The Breakdown - No, Bank of England, Crypto is Not the Same as Subprime Mortgage Debt

Starting point is 00:00:00 There are reasons to think that the inherent transparency of distributed public ledgers will be, or at least could be, a force for increasing, rather than decreasing institutional transparency. This is something that regulators could lean into if they weren't distracted larping like they understood the dynamics of crypto volatility. In short, don't blame our digital assets for your institution's messed up behaviors. If you want to point the regulatory lens anywhere, it should be around these issues of institutional transparency and system-wide leverage. Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the Big Picture Power Shifts remaking our world. The breakdown is sponsored by Nidig and produced and

Starting point is 00:00:44 distributed by CoinDesk. What's going on, guys? It is Thursday, October 14th, and today we are talking about recent statements from the Bank of England around crypto and its similarity to the subprime mortgage crisis. And now, as I was prepping this show, the Morgan Stanley CEO came out and said, I don't think crypto is a fad. Russian oligarch, Vladimir Putin, said, crypto has the right to exist. So I promise I will unpack those things tomorrow, but I had already prepped this episode, and I think it's still really important in a much bigger way than just one random speech. Here's an example of the type of headline that came yesterday along with these comments. This is from The Guardian. Bitcoin could trigger financial meltdown, warns Bank of England

Starting point is 00:01:33 deputy. Sir John Cunliff lichens danger to 2008 crash and calls for tough regulation of cryptocurrencies. Boy, did I just go into this thing ready to rip it to shreds. I was going to, for example, point out that just because one asset is roughly the same size or, hell even double the size of another asset doesn't mean they have the same characteristics, etc, etc., but when I actually dug into the speech itself, not just the media accounting of it, I found something a lot more thoughtful and worthy of consideration than I had previously guessed. It will come as no surprise that I have a very specific set of critiques, one fundamental one that I think explains a lot of the difference of how I and many people who think like me in the Bitcoin and Crypto Space view the

Starting point is 00:02:20 world as opposed to some of these bank regulators, but there's still a lot to be learned and discussed here. So, Sir John Cunleff is the deputy governor of the Bank of England focused on financial stability. Of course, if you're focused on financial stability, that's the lens that you're going to see many things through. In his speech yesterday, which he called, is crypto a financial stability risk, he admirably does not bury the lead. He starts, I want to talk today about whether the world of crypto finance poses risks to financial stability. Cryptoacets have grown by roughly 200% in 2021, from just under 800 billion to 2.3 trillion today. They've grown from just 16 billion five years ago. 2.3 trillion, of course, needs to be seen in the context of the

Starting point is 00:03:02 $250 trillion global financial system. But as the financial crisis showed us, you don't have to account for a large portion of the financial sector to trigger financial stability problems. Subprime was valued at around $1.2 trillion in 2008. When something in the financial system is growing very fast and growing in largely unregulated space, financial stability authorities have to sit up and take notice. They have to think very carefully about what could happen and whether they or other regulatory authorities need to act. End quote. He then goes on to say that, quote, crypto technologies offer a prospect of radical improvements in financial services, but then he lists his financial stability concerns. So let's dig into his reasoning. He basically has four

Starting point is 00:03:45 parts of his concern. First, that digital assets specifically unbacked cryptocurrencies, which is the term that he uses, have no intrinsic value. Two, that makes them vulnerable to major price corrections and highly volatile. Three, with the increasing connection between crypto and the traditional financial system, and for the emergence of leverage, that creates new types of risk. So let's unpack these part by part. First, no intrinsic value. This is something that you'll very, very frequently here lobbied as a critique of crypto and digital assets. But instead of talking in the abstract, let's look at the definition of no intrinsic value that he gives. He says, these have no intrinsic value. That is to say there are no assets or commodities behind them. The value of the crypto

Starting point is 00:04:30 asset is determined solely by the price a buyer is prepared to pay at any given moment. Now, that is factually correct if your definition of intrinsic value is that there are no assets or commodities backing them. However, this is an absolute morass. And the central thing is, thorny question is in some ways how we account for extrinsic value when it comes to crypto assets, specifically the extrinsic value of the belief of the community of holders. There are very different ends to this spectrum. On the one extreme, there are tokens that well and truly pretty much all the holders are just playing some sort of Ponzi version of musical chairs, where all they want is to be not the last one to get out. That was super prevalent, obviously,

