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Crypto volatility is not an isolated phenomenon
Read more on - Polity | Economy | Schemes | S&T | Environment
- The story: Several times in its journey, the Bitcoin value in crypto exchanges has fluctuated wildly. But May 2021 saw the worst swings of all time, with the crypto asset slumping by upto 40% in a single day, and then recovering somewhat. Bitcoin being the biggest, its volatility rubs off onto others too.
- Crypto contagion: With the volatility of cryptocurrencies likely to not end anytime soon, investors are thinking if this will mean trouble for other financial assets such as stocks and bonds. There is a ‘crypto contagion’ question in investor mind now.
- Possibilities: Speaking straight, this may not lead to any contagion immediately. But if the cross-ownership of assets, leverage and market functioning is seen, the there are other possibilities. Here are four -
- Crypto volatility continue or not - It is likely to continue. In 2021, there have been competing pulls between and within the private and public sectors. While the private sector was pushing an accelerating process of broader adoption of Bitcoin as a form of payment and store of value, Elon Musk in February 2021 said that Tesla had invested some of its cash in Bitcoin and would also accept it as payment for cars. That encouraged many companies to follow suit, pushing Bitcoin prices higher. With non-traditional crypto trading platforms prospering as a result, such as Coinbase’s direct listing on Nasdaq, more traditional broker-dealers looked to participate. But as the enthusiasm of Musk and Tesla came into question, and a public-sector pushback that's growing in scale emerged, the ground looked shaky.
- Are there national security risks - Many governments (and their central banks) are asking questions pertaining to links between cryptos and national security and economic and financial stability. These focus on concerns like (i) the facilitation of illicit payments, (ii) weak investor protection, (iii) the possibility of eroding the effectiveness of monetary policy and (iv) the loss of the seigniorage that comes with the widespread issuance and use of competing currencies. China and the UK are now considering central bank digital currencies, or centralized cryptos. The more they advance, the greater their desire will be to crush the decentralized variants (bitcoin). This may explain China’s May 2021 anti-Bitcoin actions.
- Are cryptos and regular asset classes linked - In general, not at all. Based on fundamentals, cryptos are neither physical nor financial substitutes for stocks, bonds and commodities. Supporters highlight their role as a decentralized global currency that will proliferate in the payments and savings ecosystems. But that needs maturity and price stability, and many years! And cryptos need a solution to the problem of high energy consumption. (due to proof-of-work related heavy mining needs)
- Can contagion spread informally - As traders' leverage rises, why not! With government bonds offering low yields, as well as asymmetrical and unfavourable price prospects, investors have seen cryptos as a way to diversify assets for their much larger equity and equity-like exposures. Contagion risk increases as cross-holdings expand in more investor portfolios, especially when trades are levered. Financial history is full of examples of how investors who are unable to sell what they want, to protect portfolios, raise cash or both, often end up selling other holdings. This is the risk of financial spillovers.
- The scale of contagion risk, small or big - It is not earth-shaking as of now, as Bitcoin holdings are not sufficiently institutionalized to constitute a stand-alone systemic risk. Many banks have little balance-sheet exposure. Any spike in volatility would have few direct spillover effects.
- Summary: The rise in Bitcoin prices, still up more than 250% in the last 12 months despite the decline in the last five weeks from $63,000 to less than $40,000, is part of an ‘everything rally’ powered by central banks’ continued liquidity push. With margin debt growing rapidly at the same time, the risk of a financial accident exists.
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