Arguably the best character in the Ice Age movie series is Scrat, the squirrel which has found the most delicious acorn. But in his constant quest to reach it through the ice, he keeps inadvertently creating bigger and bigger cracks which ultimately bring down entire ice craters. Could there be parallels with crypto investors?
While crypto currencies have been around since the mid-80s, institutional investors have only just started to dip their toes in the asset class. Endowments and family offices were early adopters while pension funds have historically been cautious. And given the performance of crypto assets since the beginning of this year, that caution appears justified. The price of Bitcoin, which accounts for almost half of the crypto market, plunged from $69,000 (£55,000) to $29,000 (£23,000) according to CoinMarketCap. What sparked this plunge and could it cause cracks across financial markets?
Crypto currencies have had a horrific start of the year. By the end of 2021, their combined market value stood at more than $3trn (£2.4trn). But within less than six months, two thirds of that value were wiped out, bringing the total crypto market size down to just above $1trn (£800bn). Crypto investors suffered from an adverse combination of a gloomier investment outlook due to monetary tightening and its close correlation to stock markets, which were also in decline.
But what ultimately sent crypto coins sliding was the collapse of terra, designed to be a stablecoin, and its sister currency luna. Stablecoins play a key role in the majority of crypto transactions as they back up between 80% and 85% of crypto trades.
Despite this vital role, the total stablecoin universe is only $180bn (£143.8bn), compared to the size of the total crypto market, which at its peak last year exceeded $3trn (£2.4trn). Pegged against a stable currency, usually the dollar, stablecoins are supposed to offset some of the crypto market’s volatility.
In some cases, this peg is being reinforced with dollar reserves. But in the case of terra, it wasn’t. Terra was backed by an algorithm linked to its sister coin luna, a construction which makes mortgage-backed securities sound safe as houses. It all worked splendidly, until luna’s value slid from $117(£93) to zero, the stablecoin turned out to be not so stable after all.
Terra accounts for only a fraction of the stablecoin market, its far more influential counterpart is tether, a stablecoin which backs up its dollar peg with a combination of liquid reserves. According to its report published in March, its assets, which at the time exceeded $80bn (£64bn), consist of a combination of US treasuries and corporate debt, but also a significant non-disclosed allocation of $4bn (£3.2bn) to “other investments”.
The collapse of terra has brought the viability of tether’s peg in to question and investors are suddenly asking much more carefully how liquid those reserves are. By the end of May, tether has faced more than $10bn (£8bn) in withdrawals and is struggling to maintain its peg.
Institutional investors could be shrugging their shoulders at this drama. After all, the cost of the crypto crash is largely not being born by professional investors but by those who can afford it the least. Polls of crypto investors suggest that they are on average younger, not on a high income and underbanked, meaning they rely on credit cards and payday loans to manage their finances. According to a survey by Morning Consult, 70% of crypto owners are born after 1980 and more than half earn less than $50,000 (£40,000).
Tip of the iceberg
But the fact that crypto assets have caught the eye of the regulator suggests there could be wider cracks in the financial system. Institutional investors might do well to heed attention. The key question for regulators is what happens to broader market liquidity if investors lose faith in the ability of stablecoins to maintain their peg to the dollar.
In some ways, that is not too dissimulator to conventional banking sector, where $2.4trn (£1.9trn) of capital backs up the entire US economy worth $23trn (£18.4trn), as Michael Hsu, acting comptroller at the US Department of Treasury, said in a speech.
Risks in crypto markets have been the centre of attention of the ECB, the US Federal Reserve and the Financial Stability Board. In the first instance, a run on crypto could spark a flight towards perceived safe haven assets. Last year, the Chinese ban on crypto investing not only caused the value of Bitcoin to slide; it also caused a short-term fall in German bund yields.
Whether the crash in crypto could spread to other assets now depend crucially on the ability of tether to maintain its peg and their faith that tether’s reserves can be easily liquidated. But if all holders of stable coins would collectively decide to sell their assets, this could dry up liquidity in short-term credit markets, as Fitch Ratings warned in a report last year.
That in turn could hit institutional investors which rely on market liquidity not just to meet pension payments and insurance payouts, but also to meet potential cash calls from managers. This could be a question of timing.
In itself, the size of the crypto market only accounts for a fraction of global financial markets, but said markets are already riled up by the combination of monetary tightening. Squirrels chasing the bitcoin acorn may not only be ones, as cracks are starting to widen in other asset classes such as private equity or debt. Crypto may only be the tip of the iceberg.