Starting point is 00:05:11 during the ICO days. It has been present in parts of this bull market, particularly in some of the areas of the Binance smart chain tokens and TikTok, although even some of those have communities theoretically. But that's one end of the spectrum, is that there are tokens that are really just for financial gamesmanship. On the other end of the spectrum, you have tokens that have communities of holders that are extraordinarily mission committed to what they believe the value of those tokens to be. Bitcoin, of course, is the easiest and clearest example, where the holders and community of Bitcoiners believe it to be valuable as a hedge against centralized failures. Those centralized failures might be in the form of currencies that devalue because of monetary

Starting point is 00:05:51 policy. For others, those centralized failures are in the form of local corrupt monetary regimes that unfairly seize people's assets. Obviously, if you've listened to this show for any period of time, you know that I have this sort of conviction around Bitcoin that so many other fellow bitcoins have. However, interestingly, Bitcoin perfectly demonstrates the fascinating and key relationship between extrinsic and intrinsic in the context of digital assets. It has certain intrinsic features for which it is valued by the community. Central among those is a math-based rather than a human-based monetary policy. However, the history of Bitcoin forks show that those things don't actually matter if they don't have a critical mass of belief behind them. You could

Starting point is 00:06:35 spin up a fork of Bitcoin, for example, that caps the supply at 20 million, so it's even more scarce, and that's its main value proposition. But unless you got a critical mass, a network effect of people who believed that, it's not going to hold a candle to the real Bitcoin. This has been one of the most important lessons of the last four or five years. The point here is that there are intrinsic features of some of these coins, or at least Bitcoin, that give them a certain type of value for their community. But what matters or what enforces that value, what brings that value to life, is in fact the network effect of believers. As I said, though, this is a morass because so many of us Bitcoiners look at other fervent

Starting point is 00:07:16 token communities, and I'm not going to name names because I get annoyed fighting with you guys on Twitter, but some of us look at those communities and see them as having not so much belief as much as delusion, which of course is the same accusation that gets lobbed at us all the time from the outside. As I said, this is a really complicated morass, but a very interesting and important one. NIDIG sponsors this podcast, and they also put out a really good newsletter, focused purely on Bitcoin. If you want insights into what's driving market moves, regulatory changes, and the metrics that deserve your attention, sign up at nidig.com slash NLW. That's NYDIG forward slash NLW. In terms of the salient detail for this Cunliff speech, he is saying

Starting point is 00:08:09 that the fact that cryptos have no intrinsic value is relevant for his second point, which is that that lack of intrinsic value makes them vulnerable to major price corrections. As he says, quote, the main use of unbacked crypto assets is for speculative investment. Now, in my estimation, the key thing here and the connection to this first argument about intrinsic value is that volatility and vulnerability to major price corrections has a relationship with the ratio of speculators versus long-term holders in a particular community. Bitcoin, for example, has proven over and over that while, yes, leverage traders can get totally washed out and contribute to major price corrections that happen very quickly, in the medium and

Starting point is 00:08:48 long term, the community of long-term holders continues to grow, as does the price floor that they enforce in the markets. Cunlove, to his credit, actually makes some mention of this, saying that, quote, attitudes to unbacked crypto assets, however, appear to be shifting. In the UK, fewer holders now say they see them as a gamble, and more see them as an alternative or complement to mainstream investment. Around half of existing holders say they will invest more. And again, this is across all crypto assets. This isn't just Bitcoiners on Bitcoin Twitter. This, however, brings Conleft to his next concern, which is that crypto increasingly is connected to the traditional financial system. Quote, while retail investment predominates in this market, there are signs of

Starting point is 00:09:29 growing institutional investor interest, with these investors now thinking about whether to have crypto in their portfolio. More complex investment strategies are beginning to emerge, including crypto futures and other derivatives. At the same time, core wholesale finance and financial market infrastructure firms are putting their toes in the water. Several global banks are offering or are planning to offer digital asset custody services. Some international banks have started to or are looking at trading crypto asset futures and non-deliverable forwards and offering wealth management clients crypto asset investments following client demand. He goes on and on and on with all the different ways that the traditional financial world is getting into crypto. But what matters, he says,

