Does a Cryptocurrency Crash Threaten the Financial System?

On Tuesday, Bitcoin fell below $ 30,000 for the first time in 10 months, while the cryptocurrency overall lost nearly $ 800 billion in market value last month, according to data site CoinMarketCap, as investors worry about tightening monetary policy. Crypto is a much larger market than the Fed’s last tight cycle, which began in 2016, which raises concerns about its interconnectedness with the rest of the financial system.

How big is the cryptocurrency market?

In November, the most popular cryptocurrency, Bitcoin, hit an all-time high of $ 68,000, pushing the crypto market value to $ 3 trillion, according to CoinGecko. On Tuesday, that number was 1.51 trillion. Bitcoin is worth about $ 600 billion, followed by Ethereum, which has a market cap of $ 285 billion. Although cryptocurrencies have enjoyed explosive growth, the market is still relatively small.

For example, the U.S. equity market is valued at $ 49 trillion, while the Securities Industry and Financial Markets Association has set an outstanding U.S. fixed income market value of $ 52.9 trillion by the end of 2021. Who owns and trades cryptocurrencies? Cryptocurrency began as a retail phenomenon, but institutional interest in exchanges, companies, banks, hedge funds, and mutual funds is growing rapidly.

Although it is difficult to find data on the ratio of retail to institutional investors in the crypto market, Coinbase, the world’s largest cryptocurrency exchange, said that institutional and retail investors each accounted for about 50% of the assets on its platform in the fourth quarter. Its institutional clients made $ 1.14 trillion in crypto transactions in 2021, up from just $ 120 billion in 2020, Coinbase said.

Most of the conventional bitcoin and etherium are in the hands of a select few. An October report by the National Bureau of Economic Research (NBER) found that 10,000 Bitcoin investors, both individuals and entities, controlled about one-third of the Bitcoin market, and 1,000 investors owned about 3 million Bitcoin tokens. By 2021, about 14% of Americans have invested in digital assets, according to research from the University of Chicago. Can a crypto crash hurt the financial system?

Although the overall crypto market is relatively small, the US Federal Reserve, the Treasury Department and the International Financial Stability Board have flagged stablecoins – digital tokens associated with the value of traditional assets – as a potential threat to financial stability. Stablecoins are mostly used to facilitate business in other digital assets. They are supported by assets that may lose value or become ineffective in times of market pressure, while the rules and disclosures surrounding those assets and the rights of investors to release are unclear.

This could make stable coins susceptible to losing investor confidence, especially in times of market pressure, regulators said. This happened on Monday, when TerraUSD, a major stable coin, broke its 1: 1 peg to the dollar and fell as low as $ 0.67, according to CoinGecko. The move partly contributed to the collapse of Bitcoin.

While TerraUSD maintains its tie with the dollar through an algorithm, investors run stablecoins that maintain reserves in assets such as cash or commercial paper that can spread across the traditional financial system, putting pressure on that underlying asset class, according to regulators.

According to regulators, more companies ’fortunes are involved with the performance of crypto assets, and as traditional financial institutions push more into the asset class, other risks are emerging. In March, for example, the regulator in charge of the currency warned that banks could be tripped up by crypto derivatives and unhearded crypto exposure, if they deal with little historical value data.

Yet, regulators as a whole are divided on the form of the threat of crypto crashes for the financial system and the wider economy.