by Scott Woodcock, Senior Research Analyst, Neuberger Berman
Today’s CIO Weekly Perspectives comes from guest contributor Scott Woodcock.
In June 2007, Bear Stearns was forced to bail out several of its hedge funds. They had been buying what were then relatively obscure, highly leveraged credit securities that were exposed to subprime mortgages; 16 months later, the Global Financial Crisis was engulfing the entire world.
More recently, reporting on the collapse of the FTX Cryptocurrency Exchange and its related entities suggests that as much as $10 billion of customer funds were inappropriately removed from the exchange. At least $1 billion is apparently still unaccounted for. Bitcoin, which was already down 60% from its peak, has fallen another 30% since FTX went under.
Reckless risk-taking and misappropriating customer funds are very different things. Nonetheless, the widespread crypto distress in the wake of FTX’s sudden collapse has some asking, could this meltdown be the sector’s “subprime moment,” potentially leading to a cascade of selling in the broader financial markets?
The failure of FTX, which filed for bankruptcy protection on November 11, has raised serious questions about the transparency, regulation and ethics of the $1 trillion cryptocurrency market.
Nominally, FTX operated as an exchange on which customers could trade and hold cryptocurrencies. But when press reports questioned its solvency, customers started withdrawing funds from the exchange in high volumes, and an inadequate pool of liquid assets left the company unable to meet the redemptions.
Exchanges typically segregate unmargined customers assets, so they should not experience this sort of liquidity crunch. However, it appears that FTX inappropriately used customer assets as collateral to finance the operations of Alameda Research, the firm’s proprietary trading and investment business. When customers tried to sell those assets, the result was effectively a run on a shadow bank.
The incident has raised fears about other large cryptocurrency exchanges, many of which operate offshore, like FTX, in jurisdictions that do not have stringent requirements around segregation and safeguarding of customer funds.
One reason we do not believe FTX will prove to be the Bear Stearns of a crypto-induced market crash is that it is far from the industry’s first big failure.
The industry’s Bear Stearns moment arguably happened back in May, when the TerraUSD algorithmic “stablecoin,” which was supposed to exhibit a 1:1 relationship with the U.S. dollar but was not fully backed by liquid assets, effectively “broke the buck.” The Terra/Luna ecosystem had a market capitalization close to $50 billion at the time, and the event led to the unwinding of a significant amount of leverage in the crypto universe and the failure of some of the weakest players in the industry. The silver lining is that this clear-out limited the damage wrought by later, large failures such as that of FTX.
The Terra/Luna collapse also lent impetus to this year’s general crypto sell-off. According to CoinMarketCap, the total market capitalization of all recorded cryptocurrencies has fallen from almost $3 trillion in November last year to around $800 billion today.
That means there are five listed companies with market capitalizations bigger than the entire cryptocurrency universe. The largest, Apple, has a market cap three times larger than the crypto market. Even at $3 trillion, the crypto market was small compared with the $110 trillion-plus market capitalization of global listed equities.
Furthermore, institutions with large holdings in traditional markets—where stresses can therefore have wider ramifications—have tended to steer clear of cryptocurrencies. While some institutional investors had become interested in offering crypto products to their customers, the combination of regulatory concerns and volatility caused them to proceed slowly.
According to the Fidelity Digital Assets Survey 2022, while almost half of high-net-worth investors have adopted some exposure within the last two years, fewer than 7% of pension plans, endowments and foundations have done so. Even in the hedge fund world, outside of crypto specialists, only 10% of managers had made investments.
A May 2022 paper from the Bank for International Settlements similarly found very low banking sector exposure to crypto. Evaluating risks posed by digital assets, the U.S. Treasury Department’s Financial Stability Oversight Council warned in its October 3 report that interconnections between crypto assets and the traditional financial system had been increasing, and that further connections would raise the risk of contagion, but it also observed that, so far, these connections are “relatively limited.”
It’s worth noting that the most recent systemic crisis in financial markets originated with supposedly staid and boring U.K. government bonds, not cryptocurrencies—because a relatively small number of U.K. pension funds hold such a large concentration of those government bonds.
In summary, the crypto universe remains relatively small in comparison to other risk assets like equities, with limited overlap for contagion into traditional markets. The financial and regulatory fallout from the FTX failure is likely to keep it that way for longer, in our view.
For example, FTX had planned an aggressive entrance into the cryptocurrency derivatives market and appeared to be eyeing a longer-term move into traditional asset classes such as equities, thereby mounting a disruptive challenge to incumbent exchange operators such as the Chicago Mercantile Exchange (CME Group) and Intercontinental Exchange (ICE). Unsurprisingly, its regulatory application has now been withdrawn.
While decentralized finance enthusiasts are likely to continue their search for disruptors, the heady days of startups taking on the likes of CME Group or Visa—and thinking they can do so without inviting burdensome regulatory scrutiny—are probably over.
In this context, crypto failures can certainly dent investor sentiment and cause bouts of volatility, but we see diminishing routes for serious systemic contagion to more fully regulated financial markets.