Starting point is 00:10:05 is this new institutional interest combined with the volatility and combined, of course, with leverage. The price of Bitcoin, he says, has fallen by over 10% in a single day on nearly 30 occasions in the past five years. However, and this is where Cunliff definitely endears himself a bit to me, he says, we should be clear that investors losing money on speculative investments does not, in and of itself, constitute a financial stability problem, though it may well be a concern for authorities responsible for investor protection. It is a necessary feature of the financial system that investors who understand the risk of speculative investments can make losses, including large ones, as well as gains. The responsibility of the financial stability authority is to ensure that the system is resilient so that price corrections and consequent losses can occur without knock-on effects on the financial

Starting point is 00:10:52 system as a whole and without damage to the real economy. End quote. To make his point, Cunliff uses a contrast between the dot-com bubble and the subprime mortgage-backed securities bubble as case in point. One saw something like $5 trillion of losses versus the others $1.2 trillion of localized losses, which were smaller but had much bigger knock-on effects. Why is that? Quote, whether a major price correction is absorbed by the system, admittedly leaving some investors with very sore heads, or whether it is amplified into a systemic impact, depends on

Starting point is 00:11:22 a number of key characteristics of how the asset is integrated into the financial system, especially interconnectedness and leverage. It depends also on the resilience of the system at the time of the correction, the liquidity in the system under stress and the ability of core elements of the system to absorb any losses. So here is where Sir John and I start to truly deploy. part. He writes, so a necessary thought experiment from a financial stability perspective is what would happen in the financial system if there was a massive collapse in the price of unbacked crypto assets, at the extreme end if the price fell to zero. Such a collapse is certainly a plausible scenario, given the lack of intrinsic value and consequent price volatility, the probability of contagion

Starting point is 00:12:01 between crypto assets, the cyber and operational vulnerabilities, and of course the power of herd behavior." End quote. Very, very little in crypto's history suggests that this is anything close to the, quote, plausible scenario that Sir John says it is. Crypto has undergone more severe market corrections in the last few years than most traditional market investors go through in their lifetimes, and it has just kept growing. Keep in mind, this is with the entire financial and political world rooting on its demise. It's not like it's been easy out here. What's more, the growth is not just more new speculators coming in. It's a deepening conviction of the baseholders who, as I mentioned before, set price floors. There is a high likelihood of future 50% corrections. And yes,

Starting point is 00:12:46 leverage-led blowouts that lead to 10 to 20% moves in a very short period of time. Those could have big consequences in market structures where institutions are more bought in, and especially if those institutions are contributing to the overall leverage in the system. But the notion that crypto can just go to zero is at this point preposterous. And by the way, I'm not a lot. I'm not just talking about Bitcoin. I'm talking about 2017 vintage zombie coins that retained even throughout the bare market some portion of their value, if very little liquidity, because holders had no incentive or really ability to dump. There's always a reason to keep rooting on their future. So point one, the idea that crypto can just go to zero just doesn't hold water. But it is not

Starting point is 00:13:26 preposterous to ask, are there issues with the volatility that is realistic that we've all been able to bear so far as these big institutions come in? So the real real. So the real estate, issue, and Conliff is far from the only one to bring this up, has to do with what happens when opaque institutions are buying too much crypto, with too much leverage, and a sudden price movement results in them being margin-called. This is where something that happens in the crypto industry could spill over into other assets. Let's quickly take a detour into the example that everyone is bringing up because it's fresh in mind when they talk about financial stability in this sort of issue. Archegos, for those who haven't listened to my episode, which was a

Starting point is 00:14:03 TLDR on Archigos was a family office managing $5 to $10 billion. Bill Huang, whose fund it was, had previously settled around insider trading and stock manipulation, but that's not really the point. Archigoths used sophisticated instruments which allowed it to trade with a lot of leverage and a real lack of transparency around its true exposure, especially to any one given asset. Some have estimated the total exposure for this $5 to $10 billion fund at around $50 billion, and some even estimate up to $80 billion. $1K2,000. Archagos was also using multiple prime brokers, like more than a half dozen. When some of its

Starting point is 00:14:36 positions started going south, such as Viacom, which went from 8440 a share to 6635 a share in two days after it announced a fundraise that investors clearly didn't like, Arcagose was hit by margin calls from multiple prime brokers at the same time. It couldn't meet them. And so the prime brokers started doing what prime brokers do in that situation, dumping Arcago's position at an incredible clip. To have a sense of just how much activity was going on Viacom had about 10x its daily trading volume when this was happening. These liquidations spread out, and while the first brokers to margin call Archegos were fine, or at least comparatively fine, only racking up losses in the hundreds of millions of dollars,

