How would we cope with a Cryptocalypse?

Crypto-currencies are one of those features of modern life that tend to polarise people. To their supporters, they represent the future of payments mechanisms, a non-centralised currency in the making, and a means to move away from extractive capitalism by breaking the monopoly over money that the banks hold. To their detractors, crypto-currencies are nothing more than a Ponzi scheme, of no more value than a bag of magic beans. 

The supporters of crypto have been growing in recent times. This has, undoubtedly, been given a boost during the pandemic. A mainly younger demographic, new to investing, bored by living through a sequence of lockdowns, funded by public largesse, have discovered the attractions of casino capitalism. Egged on by investing 'tips' on sites such as Reddit, this demographic has piled into crypto. Today, there are about three times more digital wallets (the means by which crypto-currencies are held) compared with 2018. At this point in time, the supporters of crypto could be right. As could the detractors.

Despite small economies such as El Salvador adopting crypto as legal tender, there have been few signs of crypto replacing more traditional currencies. This is despite the market capitalisation of all crypto-currencies rising from $330 billion to $1.6 trillion in the past year. The detractors ascribe this lack of uptake to one key factor - the widely fluctuating value of crypto-currencies. This rather undermines the use of crypto as a means of exchange. In El Salvador, where Bitcoin is legal tender, prices are quoted in dollars and then converted to Bitcoin at the prevailing rate at the point of sale. The wild changes in the price of crypto also undermines it's function as a store of value and a standard for deferred payments. In the absence of an authority to stabilise the value of crypto - a central bank, in other words - it will continue to fail to perform the functions that are needed from a currency.

If that's the case, what are we left with? All that is left is an asset with little in the way of intrinsic value - it is not guaranteed by a monetary authority or secured by an underlying asset. It is an asset that rests solely upon trust. The investment case for the asset is the 'bigger fool' approach. I may be a fool for investing in crypto, but there is always a bigger fool than me who is willing to buy it from me. This is the dimension that allows the detractors to accuse crypto of being nothing more than a Ponzi mechanism. What happens if the supply of fools dries up? What happens if there is a crisis of confidence in crypto and the demand for crypto assets collapses? In the absence of a central authority to stabilise the value of crypto, in the face of widespread selling of the assets, there is nothing to stop the value falling to zero. What would happen then? Would it matter?

It is useful to divide crypto investors into three camps. First, there are the 'diehards'. These are the true believers in crypto who provide the most ardent support. Second, there are the 'fellow travellers'. These are the investors who see the rising trend of crypto values and who want to participate in this momentum. Third, there are the 'crazies', who simply want the gambling aspect of crypto investment. In the event of a crash, we can expect the diehards to stay with crypto. To sell would represent a fundamental challenge to their belief systems. The crazies would be very quick to leave the market and move on to better things, such as sports betting. For a crash to have a mild impact, the diehards need to persuade the fellow travellers to stay with it. If they can do this - perhaps by replacing the market weight of the crazies - then the fellow travellers will stick with it as their losses would be manageable. If they fail to do this, then the fellow travellers are likely to cut their losses and the value of crypto would fall a very long way, possibly to zero.

The impact of the value of crypto falling to zero would depend upon how long the investors have been in the market. The diehards - who have been invested for more than 12 months - would lose a great deal of unrealised gains (paper profits), but less so in relation to how much they paid for their assets in the first place. The crazies - those invested for less than 3 months - would be likely to be wiped out. If they are leveraged holders of crypto, the losses could well exceed their market capitalisation. The fellow travellers - those invested between 3 to 12 months - would fall in between the two. What is more concerning is that institutional investors (hedge funds, university endowments, mutual funds and a number of companies) are disproportionately situated as either crazies or fellow travellers. These investors are not noted for an overwhelming appetite for risk.

The Economist estimates that the first shockwave of a crypto collapse could be in the region of $2 trillion - about the market capitalisation of Amazon. The secondary impacts are not difficult to see. Loans secured by crypto assets would face calls for liquidity. Leveraged loans to purchase crypto assets would face margin calls. There would be a rush for liquidity leading to investors to cash in conventional assets - firstly financial instruments, and then property assets. At this point a cryptocalypse has the potential to bleed into the real economy. It is likely that interest rates would rise as credit would become scarcer because banks would face difficulties in valuing assets used as collateral in loans. The financial system would start to slow the operation of the real economy, which could lead to a degree of retrenchment on the part of consumers. It is hard to estimate how bad it could get, but it has the potential to give rise to a situation far worse than the financial crisis of 2008.

Of course, this doesn't all happen in a vacuum. The monetary authorities can currently take action to protect the real economy from a cryptocalypse from happening. The crypto system could be isolated from the monetary system by, for example, requiring that collateral on loans within the crypto derivatives market is restricted to conventional cash. The authorities could require the tighter regulation of crypto exchanges. The authorities could insist that crypto holdings are valued at zero in calculations of capital adequacy. There are a whole raft of measures that could be undertaken to make the world safe from crypto. It is comforting that this is the current direction of regulatory travel, even if the pace is a bit slow.

Stephen Aguilar-Millan

© The European Futures Observatory 2021