What if bitcoin drops to zero?

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August 2, 2021

The recent expansion of the crypto-universe is a wonder. Just a year ago, around 6,000 currencies were listed on CoinMarketCap, a website. Today there are 11,145. Their combined market capitalization has exploded from $ 330 billion to $ 1.6 billion today, which is roughly equivalent to Canada’s nominal GDP. Over 100 million unique digital wallets hold them, roughly three times the number in 2018.

Holders have also become more sophisticated and feature deep pockets. Institutions represent 63% of trade in value, against 10% in 2017 (see graph 1). Skybridge, a hedge fund run by Anthony Scaramucci, provides an illustrative example. Its $ 3.5 billion diversified fund began investing in crypto in November; in January, he launched a $ 500 million bitcoin fund. The exposure of its 26,000 clients, which range from wealthy individuals to sovereign wealth funds, is increasing. Bitcoin accounts for 9% of the value of its primary vehicle, up from 5% originally, and the dedicated fund is now worth around $ 700 million.

However, this maturation has not succeeded in taming the wild gyrations that characterize the crypto markets. Bitcoin went from $ 64,000 in April to $ 30,000 in May. Today, it hovers around $ 40,000, after dropping to $ 29,000 on July 29. Every swerve down raises the question of just how serious the fallout could be. Too much seems to be at stake for cryptocurrency to crumble and not just for the diehards who see bitcoin as the future of finance. Algorithmic traders now perform a significant portion of transactions and have automatic buy orders when bitcoin drops below certain thresholds. Yet in order to grasp the growing ties between the crypto-sphere and mainstream markets, imagine the price of bitcoin plummeting to zero.

A rout could be triggered either by internal shocks to the system, for example by a technical failure, or by a big hack of a leading exchange. Or they could come from outside: a crackdown by regulators, for example, or an abrupt end to the rally in the markets, for example in response to rising central bank interest rates.

There are three types of crypto investors, explains Mohamed El-Erian of Allianz, an insurer and asset manager: fundamentalists, who believe that bitcoin will one day replace government-issued currencies; tacticians, who believe its value will increase as more and more people invest in it; and speculators, who want to gamble. Although a crash comes as a monumental upheaval for the first group, it is the least likely to sell; the third, meanwhile, will flee at the first sign of trouble. To avoid a terminal crush, the second group must be persuaded to stay. This is unlikely to happen if the price drops to zero.

A crash would puncture the crypto economy. Bitcoin miners who validate transactions in exchange for a chance to earn new coins would have less incentive to continue, which would end the process of verifying and providing bitcoin. Investors would likely get rid of other cryptocurrencies as well. Recent tantrums have shown that where bitcoin goes, more digital money follows, says Philip Gradwell of Chainalysis, a data firm.

The result would be the destruction of a significant amount of wealth. Investors who have held bitcoin for more than a year, having bought it at a low price, would have less to lose, despite large latent gains (see graph 2). The biggest losses would fall on those who bought less than a year ago, at an average price of $ 37,000. This would include most institutions exposed to crypto, including hedge funds, university endowments, mutual funds, and some companies.

The total erased value would go beyond the market capitalization of digital assets. A crash would also wipe out private investment in crypto companies such as stock exchanges ($ 37 billion since 2010, according to PitchBook, a data company) as well as the value of listed crypto companies (worth around 90 billion dollars). billions of dollars). Payment companies like PayPal, Revolut, and Visa would lose some of their growing and juicy businesses, hurting their ratings. Companies that have rode the crypto boom, like Nvidia, a microchip maker, would also take a hit. In total, maybe $ 2 billion could be lost from that first shock wave, a little more than Amazon’s market cap.

The contagion could spread through multiple channels to other assets, both crypto and mainstream. One channel is leverage. 90% of the money invested in bitcoin is spent on derivatives like perpetual swapsbets on future price movements that never expire (see chart 3). Most of them are traded on unregulated exchanges, such as FTX and Binance, from which clients borrow to make even bigger bets. Modest price movements can trigger large margin calls; when not reached, exchanges do not hesitate to liquidate their clients’ holdings, turbocharging drops crypto prices. The stock markets are expected to swallow big losses on defaulted debts.

