Crypto Warnings Invoke US Subprime Mortgage Bust and 2008 Financial Crisis

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Regulators comparing the crypto craze to the collapse of subprime mortgages in the United States in the 2000s may sound alarmist, but the more crypto integrates into mainstream investing and markets, the more such warnings may become premonitory.

The size of the crypto markets relative to the universe of financial assets remains tiny, but it is growing rapidly, much faster than the restrictions and controls imposed on the loosely regulated and rapidly evolving industry.

Hardly a week goes by without a major bank or asset manager rolling out another crypto product or service. In recent days, Fidelity and BlackRock have launched blockchain, crypto and metaverse exchange-traded funds, and Goldman Sachs has offered its first Bitcoin-backed lending facility.

Policymakers clamoring to crack down on crypto’s “Wild West” — to counter a range of risks from volatility to fraud, cybercrime to contagion — is nothing new.

The Wall Street Journal reported on Thursday that U.S. Senator Elizabeth Warren wrote to Fidelity’s chief executive questioning the “advisability” of the company’s decision to add Bitcoin to its 401(k) retirement plan options. because of “significant risks of fraud, theft, and loss.”

What is intriguing is the recent flurry of references to the US subprime housing market, whose runaway boom and bust was a catalyst for the Great Financial Crisis of 2007-2009. They came amid mounting evidence that the ties between Bitcoin and Wall Street have never been stronger.

In an April 4 speech on crypto, Securities and Exchange Commission Chairman Gary Gensler noted that several platforms ran prime-time TV ads during the Super Bowl, much like subprime lender AmeriQuest before. the GFC. He reminded his audience that AmeriQuest went bankrupt in 2007.

In an April 7 speech on digital assets, Treasury Secretary Janet Yellen warned against repeating the mistakes of the 2000s that saw shadow banking and an explosion of new financial products combine to fuel levels of risk. dangerous.

And on April 25, European Central Bank board member Fabio Panetta noted that crypto is now bigger than the $1.3 trillion U.S. subprime market, and said that it shared a “similar dynamic” with the market that ultimately brought the global financial system to its knees.

Could crypto really cause similar damage?

At first glance, no. But the more traditional banking and finance get involved, the more the links between the two worlds become obscured, the more ordinary investors are exposed, and the more the risks suddenly become systemic.

Alastair Sewell of Fitch Ratings in London says regulators’ concern is the “on-ramp” and “off-ramp”, the point where the ordinary investor enters and exits a crypto investment.

“It will probably be a bank, a bridge between traditional finance and digital finance. And some of the digital houses can tap into the capital markets, so investors are increasingly exposed to the broader crypto ecosystem around them,” Sewell said.

BITCOIN CORRELATION

The global crypto universe grew roughly tenfold in 2020 and 2021, and now stands at around $2 trillion. This is only 0.5% of global financial assets, but there are over 17,000 different crypto-asset tokens in circulation.

The positive correlation between Bitcoin and Wall Street has never been stronger. This suggests that cryptocurrency is not the alternative investment of choice to diversify portfolios or hedge against inflation, but is just as vulnerable as stocks in times of heightened uncertainty and volatility.

And cryptocurrencies are inherently more volatile than traditional stock markets – they are smaller, less mature, less liquid, and institutional investors play a much smaller role. But that is changing.

“As in the case of the subprime mortgage crisis in the United States, a small amount of known exposure does not necessarily mean a small amount of risk, especially if there is a lack of transparency and insufficient regulatory coverage. “, said the Financial Stability Board of Basel. in February.

Bitcoin and the S&P 500 Index have been positively correlated daily since December 27. It’s been over four months, the longest uninterrupted period on record, and the strength of this correlation is recently the highest on record.

The link between Bitcoin and the Nasdaq Composite is even closer. They have been positively correlated since November 26 of last year, also the longest period ever, and the recent strength of this correlation is also unprecedented.

The degree of leverage in the system is also critical in assessing systemic risk. Right now, because the market is so opaque, it’s unheard of. We now know, with a 20/20 hindsight, that the leverage and cross-exposure in US securitized and secured venture housing was extraordinarily high.

According to hedge fund industry data provider HFR, the cryptocurrency hedge fund universe currently has around 100 funds with a total of $55 billion in assets under management. Again, that’s a tiny fraction of the $4 trillion, but heavily indebted and growing, hedge fund industry.

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