect of radical improvements in financial services. However, while the financial stability risks are still limited, their current applications are now a financial stability concern”

Sir Jon argues “the bulk of Cryptoassets have no intrinsic value and are vulnerable to major price corrections. The crypto world is beginning to connect to the traditional financial system and we are seeing the emergence of leveraged players, and, crucially, this is happening in largely unregulated space.”

“Unbacked cryptoassets make up nearly 95% of the $2.3 trillion. They are essentially non-replicable strings of computer code that can be owned and transferred without intermediaries. Bitcoin, of course, is the most prominent example, but there are now nearly eight thousand unbacked cryptoassets in existence. These have no intrinsic value, that is to say there are no assets or commodities behind them. The value of the cryptoasset is determined solely by the price a buyer is prepared to pay at any given moment. As a result, their value is highly volatile.

“A more direct issue from a financial stability perspective, given the unbacked and volatile nature of these assets, is the implications of a major price correction. Such major corrections have been relatively frequent in the short lifespan of unbacked cryptoassets. The price of bitcoin has fallen by over 10% in a single day on nearly 30 occasions in the past five years, with the largest of these a fall of nearly 40% following a cyber-incident at a prominent exchange coming in March last year.

“The forward-looking question is what could result from such events, if these cryptoassets continue to grow at scale, if they continue to become more integrated into the traditional financial sector and if investment strategies continue to become more complex?

“In thinking about this, we should be clear that investors losing money on speculative investments does not, in and of itself, constitute a financial stability problem, though it may well be a major concern for authorities responsible for investor protection.

“In the dot-com crash of the early 2000s investors lost over $5 trillion following a sharp correction in equities, with the technology-focussed NASDAQ losing over 75% of its value. In the months before the crash, the index had a market capitalisation of roughly $3.6 trillion and this followed five years of exuberant growth, averaging 42% each year. In this instance, the losses for investors were material but there was no loss of financial stability.

“By contrast, the collapse of the $1.2 trillion market in sub-prime mortgage backed securities in 2008 triggered the great financial crisis. In that case, the knock-on effects of a price collapse in a relatively small market was amplified and reverberated through an un-resilient financial system causing huge and persistent economic damage.

“Whether a major price correction is absorbed by the system, admittedly leaving some investors with very sore heads or whether it is amplified into a systemic impact depends on a number of key characteristics of how the asset is integrated into the financial system, especially interconnectedness and leverage. It depends also on the resilience of the system at the time of the correction, the liquidity in the system under stress and the ability of core elements of the system to absorb any losses.

“So a necessary thought experiment from a financial stability perspective is what would happen in the financial system if there was a massive collapse in the price of unbacked cryptoassets – at the extreme end, if the price fell to zero.

“Such a collapse is certainly a plausible scenario, given the lack of intrinsic value and consequent price volatility, the probability of contagion between cryptoassets, the cyber and operational vulnerabilities, and of course, the power of herd behaviour.

“A massive collapse in cryptoasset prices, similar to what we have seen in tech stocks and sub-prime, is certainly a plausible scenario. In such a price correction scenario, the first question that arises is the degree of interconnectedness between crypto and the conventional financial sector.

“The simplest form of connections are direct exposures, people or institutions holding cryptoassets for speculative purposes. As a large proportion of this activity is still being carried out outside the traditional financial sector, regulators have a limited line of sight into who is holding these assets. It is clear, however, that there are a large number of retail investors in this space –FCA survey research estimates 2.3 million adults own cryptoassets in the UK alone. However, the possible losses to retail investors, while raising, as I have said, investor protection concerns, is currently unlikely by itself to be large enough to be a financial stability risk.

“The picture is less clear for financial institutions. It is useful to distinguish between institutional investors and banks. A recent report identified 150 to 200 specialist crypto hedge funds. The investors behind these funds are typically high net worth individuals and family offices. In many respects this is a similar story to that of retail investors, though we would expect more appetite to take leveraged positions in these sectors.

“Taking together the volatility of unbacked and largely unregulated cryptoassets, their nascent but
fast-growing integration into the financial sector and the appearance on the scene of leveraged players, my conclusion is that while a severe price correction would not cause financial stability problems now, all else equal, the current trajectory implies that this may not be the case for very long.”

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