The rush to respond to cryptocurrency margin calls, the collateral of choice for leveraged derivatives, could force bettors to ditch conventional assets to free up money. Granted, they could give up on trying to answer those calls as their crypto holdings would not be worth much, which could contain the sale. But other types of leverage exist, where regulated exchanges or even banks loaned dollars to investors who then bought bitcoin. Some have loaned dollars against crypto collateral. In either case, borrowers close to default could seek to liquidate other assets.

The extent of leverage in the system is difficult to assess; the dozen or so exchanges that list perpetual swaps are not all regulated. But open interest, the total amount of derivative contracts outstanding at any given time, gives an idea of ​​the direction of travel, says Kyle Soska of Carnegie Mellon University. It has gone from $ 1.6 billion in March 2020 to $ 24 billion today. This is not a perfect approximation of total leverage, as it is not clear how many guarantees are behind the different contracts. But the forced liquidations of leveraged positions during past downturns give some idea of ​​the extent of the risk. On May 18 alone, as bitcoin lost nearly a third of its value, it hit $ 9 billion.

A second channel of transmission comes from the stable coins that oil the wheels of crypto trading. Since the change from dollars to bitcoins is slow and expensive, traders wishing to make gains and reinvest the products often trade in stablecoins, which are pegged to the dollar or the euro. These coins, the largest of which are Tether and USD, are now collectively worth $ 100 billion. On some crypto platforms, they are the main medium of exchange.

Issuers back up their stablecoins with stacks of assets, much like money market funds. But these are not only, or even mostly, held in cash. Tether, for example, says 50% of its assets were held in commercial paper, 12% in secured loans and 10% in corporate bonds, funds and precious metals at the end of March. A cryptocrash could lead to a stampede on stablecoins, forcing issuers to dump their assets to make redemptions. In July, Fitch, a rating agency, warned that a sudden massive buyout of ties could affect the stability of short-term credit markets. Eric Rosengren, the head of the Boston Federal Reserve, noted that regulated investors with similar liabilities to Tethers are not allowed to invest in many assets because it would represent a stability issue.

A cryptocalypse could affect the broader sentiment even beyond fire sales. The extent of this is unclear: more entities are now exposed to cryptocurrencies, but few have staked much of their wealth there, so the losses would be widespread but shallow. Above all, the banks are immune; and most won’t be rushing to keep bitcoin on their balance sheets anytime soon. The Basel Supervisors’ Club recently proposed that banks set aside an expensive $ 100 for every $ 100 in bitcoin they acquire.

But a worse case is not hard to imagine. Low interest rates have led investors to take more risk. A crypto meltdown could chill them on other exotic assets. Over the past few months, the correlation between bitcoin prices and memes stocks, and even stocks in general, has increased. This is in part because bettors reinvest the gains made on trendy stocks into crypto, and vice versa.

A massive sell-off would start with the most indebted punters, usually individuals and hedge funds in high-risk areas: stocks memes, junk bonds, special purpose acquisition vehicles. Investors exposed to these, faced with questions from their investment committees, would follow suit, making risky assets less liquid, and possibly causing a general slump. If that seems unlikely, remember that the S&P 500, the Americas ‘leading stock index, fell 2.5% in one day after retail bettors’ infatuation with GameStop, a video game retailer, took to the opposite of some hedge funds.

For general market turmoil to ensue, therefore, a lot would have to go wrong, including the price of bitcoin falling to zero. But our extreme scenario suggests that leverage, stablecoins, and sentiment are the primary channels through which any downturn in crypto, big or small, will be transmitted more widely. And crypto is only becoming more and more linked to mainstream finance. Goldman Sachs Plans To Launch Exchange Traded Crypto Fund; Visa has launched a debit card that pays customers’ rewards in bitcoin. As the crypto sphere grows, its potential to further disrupt the market will also increase.

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