The Economist published an article this week which discussed the potential fallout if Bitcoin were to drop to $0 in global financial markets. Normally these hypothetical scenarios consist of a lot of speculation and fluff and I would not point people towards them but this one seemed to be much better researched and provoked deeper questions about the effects of crypto and its reach within the “traditional” economy which I thought were worth exploring in more detail.

Before I get into the characteristics of Bitcoin and crypto that could be troubling, this post is not meant to be a scare post in order to grab negative attention. I am often critical of the fact that the mainstream media inundates us with negative news because they are conscious of the negative bias that human beings possess when it comes to information collection. For instinctual survival reasons, we are prone to focus on distressing and negative news. This served us well in the forests and jungles when it came to information on potential predators or enemies, but doesn’t serve us as well in the modern world, which for the most part is drastically less dangerous and that we live in much longer than when these habits served us. It’s one reason that I think people are increasingly depressed and feeling aggrieved in some way because it often ignores the spectacular rise in living standards and poverty reduction we have seen worldwide in the past 150 years. Even I was surprised to learn the other day that the US economy is twice the size nominally and 50% larger in real terms than it was in the year 2000 when the last dot com boom crashed.

This post is intended to be more of a risk assessment of the current state of Bitcoin as well as crypto as a whole. These are assets that were born out of a skeptical worldview as a way to plot a future around governments that has ended up ingraining itself within the very established and regulated investment world. The implications of this could affect those that don’t even directly hold Bitcoin so becoming aware of more than just memes and day to day gyrations is becoming more relevant for all types of investors.

Institutional Inflows in 2020

Whether it is available to retail investors or not through an ETF, institutional Bitcoin has already been with us for some time and it is those institutional flows that really seem to have bid up the price since late 2020. Institutional buyers have been able to access Bitcoin through grayscale trusts which are legal entities that issue shares and then use the proceeds from those shares to buy Bitcoin. This is the main avenue that institutional investors have been able to tap into the Bitcoin market and have helped hedge funds capitalize on the fad. Many hedge funds had just made crypto available to their investors as of late 2020 and helped push the price up by squeezing the supply of coins available.

Exchange traded products or ETP’s are the vehicle which non-US investors are also able to tap the resource of the grayscale trusts and investors have poured hundreds of millions into these funds over the past year.

Hedge funds and institutional money from abroad mostly consists of that of the ultra wealthy who have a need to diversify their investments further. The rich want into Bitcoin and other crypto because it offers a new and volatile potential for return. Just 1% of the assets of someone worth $100 million is a million dollars so people like this can afford to throw large enough sums towards a speculative asset. The same for a pension fund with billions of dollars that wouldn’t lose much were Bitcoin to go to zero tomorrow.

Yet these investors and these firms getting involved, starts to create its own problems in terms of scale which will inevitably bleed into other markets if a severe downturn in Bitcoin and crypto ever takes place. This is because some traders have leveraged themselves highly or are using other means to convert large crypto holdings to cash like products realize their profits.

Mohamed El-Erian of Alliance, owner of PIMCO, breaks the owners of Bitcoin down into 3 groups:

• Fundamentalists – These are the die hard holders that hold Bitcoin and crypto for their belief in an alternative decentralized monetary system and are likely to never sell no matter the gyrations.
• Tacticians – These believe that crypto will rise as more and more people adopt and invest in crypto.
• Speculators – These are the gamblers that are willing to punt on the price.

In order to keep price floors in tact, the speculators can leave but the tacticians, many of whom may be backing these recent institutional flows, will have to stick around. If they were to leave, either being spooked by a regulatory crackdown or some fundamental breakdown in crypto such as a large scale hack or heist, the bottom could fall out of the market. This is when things would start to get interesting.

Bitcoin Derivatives and Dependent Companies

The Bitcoin derivatives market has grown tremendously in the past year, surpassing that of the spot market for Bitcoin. Although special vehicles are needed for banks or other traders to buy actual Bitcoin, they can already trade Bitcoin futures on the Chicago Mercantile Exchange. Others can trade on unregulated exchanges such as FTX and Binance. Were the price to drop however, this may produce margin calls on many of these derivatives, when they are not met, the exchange would then liquidate the holdings which would further drive down prices.

The snowball effect would touch crypto exchanges that are publicly traded like Coinbase which derive their income from the flow of crypto. It could also touch payments firms which facilitate Bitcoin payments as well such as PayPal and Visa. Then there are the firms like Tesla that directly hold Bitcoin and would have to recognize a mark to market write down which would directly impact their quarterly numbers.

Particular trading firms will also be affected. I pointed out last week how Robinhood derives a significant portion of its revenue from crypto. Since all crypto currencies are highly correlated, it’s likely that a fall in Bitcoin would produce big falls in other crypto as well, denting revenue for trading firms like Robinhood and WeBull.

The Economist article also pointed to another interesting transmission mechanism which would come in the form of dollar linked tokens or “stablecoins” like Tether or USD coin. Since traditional capital market transactions take 3 business days to settle, the growth of these stablecoins has been fueled partly by those who are able to quickly transition Bitcoin gains into Tether which then represents an underlying dollar asset and can be done almost instantly. For every dollar token issued, Tether then invests the real dollar they receive in short term assets like commercial paper, loans and corporate bonds. The holdings of Tether that back its dollar tokens are now estimated to be $100 billion, which rivals many of the largest commercial paper buyers in the market. Massive redemptions of stablecoins for actual dollars could force companies like Tether to dump their real asset holdings, further roiling the market for these assets.

2008 All Over

Just as in 2008, it could be a liquidity crunch which spells the fate for Bitcoin and crypto just as it did for mortgage securities.

The first reason being that although the new, big money investors in the past year have helped drive gains, much of Bitcoin is still likely held by that first segment of die hard fundamentalists which have held almost half the supply of Bitcoin for more than a year.

We know this because those who have above 100% gains account for a large proportion of those currently holding Bitcoin. much of those gains was experienced by those who entered prior to a year ago.

This may explain the big moves we have seen up and down lately as the “tacticians” attempt to avoid losses or capture gains with the movement of Bitcoin daily. The gains and losses being produced are being backed by a relatively small proportion of coins which are in circulation and deemed highly liquid or liquid by Chainanalysis.

In addition, if we assume the theoretical example of Bitcoin dropping to very low values like $50-$60 per coin, then the viability of even confirming a transaction comes into question as the energy consumed just to make a transaction is estimated to take about 1,544 kWh which costs about $106 in the US and $57 in China. Fall too low and there isn’t even any monetary incentive to keep the blockchain going for miners. Those die hard holders then would have to rely on each other to even facilitate transactions on the blockchain.

If wallets or transactions were to freeze up, there may inevitably be calls for the government to intervene and protect investors from experiencing these types of losses again. That would likely mean the end of the Wild West of crypto as we know it currently, either through tightly controlled rules or the introduction of a central bank digital currency to supplant Bitcoin once and for all. This isn’t without precedent, the government issued dollar supplanted the “bank note” currency of the 19th century when banks failed and depositors lost their savings. The introduction of the Federal Reserve followed not long after.

Yet a crash of Bitcoin and crypto would likely leave investors much more skeptical of tech and scarred for many years, preventing investment into new innovative technologies. Crypto is now estimated to be worth $2 trillion globally. The last dot com bubble bursting was estimated to have wiped out $6.5 trillion in the stock market. A crypto crash may not tilt the economy into recession but it definitely now has the power to provide more conventional investors with a scare.

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