Weighing the Crypto Threat to the Global Financial System

Do cryptocurrencies threaten global financial stability? The Financial Stability Board (FSB), an international body of financial authorities and regulators, released a report last week voicing worries—adding to related murmurs amongst financial commentators we follow. Whilst we don’t think the FSB’s findings are a call to action, examining how the crypto space could impact broader global markets can help investors weigh the likelihood of the discussed potential negative outcomes actually coming to pass.

Before examining the FSB’s arguments, some background: Cryptocurrencies are digital currencies not created or controlled by national governments. According to many of their proponents, cryptocurrencies’ advantage is their strictly limited issuance (making them scarce) and use of a digital ledger called the blockchain, which records past transactions and prevents counterfeiting. Their rising popularity in recent years is due in part to some proponents’ expectation that cryptocurrencies are the future of money—spurring a broader industry aiming to capitalise on this potential growth.

The FSB focused on vulnerabilities in private sector crypto assets, from unbacked crypto (e.g., bitcoin, the first and most prominent cryptocurrency based on our financial news coverage) and stablecoins (cryptocurrencies with a fixed value that are backed by a basket of securities, much like a money market fund) to decentralised finance (DeFi) and crypto-asset trading platforms. Think of unbacked tokens and stablecoins as your general cryptocurrencies—i.e., something trying to be electronic cash—whilst DeFi and crypto-trading platforms aim to provide financial services (e.g., lending) using private-sector crypto assets. With digital coins expanding rapidly and becoming a larger part of the financial system, the FSB warns more regulation and oversight are needed, or else cryptos’ problems could spill into global capital markets—with potentially dire consequences.^[i] For example, the FSB posits that a major stablecoin failure could roil short-term funding markets if the coin issuer had to liquidate its reserve holdings in a disorderly fashion—especially if it triggered holders of other stablecoins to liquidate en masse.^[ii]

But as the FSB and many financial commentators we follow have pointed out, to harm global markets, crypto markets need a transmission mechanism (something that connects one market to another). In our view, throughout cryptos’ limited history, no link existed: Hence, bitcoin’s busts in both of the long stretches of rising stock markets occurring during its existence didn’t derail stocks.^[iii] But with cryptos’ rising prominence, we have seen some observers argue new potential transmission mechanisms are forming.

A Crypto Wealth Effect

Beyond the FSB, we have seen some commentators posit that crypto investors, emboldened by their rising portfolios, will spend more because they feel wealthier, thereby boosting consumer spending—an economic theory known as the wealth effect. Relatedly, if their crypto portfolios fall, investors will allegedly feel poorer and become less likely to spend. However, our research suggests the wealth effect is more myth than reality, and we think the digital version has issues, too. For one, spending crypto isn’t equivalent to spending a broadly used fiat currency. In the US, for example, spending a cryptocurrency is like selling it for tax purposes, subjecting the transaction to taxes on investment gains—an incentive, in our view, against spending directly from bitcoin wallets with big unrealised gains. People could sell and use the proceeds to shop ’til they drop, but based on our observations, many investing in cryptos see their holdings as long-term investments—theoretically arguing against selling. Two, we haven’t seen much evidence increased crypto wealth is circulating through payment systems in a major way. In its 2021 fiscal year, multinational payment processor Visa noted $3.5 billion (£2.6 billion) in payments volume on crypto-linked card programs—a drop in the bucket of the company’s total payments volume of $10.4 trillion (£7.8 trillion).^[iv]

Lending Against Crypto Holdings

Another argument we have seen in financial headlines: warnings about the fallout from investors using their crypto holdings as collateral to get a loan. If the value of those holdings plunges, the lender may issue a margin call (where a broker asks for additional funds after a customer’s account, which is the collateral, falls below a certain required level). A failure to meet those calls could drive a spate of selling, perhaps spurring more market volatility. Whilst that scenario is possible, our research has found that borrowing against crypto isn’t too readily availabile today. Relatively few custodians and digital wallets will extend material credit against digital assets at this point, and lending against crypto likely comes with high interest rates and all of the typical risks associated with going on margin (in which a customer borrows money to buy securities). Moreover, depending on the location, using crypto as collateral for a loan may not even be allowed. Whilst the business seems to be growing, research outfits estimate the amount of crypto lenders’ loans outstanding in the tens of billions of pounds, which, as researchers from S&P Global described it, “… represents a few basis points [hundredths of a percentage point] of global banks’ total lending.”^[v] 

