Weekend thought: What if Crypto Collapsed?

At the start of the week, I had lots of conversations with people worried about Evergrande defaulting and the possibility of contagion. By the end of the week, those talks had mainly died down (likely in large part because the Chinese Central bank seemed to be making moves to alleviate / contain the crisis).

I am far from a “macro expert”; for a long time, I agreed with the Peter Lynch rule that if you spend more than 15 minutes a year thinking about the economy and market forecasts, you’re wasting time. However, I’ve seen mammoth fortunes made twice in the past fifteen years when the market was slow to interpret cascading negative events (first in the financial crisis, and then with Covid in early 2020), where people who could (correctly) see that the market was missing just how bad things could get were able to buy cheap insurance and make huge sums (the “Big Short” in the financial crisis and Ackman’s mammoth short before Covid), so I’ve tried to push myself to spend a little more time looking and thinking about possible blow up / contagion events whenever they appear.

As far as Evergrande goes, I personally haven’t been too concerned. Why? Contagion risk tends to come when something unexpectedly becomes a disaster that effects every part of the world economy. With COVID, the whole world went from “normal to essentially shut down within a few weeks. With the financial crisis, the whole world had been built with the understanding that U.S. housing prices wouldn’t go down, and when that proved wrong the downside would blow up global financial institutions.

So with Evergrande, I don’t see either of those risks. People have been talking about how overleveraged they are for at least a year (here’s a random article from September 2020, though I believe there were signs years earlier), so it’s not like this was an unexpected blow up that people didn’t have time to prepare for. And, while Evergrande has tons of debt, it doesn’t seem like their debt was widely held by global financial institutions in sizes that would dent any of their balance sheets.

But thinking about Evergrande’s contagion risk did get me thinking about other black swan style downside risks. And the one that kept jumping out to me was simple: what would happen if the whole crypto market blew up? Would that have downside for the “real world” economy?

Let me be clear: I’m not saying crypto will blow up (though, humorously, I mentioned tether blowing up as a risk to crypto last month, and one rumor that keeps popping up about Tether is that they own a bunch of Evergrande commercial paper (a rumor they continue to deny), so the two could be correlated!). I’m just wondering what a tail scenario would look like if that blow up did come to pass (again, something that seems insanely unlikely, but at least somewhat plausible given all the regulation that seems set to sweep the sector!)

On the one hand, it’s hard to see how crypto blowing up could destabilize the economy. I’m not aware of any major financial institution that has serious exposure to crypto, and even if they did regulators generally set insanely high capital requirements for crypto related assets so even if crypto did go to zero the financial institutions should be able to stomach those losses. And, for as much buzz as crypto gets, the main use cases of crypto are currently using it as a trading sardine, using it to create pet rocks (which can then be used as a trading sardine), or using it to maybe one day be able to go see a movie at AMC, so even if all crypto went away it’s hard to see what real value crpyto’s blow up would destroy. I mena, you’d see a few companies go bankrupt or into distress (Microstrategy (MSTR) is basically a levered bet on bitcoin at this point), but again there aren’t tons of firms with big exposure, so it’s hard to see how crypto going to zero has real spill over effects.

On the other hand, Bitcoin and Ethereum together have a market cap in excess of $1T (that’s one trillion dollars), which is enormous (it’s about the annual GDP of all of Florida, and larger than the market cap of all but the absolute largest companies on the stock market). I know that a lot of that crypto wealth is held by early evangelists who have basically no cost basis in it and are probably set for life regardless of what the crypto does from here, but that is still an enormous market cap. It’s hard to imagine that much wealth could be evaporated without any dislocation or follow on effects.

Perhaps the real spillover would be political; if thousands (tens of thousands? hundreds of thousands?) of people across the world lost huge sums in a crypto bust, I’d think the political backlash would be enormous. At a minimum, you’d get tons of populist anger that could be tapped into in weird ways by some politicians, but I’d also imagine there’s possibility for insane regulations to get passed in its wake as well.

Anyway, no real stance from me here. I’ve long been a crypto skeptic (I’ve viewed them mainly as speculative trading sardines, though they can certainly be lucrative and present unique arb opportunities!), though I’ve been reasonably intrigued by all of the possibilities of Ether. But it’s a volatile asset class and there’s a chance the whole thing ends in tears, and given its size I’ve been trying to think through the real world (if any) if it did end.

If you’ve got thoughts on what would happen if crypto imploded (or any other crazy tail risks that you think the market is missing), I’d certainly love to hear them!