Well, the party is fun while it lasts. However, now the liquidity wave is crashing down as usual as credit conditions tighten. This week’s crypto crash was the first to get exposed on the beach, and let’s hope the damage doesn’t spread to the financial system and broader economy.
About $200 billion in crypto assets exploded in 24 hours, leading to the demise of the so-called TerraUSD stablecoin. The crypto universe was once small and dominated by Bitcoin enthusiasts, but it has ballooned as investors seek higher returns amid negative real interest rates.
Hundreds of cryptocurrencies have been minted in a variety of speculations. Anyone can create a virtual currency, market it to investors, and use the money as they please. While fiat currencies like the dollar are backed by governments, cryptocurrencies are backed by trust in their developers. What could happen?
Investors found out this week. Stablecoins are said to hold a fixed peg and allow investors to seamlessly trade crypto assets. Some are backed by fiat money, though their inventors don’t always disclose what’s in their stockpile. Other stablecoins like TerraUSD are underpinned by algorithms, sometimes linked to another cryptocurrency — in Terra’s case, the Luna token.
To stimulate demand for its currency, Terra’s developers created a “decentralized lending” platform that offers up to 20% interest on deposits. Terra is said to be worth $1. We were also told before the 2008 financial crisis that money market funds were not going to break the coin. Then one person did.
Although the algorithm is said to be insecure, Terra is backed by the trust of the market. And we’ve learned over and over what happens when investors panic. As investors sold off the cryptocurrency, Terra’s algorithm broke and its value dropped to 36 cents on Wednesday. What happens to Terra owners? Keep stable.
One risk is that Terra’s path causes investors to lose confidence in other cryptocurrencies and creates a market contagion. Cryptocurrencies commonly used as collateral for trading and other popular tokens are taking a beating this week. Stablecoin Tether, backed by undisclosed reserves of hard currency, fluctuated against its dollar rate on Wednesday.
Cryptocurrency exchanges, which benefited from massive market liquidity and lack of investor discipline, have also collapsed. Coinbase assures customers that there is “no risk of bankruptcy.” But on Tuesday, it also revealed that its customers would be unsecured creditors in the event of bankruptcy, meaning $256 billion of their crypto and fiat money could be wiped out. Happy about Coinbase to tell us now.
Another danger is crypto turmoil spilling over into the banking system. Cryptocurrency enthusiasts claim that virtual currency “disconnects” financial institutions because you don’t need a bank or broker to make transactions. That was true up to a point. But the credit to buy crypto has to come from somewhere. Who is standing behind it? Nobody know.
The cryptocurrency market skyrocketed to $2.9 trillion last November from around $500 billion in November 2020. This increase is not only driven by the gambling of the younger generation. with stimulus testing. Central banks gave credit essentially free, which incentivized speculation.
The problem is that there are always unexpected casualties when risk aversion turns back to vengeance. This is why junk bond prices are falling on concerns that some companies may struggle to roll over their debt, especially if tightening by the Federal Reserve sends the country into a recession.
The European Central Bank recently warned banks to hold more capital on leveraged loans that are sensitive to interest rates, to cover possible losses. As rates rise, some may default. About $800 billion in leveraged loans in the US were issued last year, 60% more than in 2019. Regulators won’t know who overspent until the market shakes.
Debt covenants and market discipline had deteriorated before the pandemic. With the economy closed, the Fed was right to support financial markets. But it continues to provide support long after it is needed. As inflation heats up, the wonders of the Eccles building assure investors that it is only “transient” and that monetary policy will remain accommodative.
With inflation continuing and rising above 8%, the Fed has no choice but to tighten. Some extreme investors might be wiped out, but this is what happens when the Fed keeps conditions too easy for too long and then has to stop abruptly.
Cryptocurrencies have fervent supporters and the best people can find a lasting place in the financial markets. But more than a few will be washed away in this purge. As we learned in 2008, problems on Wall Street can quickly spread to Main Street. The challenge for regulators is to protect the financial system from damage that will not end with cryptocurrencies. They better prepare for further casualties.
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https://www.wsj.com/articles/warnings-from-the-crypto-currency-crash-stablecoin-liquidity-terrausd-11652390321 Warnings From the Crypto Crash