As of early December 2021, a single bitcoin is trading at a little over $49,500. With circulating supply of 18,891,656 BTC, that gives the leading cryptocurrency a total market capitalisation of $937,782,834,499 – just shy of $1 trillion. The market capitalisation of Ether, the digital currency of the Ethereum smart contracts blockchain, is $500,534,205,575.
The combined value of all 7940 cryptocurrencies and digital tokens listed on the cryptocurrencies market data site Coinmarketcap.com is over $2.6 trillion, 42% of which is accounted for by Bitcoin.
The value of the cryptocurrency market is currently around the same size as France’s 2019 GDP and only a little, $100 billion or so, short of the UK’s. Bitcoin’s market capitalisation alone is greater than the 2019 GDP of the Netherlands.
Given the huge amount of wealth now tied up in cryptocurrencies, and especially bitcoin, what kind of impact would it now have on financial markets if, as sceptics are still convinced will happen, their valuations go to zero? If cryptocurrencies really are nothing more than a speculative bubble, the mother of all financial bubbles, and will eventually be revealed as The Emperor’s New Clothes, that should be what happens.
If and when collective belief in bitcoin’s ability to establish itself and the broader cryptocurrencies market as a mainstream asset class dissipates, it should lose all economic value. That might happen because global regulators like the SEC in the USA and the UK’s FCA follow the example already set by China and ban unregulated cryptocurrencies as offering a too effective and easy route for money launderers.
If blockchain-based cryptocurrencies exist 10 years from now, and the evidence suggests they probably will, they may not be today’s. But rather regulated alternatives that offer the technological advantages of digital currencies built on more advanced forms of blockchain than bitcoin but not the anonymity that poses such a problem for regulators, lawmakers and law enforcement.
That’s the obvious reason why many are still sceptical of today’s cryptocurrency market and call it a huge bubble. And the fact there are thousands of tradable cryptocurrencies and other digital assets like NFTs suggests there is no way all of them, or even many of them, have a viable long term future.
But with so much wealth now tied up in bitcoin and cryptocurrencies what would be the impact on the global financial system if it were to evaporate overnight? Or through a longer, more drawn-out process over months or even years?
Is Bitcoin becoming too big to fail? And if it is too big to fail might that mean financial regulators trying to find a way to bring it into the regulatory fold and part of mainstream financial markets that somehow solves the anonymity issue?
Who owns and trades Bitcoin and other cryptocurrencies?
An investigation by The Economist into how closely intertwined crypto and mainstream financial markets have become found that as of August 2021, institutional investors accounted for 63% of cryptocurrency trading. In 2017 institutional investors accounted for just 10% of crypto trading volumes, demonstrating how the market has changed from one dominated by individuals.
The hedge fund SkyBridge capital is offered up as an example. Run by Anthony Scaramucci, the $3.5 billion fund started to make allocations to Bitcoin in November 2020 and launched a dedicated $500 million Bitcoin fund in January of this year. At the time of the investigation four months ago, 9% of SkyBridge’s main fund was allocated to Bitcoin and the dedicated fund worth around $700 million.
The 26,000 investors in SkyBridge Capitals funds are said to include sovereign funds as well as wealthy individuals and family offices. The institutional investors in Bitcoin and cryptocurrencies now range from hedge funds and even mutual funds to university endowments and even some companies. Tesla chief executive Elon Musk famously announced in February the electric cars company had invested $1.5 billion in Bitcoin.
How much wealth would really be wiped out by a cryptocurrencies crash?
The large majority of institutional investors exposed to Bitcoin bought into the market from 2020 onwards. That means, says the same study in The Economist, their average purchase price is $37,000, leaving them far more exposed to a crash than earlier investors who would mainly take relatively light real losses. Even if the loss of huge unrealised paper gains would hurt badly psychologically.
But losses would spread much further than those from the direct loss of value of Bitcoin and other cryptocurrencies. The roughly $40 billion start-up data company PitchBook says has been invested in publicly listed crypto market companies since 2010 would also be largely wiped out.
Fintech and payments companies like Revolut, PayPal and even Visa, which this year launched a credit card offering rewards points paid in Bitcoin, would lose what has become a valuable, quickly growing part of their businesses. That would almost certainly seriously hit their market valuations. Makers of the powerful processors used by cryptocurrency miners, that are financially incentivised through cryptocurrency rewards to provide the computing power P2P blockchains require to run, like Nvidia, would also lose a profitable chunk of their business.
Could a crypto markets crash infect mainstream finance?
The failure of publicly listed companies worth a combined sum in the hundreds of billions, as well as a heavy hit to the valuations of mainstream financial sector companies with exposure to crypto markets, would have a meaningful impact on mainstream financial markets. But while it would be a shock it probably won’t result in major structural damage.
What, however, could is the fact as much as 90% of the total wealth invested in Bitcoin is bound up in derivatives such as futures and traded on unregulated exchange. Most derivatives positions are taken using leverage, which essentially means borrowing money to magnify gains made in successful trades. However, the losses taken in losing trades are equally magnified.
