This is the latest installment in my series of posts about ICO Mania.
A question of liquidity
On Sunday, I pointed out that Bitcoin, by setting itself up as a sort of decentralized bank, was also creating an unreasonable expectation to its new “depositors” that they will always be able to redeem their assets at par, given a wild mismatch between its $200 billion “market cap” and the quite clearly lower levels of dollar liquidity on the markets – not all of it “new” and some of it of questionable provenance.
This expectation is dangerous as it means, in the event of a liquidity crunch, people will behave not as people necessarily behave when there’s a sharp sell-off in a stock, but more along the lines of when their bank’s solvency is being called into question. Remember bank runs?
Recent news stories make it pretty clear that the new people clearly have no idea what they’ve gotten themselves into.
In case you didn’t know, Bitcoin is the Gom Jabbar of high finance. Cypherpunks who have populated the space to date hold the line because they do not care about money, and therefore do not know fear.
These new people are different. The only reason they are here is the money.
They reek of fear.
When we consider that fresh, naive amateurs are (and their money is) flowing into the sector at a rate of millions of people per month, we should also understand that these amateurs are more susceptible to the animal spirits than their stoic, abrasive, less-socially-adept, battle-hardened forebears. They will be prone to cut and run. As such, a shock to the system, such as an exchange being taken down in a necessary and overdue enforcement action, could lead to a loss in confidence in the entire cryptocurrency ecosystem as a whole and a stampede for the exits the likes of which Bitcoin has not seen to date.
As Bitcoin qua decentralized bank is running a fractional reserve with a chronic shortage of dollars, a shock therefore has the potential to not just drive the price of Bitcoin down a little bit, but also lead to a major liquidity crunch and abject panic.
Credit comes to crypto – aka “Bitprime”
So, on Sunday, I wrote:
In the current environment, there are a number of ways such a shock could arise. To begin with, I seriously question the intermediaries’ and traders’ ability to top up their USD holdings quickly enough to catch up with their depositors’ and counterparties’ paper gains in Bitcoin. There is also the possibility that, in the event of a correction or an enforcement action, a risk-averse bank to a major service provider withdraws either credit or banking services to that provider, compromising that service provider’s ability to convert BTC into dollars, provide margin lending, or even to hold fiat deposits at all.
I had a hunch people were lending into the sector. I just didn’t know the degree of alacrity with which this lending was taking place. Fortunately, I was reading CoinDesk this afternoon and their reporting from the Consensus:Invest conference delivered:
Dan Matuszewski, the head of trading at Circle Internet Financial, said during a morning panel that there is a “real strong need” for the ability to borrow in this market.
It would not only facilitate short positions but also provide working capital for trading desks to make markets, he said.
During his talk, Boonen of B2C2 acknowledged the irony of the situation given that bitcoin was born as a reaction to the 2008 credit crisis.
“Bitcoin enthusiasts really, really do not like credit,” he said. But, he added, “for better or for worse, credit is an important part of a functioning and liquid financial market…”
…Even before the institutional money started flowing in, he noted, “by necessity, credit did creep back into bitcoin and crypto markets in general,” with the major exchanges offering leverage to the early retail investors.
So someone’s lending directly into the market, we just don’t know who, nor how much, nor where the liquidity for these lines of credit is ultimately coming from.
Leverage sneaks into the ecosystem in other ways, too; for example, Coinbase accepts credit cards, which is basically margin trading for Grandmas, without collateral and with 20%+ rates of annual interest. Given that rather a lot of people seem to be interested in buying Bitcoin in this way, and that platform is racking up a few hundred thousand new users a week, there’s undoubtedly systemic risk building up there.
Then there’s Bitfinex and Tether, which I do not intend to discuss save to share this passage of Nathaniel Popper’s in the New York Times:
“One persistent online critic, going by the screen name Bitfinex’ed, has written several very detailed essays on Medium arguing that Bitfinex appears to be creating Tether coins out of thin air and then using them to buy Bitcoin and push the price up.”
Long story short, the neophyte Bitbro masters of the universe, too young (or too busy working as a dev in California) to know what a financial crisis feels like, and too dilettantish to find out, are successfully (a) getting buyers to leverage themselves to buy coins, in some cases probably up to the hilt, or (b) convincing institutions to lend into this titanic, one-way, unhedged, $200 billion insanity trade, and trying to convince more of them to do so in greater amounts.
This could get serious
There are two, not necessarily mutually exclusive ways people are responding to the Great Bubble of 2017: anticipatory schadenfreude on the one hand, abject horror on the other.
So far the response from mainstream finance has been the former, with the WSJ’s treatment of the subject being more or less a long-form joke.
But while there is something ineffably twee about a retiree trying to show how they’re hip and “down with the kids” thanks to their position in “big coin,” the fact that they are doing so raises very serious questions about bubble-driven risk (and attendant negative externalities to society) which merits closer attention.
As of right now, the notional value of the cryptocurrency sector is roughly 1/3rd the size of Long-Term Capital Management (“LTCM”) at its peak.
Cryptocurrency is, admittedly, much smaller than the subprime bubble, which was roughly 2 orders of magnitude larger than Bitcoin today. But Bitcoin has shown, on several occasions, a persistent ability to defy detractors like me to grow an order of magnitude in less than 12 months; if it does so again, it will be 3x larger than LTCM. LTCM on its own very nearly ruined the world in 1998.
If we aren’t careful this is the kind of market where a financial institution can get in serious trouble extremely quickly (imagine the damage a character like Nick Leeson or Kweku Adoboli could have done trading Bitcoin contracts – which are coming soon to both the CME and, reportedly, Nasdaq as well).
We know that cryptocurrency marketing is writing checks the technology can’t cash; most of these systems are unusable as backbones for global finance. It is a matter of time before the punter on the street becomes as disillusioned as I, an irascible blockchain software entrepreneur, have become. It’s just that none of the newcomers know what they’re doing, and most of the old-timers who have figured this out are keeping their mouths shut out of self-interest.
Put another way, this is a disaster waiting to happen. Fortunately for us, 2008 is not ancient history, and the fact that Bitcoin is a classic, manic bubble is so transparently obvious that it should be impossible for thinking people to deal with it otherwise. There are no excuses for not doing right by the societies and taxpayers who had to bail out the financial services industry last time around.
Just say no
So, banks, shadow banks, and anyone else of systemic importance, I implore you: for the good of everyone, by which I mean for the good of the human species, keep this garbage, and anything connected to it, the hell off of your balance sheets. For once, please have the good sense to not load up on frothy bubble-driven financial assets, which you have done hitherto with such predictable regularity that the ECB can model it and write a 52-page paper on the subject which is actually fun to read.
That way, when regulators finally bring this party to the bitter end it so richly deserves, the rest of the ship won’t go down with it.