Starting point is 00:15:12 others took a major multibillion-dollar loss. Nomura lost $2.87 billion, and Credit Suisse lost $5.5 billion, in fact, forcing them to raise an additional $1.9 billion from investors to get their balance sheet right. Yet still, most people felt like we dodged a bullet here, where it didn't go too much farther than these huge institutions. So while it was still remarkable that this relatively small fund could cause so many billions of dollars of losses so fast, it didn't quite spread into full financial contagion. That's the bullet that regulators like Cunleaf felt was dodged. This sort of thing is clearly on the mind of Sir John when he said,

Starting point is 00:15:46 direct exposures provide an immediate channel by which losses could be transmitted from crypto assets to the existing financial sector. However, there are also potential second round or indirect effects which can spread the impact into other asset classes. For example, a severe fall in the value of crypto assets could trigger margin calls on crypto positions forcing leveraged investors to find cash to meet them, leading to the sale of other assets and generating spillovers to other markets. We saw last year during the dash for cash that this dynamic can put pressure on the amount of liquidity in the system. Similarly, there is a possibility of contagion. A large fall in crypto valuations could affect investor risk sentiment more broadly, causing investors to sell other assets

Starting point is 00:16:23 that are judged to be too risky and those perceived to have a similar investor base. Ultimately, Sir John's TLDR is, taking together the volatility of unbacked and largely unregulated crypto assets, their nascent but fast-growing integration into the financial sector and the appearance on the scene of leveraged players. My conclusion is that while a severe price correction would not cause financial stability problems now, all else equal, the current trajectory implies that this may not be the case for very long.

Starting point is 00:16:48 So here's my issue with this at core. It's not that Sir John or anyone else is wrong to ask this set of questions about financial stability. However, I think it's a red herring, a distraction to look at the intrinsics of crypto assets as the primary issue to be dealt with here. Viacom is about the most boring old-school stock one can imagine. The issue with Archegos was leverage, too many prime brokers, and too much opacity. It was with instruments and institutions not the underlying asset. In other words, as banks have had inquiries about archegos and regulators are looking at Arcagos, the issues they're thinking about are not how do we make sure we limit how people

Starting point is 00:17:31 buy Viacom stock. In fact, I would argue that, one, the focus on the intrinsics of crypto assets is ultimately distracting from the real culprit, which is institutional transparency and leverage. Two, we've already seen the start of a downshift in leverage available from exchanges, and that's likely to increase as they fit further into public policy frameworks. Three, there are reasons to think that the inherent transparency of distributed public ledgers will be, or at least could be, a force for increasing, rather than decreasing institutional transparency. This is something that regulators could lean into if they weren't distracted,

Starting point is 00:18:05 larping like they understood the dynamics of crypto volatility. In short, don't blame our digital assets for your institution's messed up behaviors. If you want to point the regulatory lens anywhere, it should be around these issues of institutional transparency and system-wide leverage. Now, I think part of the issue with this speech is that it was run through the media gauntlet. Like I said, that headline, Bitcoin could trigger financial meltdown warns Bank of England Deputy.

Starting point is 00:18:30 Indeed, calling out that headline, Terdemeester called it an example of Darvo, an acronym for deny, attack, and reverse victim and offender. Wikipedia describes Darvo as a common manipulation strategy of psychological abusers. The abuser denies the abuse ever took place, attacks the victim for attempting to hold the abuser accountable and claims that they, the abuser, are actually the victim in this situation, thus reversing the reality of the victim and offender. So of course, what he's saying is that the issue is these traditional financial institutions that are playing with leverage and doing so opaquely. The issue is the existing system, not this new nascent system. And by going after the new nascent

Starting point is 00:19:05 system, the existing institutions distract from their own abuses. As you can probably tell from this conversation as opposed to when I've discussed investor protections, I'm much more interested in the systemic risk arguments than those what I find very paternalistic, diminishing, and hypocritical investor protection arguments. Ultimately, my point is that even if we take systemic risk seriously, the place to start isn't the underlying assets. It's the institutions who lever up and obfuscate what they're doing. Until tomorrow, guys, be safe and take care of each other. Peace.

The Breakdown - No, Bank of England, Crypto is Not the Same as Subprime Mortgage Debt

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