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 murmurs in the financial press. While the FSB’s findings aren’t a call to action, examining how the crypto space could impact broader global markets can help investors weigh the likelihood of the discussed fears actually coming to pass.

The FSB focused on vulnerabilities in private sector crypto assets, from “unbacked crypto” (e.g., bitcoin) and “stablecoins” (an asset-backed crypto with a fixed value) to decentralized 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—while 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 worries more regulation and oversight are needed, or else cryptos’ problems could spill into global capital markets—with potentially dire consequences. 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 a run on other stablecoins.

But as the FSB and many pundits have pointed out, to harm global markets, crypto markets need a transmission mechanism. Throughout cryptos’ limited history, no link existed: Hence, bitcoin’s busts in both of the bull markets occurring during its existence didn’t derail stocks. But with cryptos’ rising prominence, some see new potential transmission mechanisms.

A Crypto “Wealth Effect”

Beyond the FSB, some commentators think crypto investors, emboldened by their rising portfolios, will spend more because they “feel” wealthier, thereby boosting consumer spending. On the flipside, if their crypto portfolios fall, investors will feel poorer and become less likely to spend. We have long argued the non-crypto wealth effect is bunk, and the digital version has issues, too. For one, spending crypto in the US is like selling it for tax purposes, subjecting the transaction to capital gains taxes—an incentive against spending directly from bitcoin wallets with big unrealized gains. People could sell and use the proceeds to shop ’til they drop, but many investing in cryptos are true believers—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, Visa noted $3.5 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.^[i]

Lending Against Crypto Holdings

Others warn 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—and a failure to meet those calls could drive a spate of selling, perhaps spurring market volatility. While that scenario is possible, borrowing against crypto isn’t too easy today. Relatively few custodians and digital wallets will extend material credit against digital assets at this point, and lending against your crypto likely comes with high interest rates and all of the typical risks associated with going on margin (on steroids). Moreover, depending on your location, using your crypto as collateral for a loan may not even be allowed. While the business seems to be growing, research outfits estimate the amount of crypto lenders’ loans outstanding in the tens of billions of dollars, which, as one group put it, “… represents a few basis points [hundredths of a percentage point] of global banks’ total lending.”^[ii] 

Holdings on Corporate Balance Sheets

Last year, some firms made headlines for adding bitcoin to their balance sheets. As we wrote then, it isn’t that hard to envision a scenario in which heat-chasing companies load up on a hot cryptocurrency, only to get burned by a price plunge—roiling balance sheets and hurting stocks in the process. However, that possibility looks far from likely today. Per the latest estimate, bitcoin amounts to about $9.7 billion on public companies’ balance sheets.^[iii] That alone is nowhere near enough to tank global stocks, which have a market capitalization of $59 trillion.^[iv] Public companies’ 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 action is what generates the revenue, not actually holding the cryptocurrencies. 

Stablecoin Failure

Since many stablecoins use cash, money market funds, Treasurys and/or short-term commercial paper as collateral, a major stablecoin failure could force liquidations of the coin’s reserve holdings. Some speculate that could lead 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 money market fund, falling below $1 per share (“breaking the buck”) back in 2008. That fund held loads of Lehman Brothers’ debt, so the shock of Lehman being forced under by the Fed and Treasury hit it heavily. 

But the stablecoin theory lacks a similar shock factor. As the FSB’s report indicated, regulators have been studying this issue for years, so this potential disruption isn’t sneaking up on anyone. Furthermore, there is substantial scrutiny of stablecoin reserve holdings even beyond regulators. Surprises move markets most, and policymakers’ focus saps a lot of negative shock potential.

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 negative. But it is impossible to predict how regulators or lawmakers will act. While rule changes are worth watching for, we don’t think it is wise to take 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 dollars off global GDP? The FSB estimates crypto assets amount to $2.6 trillion—approaching the size to produce a wallop.^[v] 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 $2.6 trillion is total value. It isn’t comparable to GDP—a flow of economic activity. Hence, 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.