Crypto warnings evoke US subprime mortgage bust
Regulators comparing the crypto craze to the US subprime mortgage bust of the 2000s may seem like scaremongering, but the more crypto integrates with traditional investing and markets, the more prescient these warning may become.
The size of crypto markets relative to the financial asset universe remains tiny but it is growing rapidly, far quicker than curbs and controls are being imposed on the loosely regulated and rapidly evolving industry.
Barely a week goes by without a major bank or asset manager rolling out yet another crypto product or service. In recent days, Fidelity and BlackRock launched blockchain, crypto and metaverse exchange-traded funds, and Goldman Sachs offered its first Bitcoinbacked loan facility.
Policymakers clamouring to crack down on the “Wild West” of crypto — to counter a range of risks from volatility to fraud, cybercrime to contagion — is nothing new.
The Wall Street Journal on Thursday reported that US Senator Elizabeth Warren wrote to Fidelity’s chief executive officer questioning the “appropriateness” of the firm’s decision to add Bitcoin to its 401(k) retirement plan options due to crypto’s “significant risks of fraud, theft, and loss”.
What’s intriguing is the recent clutch of references to the US subprime housing market, whose unchecked expansion and collapse was a catalyst for the 2007-2009 Great Financial Crisis. They have come amid mounting evidence that links between Bitcoin and Wall Street have never been stronger.
In an April 4 speech on crypto, Securities and Exchange Commission Chair Gary Gensler noted that several platforms ran prime-time TV commercials during the Super Bowl, as did subprime lender AmeriQuest in the lead-up to the GFC. He reminded his audience that AmeriQuest went bust in 2007.
In an April 7 speech, Treasury Secretary Janet Yellen warned against repeating the mistakes of the 2000s that saw shadow banks and an explosion of new financial products combine to fuel dangerous levels of risk.
And on April 25, European Central Bank Executive Board member Fabio Panetta noted that crypto today is larger than the $1.3 trillion (about 44.6 trillion baht) US subprime market, and said it shares “similar dynamics” with the market that ultimately brought the world financial system to its knees. Could crypto really wreak similar damage?
On the face of it, no. But the more traditional banking and finance gets involved, the murkier the ties between the two worlds grow, the more ordinary investors are exposed, and the more systemic the risks suddenly become.
Alastair Sewell at Fitch Ratings in London says the concern for regulators is the “on ramp” and “off ramp”, the point where the ordinary investor get access to and exits a crypto investment. “That will probably involve a bank, the link between traditional and digital finance. And some of the digital houses may tap capital markets, so investors are increasingly getting exposure to the broader crypto ecosystem around them,” he said.
The global crypto universe grew roughly tenfold over 2020 and 2021, and now stands at around $2 trillion. That’s only 0.5% of global financial assets, but there are more than 17,000 different cryptoasset tokens in circulation.
The positive correlation between Bitcoin and Wall Street has never been stronger. This suggests 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 intrinsically 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 US subprime mortgage crisis, a small amount of known exposure does not necessarily mean a small amount of risk, particularly if there exist a lack of transparency and insufficient regulatory coverage,” the Financial Stability Board said in February.
Bitcoin and the S&P 500 index have been positively correlated on a daily basis every day since Dec 27. That’s more than four months, the longest uninterrupted stretch on record, and the strength of that correlation recently is the highest ever. The link between Bitcoin and the Nasdaq Composite is even tighter. They have been positively correlated since Nov 26 last year, also the longest stretch ever, and the recent strength of that correlation is unparalleled too.
The degree of leverage in the system is also critical in gauging systemic risk. Right now, because the market is so opaque, that is unknown. We do know now, with 20/20 hindsight, that leverage and cross-counterparty exposure in securitised and collateralised US subprime housing was extraordinarily high.
According to hedge fund industry data provider HFR, the cryptocurrency hedge fund universe currently boasts approximately 100 funds with a total of $55 billion in assets under management. Again, that is a tiny fraction of the $4 trillion hedge fund industry, but highly leveraged and growing.