Holdings on Corporate Balance Sheets

Last year, some publicly-traded firms made headlines in publications we follow for adding bitcoin to their balance sheets. As we wrote then, we didn’t think it far-fetched to envisage a scenario in which companies, motivated by rising prices, load up on a fast-rising cryptocurrency, only to get burned if its price plunges—roiling balance sheets and hurting their stock prices in the process. However, we think this possibility looks far from likely today. We have seen estimates peg bitcoin amounting to about $9.7 billion (£7.3 billion) of public companies’ balance sheets.^[vi] We don’t think that alone is anywhere near enough to tank global stocks, which have a market capitalisation of $59 trillion (£43.7 trillion).^[vii] Public companies’ bitcoin holdings amount to a rounding error.

Now, some firms do benefit from crypto speculators trading on their platforms or using their digital wallets. But there the trading or using of cryptocurrencies is what generates the revenue, not actually holding them. 

Stablecoin Failure

Another concern raised by the FSB: Since many stablecoins use cash, money market funds, US Treasurys and other short-term securities as collateral, a major stablecoin failure could force liquidations of the coin’s reserve holdings. The FSB discusses the possibility of those liquidations leading to a liquidity squeeze in short-term funding markets—and tight liquidity could drive broader market volatility. The saga that inspires this fear is the Reserve Primary Fund, a US-based money market fund, falling below $1 per share (which headlines at the time called “breaking the buck”) back in 2008. This event garnered a lot of attention since the general perception of money market funds is that they are higher-yielding cash alternatives, so their share price shouldn’t fall below $1. However, the Reserve Primary fund held loads of Lehman Brothers’ debt, so the shock of Lehman failing in September 2008 hit it heavily.^[viii] 

But the stablecoin theory lacks a similar shock factor, in our view. As the FSB’s report indicated, regulators have been studying this issue for years, so this potential disruption isn’t sneaking up on anyone.^[ix] Furthermore, our coverage of financial headlines has found substantial scrutiny of stablecoin reserve holdings even beyond regulators. We think surprises move markets most, and policymakers’ focus saps a lot of negative shock potential, in our view.

Regulatory Uncertainty

Related to potential regulatory responses, there is the possibility policymakers take action in the form of new rules or laws. Those rules could be a plus. They may also introduce unintended consequences and uncertainty—a potential negative for markets, in our view. But we think it is impossible to predict how regulators or lawmakers will act. Whilst rule changes are worth watching for, we don’t think it is wise to take investing action based on chatter.

In our view, many of these dire scenarios miss the relevant question for investors: What is the likelihood a crypto-related development wallops trillions of pounds off global gross domestic product (GDP, a government-produced measure of economic output)? The FSB estimates crypto assets amount to $2.6 trillion (£2.0 trillion)—approaching the economic size of something capable of derailing the global economy, based on our research.^[x] But how probable is it that a negative emerges capable of decimating all crypto assets in a sudden, shocking way? Even then, what is the actual economic effect of crypto? After all, that £2.0 trillion is total value. It isn’t comparable to GDP—a flow of economic activity. Hence, we think just looking at the market value likely overrates crypto’s actual economic impact quite dramatically. Put differently, there are single stocks that approach or even exceed the market value of the entire crypto market. But their value isn’t the important factor economically—that would likely be more akin to totaling revenue and costs.

We are always monitoring for developments capable of becoming a true wallop, and cryptos’ spillover potential into global capital markets is something worth tracking, perhaps as a factor years down the line. But its probability of actually walloping markets looks low for the foreseeable future, in our view.