Why the Crypto Unwind Wasn't Contagious (This Time)
In January, as crypto and equity markets were beginning a slow, steady decline, the International Monetary Fund (IMF) published a report warning that crypto was becoming more intertwined with conventional markets. The report's writers worried that "widespread adoption [of cryptocurrency] could pose financial stability risks."
That is, a major crypto crash could have impacts on mainstream banking, equity or credit markets, in much the same way the collapse of real estate-backed instruments froze markets in the 2008 Great Recession. In particular, the IMF warned that "the rising use of leverage" in trading tokens increased the chances of systemic contagion.
While I'm no fan of the IMF as a political organ, its analysts correctly spotted the risk. In fact, we learned from a report Wednesday the formerly huge crypto fund Three Arrows Capital (3AC) is insolvent and will be liquidated, ultimately due to its margin-driven trading strategy. That sort of high-risk, leverage-driven strategy is common across crypto, contributing at least as much instability as uncertainty about the fundamental usefulness of the technology.
As it happened, the real world didn't give us a chance to test crypto's contagiousness.
Instead, crypto – like most financial markets – has been driven down by the same set of external factors, above all by rising global inflation and monetary tightening in the United States. Equity markets and consumer confidence have declined simultaneously with crypto market values, and many speculative tech stocks that experienced huge run-ups during the coronavirus pandemic have lost as much or more value in percentage terms than top-tier crypto assets over the past six months.
But even if it's somewhat academic, the question of contagion is important. Because the waves of interest from the general public peak higher every cycle, there's more notional money on the line. The biggest x-factor of crypto contagion: Direct Main Street exposure to speculative, volatile and risky crypto assets presents entirely new macroeconomic dynamics in future crises by devolving more risk towards individuals and away from institutions.
At the same time, every cycle seems to create more integration between crypto and mainstream finance. Not too long ago, remember, crypto companies had trouble even getting a bank account. Now some regulated banks actively cater to the industry.
That growing integration means a 3AC-style blowup could one day hit a traditional financial (TradFi) entity. There was a hint of that this time around as TradFi firm Jump Trading launched a crypto arm, only to make a series of misguided moves including backing the fundamentally flawed Terra system. So far, that doesn't seem to have mortally wounded the Jump mothership, but it's a likely preview of screwups to come.
Comparative size
But "contagion" doesn't refer to the interdependencies of one or even a few big funds and institutions. "Contagion" implies a thick weave of counterparty relationships across the world of finance. Crypto is certainly nearing a scale where it would have that kind of pull.
At its peak last November, the total paper value of all crypto assets was roughly $3 trillion. That's not much compared to, say, the U.S. Gross Domestic Product (GDP) of $23 trillion each year, or global GDP of about $83 trillion. But it starts to look more significant relative to finance in general: At that November peak, the IMF found the total crypto market cap was nearly 5% the value of U.S. equity markets. It was also over 5% of the $53 trillion in outstanding bonds in the U.S. market.
That's more than enough to trigger a serious financial crisis. For comparison, the total value of collateralized debt obligations before the 2008 recession was a reported $200 billion, or around $273 billion in 2022 dollars. Because CDOs were highly leveraged instruments, that was enough to trigger a near-complete breakdown of credit markets when the underlying real estate market wobbled.
Venture risks
The crypto ecosystem also includes venture capital (VC) funds, but those are practically insignificant relative to the broader economy in both scale and interdependencies. In 2021, a year that saw unmatched crypto hype, VCs bet only $33 billion on crypto startups. That's significant relative to the $276 billion VCs gave to the broader tech and software sector, but it could go to zero with no meaningful effect on the broader economy.
That's particularly true because venture capital is insulated from the broader finance industry in particular ways. Most only accept capital from high-net-worth individuals, who can absorb losses without drastically altering their economic behavior. Equally important is their minimal role beyond startup funding: If a standard VC fund fails, that cuts off a pipeline to emerging industries but it doesn't drain the entire economic lake.
The interdependencies of 3AC
Three Arrows, it is increasingly clear, was doing a lot of different things at the same time, increasing the impact of its insolvency. It was acting as a proprietary trading operation – making extremely risky leveraged long bets on bitcoin (BTC), for instance – and also as a venture fund taking positions in startups.
Worst of all, 3AC acted as a treasury custodian for some of the startups it backed, and allegedly offered financial incentives to portfolio companies to use the service. This was foolish in its own right, but there are suspicions that 3AC may have been using startup treasuries as capital or collateral for trading activities.
Those choices have, in turn, led to genuine financial contagion within crypto markets, including tragic rugpulls for a number of startups that had funds custodied with 3AC. More to the point, though, 3AC set the market up for a wave of forced sales of bitcoin, ether (ETH) and similar blue-chip assets, threatening not just individual companies but the entire market.
So while we didn't get a full-scale test of crypto's potential for contagion, 3AC co-founders Su Zhu and Kyle Davies have given us a useful preview of the kinds of behaviors that can foster it.
The remedies are varied, but at least for big financial actors they should include much higher expectations of transparency from counterparties and a more generally cautious approach to sharing too many risks under the same roof.
– David Z. Morris
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