Leveraged trading means any major downside swing in cryptocurrency prices would trigger a large number of margin calls forcing traders with losing positions to either liquidate them and lock in the losses or come up with the cash to cover them. The latter choice often means traders have to sell off other assets to free up liquid cash to cover margin calls on losing trading positions.
That of course further increases downside risk if prices continue to fall. As well as potentially infecting mainstream financial markets such as stock markets if enough conventional assets are sold off to cover mass margin calls, covering them also increases exposure and the extent of potential losses.
On the other hand, enough cryptocurrency investors choosing not to cover margin calls and liquidising losing positions would push crypto markets further down. If it were to become severe enough, the plunge could theoretically become a death spiral for cryptocurrency markets.
A run on cryptocurrency markets would also likely include ‘stable coins’. This category of cryptocurrency, the two largest stable coins are Tether and USD Coin, is used by traders as a proxy for fiat currency that makes it easier to buy, sell and trade cryptocurrencies on exchanges. To track the fiat currencies, most often the USD, stable coins are backed by mainstream assets. Tether, for example, said at the end of March that the value of its issued Tether coins is 50% backed by commercial paper, 12% in secured loans and 10% in corporate bonds, funds and precious metals.
A run on Tether would force the company behind it to liquidate assets to cover outward flows. With Tether currently worth over $750 billion in circulation that could, said the ratings agency Fitch in July, “affect the stability of short term credit markets”.
Just how leveraged are cryptocurrency markets?
Because cryptocurrency exchanges are unregulated it is difficult to tell exactly how highly leveraged exposure to the market is. However, one way to get a clue, says Carnegie Mellon University’s Kyle Soska, is to look at the total value of the total cryptocurrencies derivatives contracts open at any one time. Soska says that had increased from $1.6 billion at the start of the Covid-19 pandemic to $24 billion by this summer.
It’s not clear how much leverage is involved in those positions but on May 18 this year, Bitcoin’s value dropped by around a third. The value of positions forced into liquidation by trading platforms because margin calls weren’t covered, came to $9 billion. If the Bitcoin price had continued to drop, which it didn’t, the value of losing positions forced into liquidation would have been expected to rise sharply.
What could trigger a run on cryptocurrencies?
Most observers of crypto markets break investors into three main groups:
Fundamentalist investors are those with firm loyalty to the concept of cryptocurrencies and their role in the future of global finance. Most have been relatively early investors in cryptocurrencies and would mainly be affected by the loss of unrealised paper gains. However, they are also the most unlikely to sell out and many will hold onto their crypto assets in the belief of an eventual recovery, even if 90% or more of their value is lost.
Speculators are defined as those simply hoping to profit from trading cryptocurrency markets and have no genuine ideological attachment to the asset class. This is usually the most highly leveraged category of investor and the one that would be expected to vanish quickest if markets start to tumble.
The second group is that which the fate of crypto markets will rest on. Tacticians are usually invested in Bitcoin and other cryptocurrencies without using leverage. They see their investment as one part of a broader portfolio and hope to profit from the rise in the value of cryptocurrencies driven by more people investing in them.
If enough tacticians lose faith and sell off crypto assets after speculators have fled the market, that would drive valuations right back down to where they were before the start of the pandemic or even to levels last seen in 2016 or below.
A mass sell-off could be triggered in a few ways. The first would be regulatory intervention due to worries over the money laundering potential represented by the anonymity afforded by unregulated cryptocurrencies. The second would be a major drop in general market sentiment towards risk catalysed by, for example, banks raising interest rates.
That would be expected to first hit volatile, high risk ‘meme stocks’ like GameStop that are heavily traded by small retail investors as well as the technology stocks, like Tesla, whose valuations look most stretched. Recent months have shown a significant correlation between the market for meme stocks and crypto markets with gains made in one market often reinvested in the other. In the reverse scenario, losses in meme stocks would be expected to be often covered by the sale of crypto assets.
On a larger scale, many of the ‘tactical’ institutional investors that have recently built up exposure to Bitcoin and other cryptocurrencies could well pull out.
If cryptocurrency markets do crash they are now large enough that there would be a significant knock-on impact for mainstream financial markets. The good news is that while it could be very unpleasant it is unlikely to lead to systemic failure as bank balance sheets are not exposed to cryptocurrencies. Even in the case of those banks, like Goldman Sachs, that have launched funds and crypto asset trading and custodial services, it is their clients’ money on the line, not theirs. They will not be at risk of failure.
That could encourage regulators to, at some point, decide markets can take the pain of them bursting crypto markets by outlawing unregulated digital currencies that offer anonymity. And to not intervene in any crash and let it claim victims as a warning against future attempts to bypass regulated markets.
However, if crypto markets continue to grow in value and attract more institutional money, their cross-over with mainstream financial markets will only deepen. That could shift the balance and mean Bitcoin does start to be seen as “too big to fail”.
If a crypto markets crash doesn’t materialise relatively soon, that may well become an increasingly influential consideration in how regulators and governments start to deal with Bitcoin and other major cryptocurrencies like Ether and Tether.