When will the cryptocurrency crash?

Article author: Annie Lowrey  Article translation: Block unicorn

"The countdown to the next catastrophic crash has begun," Dennis Kelleher, president of the nonprofit Better Markets, told me.

In the past few weeks, I have heard this or similar views from economists, traders, congressional staff, and government officials.

The incoming Trump administration has promised to pass regulations that support cryptocurrencies and may relax strict restrictions on Wall Street institutions.

They believe that this will bring an unprecedented era of American prosperity, maintaining the United States' position as the leader of global capital markets and the core of the global investment ecosystem.

My vision is for America to dominate the future," Donald Trump said at a Bitcoin conference in July. "I am developing plans to ensure that the United States becomes the global cryptocurrency capital and the world's Bitcoin superpower."

Financial experts expect things to be different. First, a boom, perhaps a big boom, with prices for Bitcoin, Ethereum, and other cryptocurrencies climbing; financial firms making tons of money; and American investors basking in their newfound wealth. Second, a bust, perhaps a big bust, with companies failing, governments called in to stabilize markets, and many Americans facing foreclosure and bankruptcy.

I’ve written about Bitcoin for more than a decade, and I covered the last financial crisis and its long aftermath, so I have some idea of ​​what can cause a boom and a bust. Crypto assets tend to be extremely volatile, far more so than real estate, commodities, stocks, and bonds. With Washington pushing the envelope, more Americans will invest in cryptocurrencies. As money pours in, prices will rise. When prices fall, as they inevitably will, individuals and institutions will suffer.

The experts I spoke with didn’t dispute the idea. But they told me that if that’s the case, the U.S. and the world should count themselves lucky. The danger isn’t just that pro-crypto regulations could expose millions of Americans to scams and market volatility. The real danger is that this will lead to increased leverage throughout the financial system. It will increase opacity, making it harder for investors to identify and price the risks of financial products. And it will happen at the same time that the Trump administration is cutting regulations and regulators.

Cryptocurrencies will become more ubiquitous, and traditional financial markets will become more like the cryptocurrency markets—more wild, more opaque, more unpredictable, and with potentially trillions of dollars of consequences that will stretch over years.

“I’m worried that the next three or four years are going to look pretty good,” Eswar Prasad, a Cornell economist and former International Monetary Fund official, told me. “The real challenge will come later, when we’re going to have to pick up the pieces from all the speculative mania that has been induced by the policies of this administration.”

For years, Washington has “waged an unprecedented war on cryptocurrencies and Bitcoin,” Trump told cryptocurrency entrepreneurs this summer. “They go after your banks. They cut off your financial services… They stop ordinary Americans from transferring money to your exchanges. They smear you as criminals.” He added: “It happened to me, too, because I said the election was rigged.”

Trump is right that cryptocurrencies do exist in a separate, parallel financial universe. Many crypto companies are unable or choose not to comply with U.S. financial regulations, making it difficult for ordinary investors to use their services. (Binance, the world’s largest cryptocurrency exchange, won’t even say in which jurisdiction it’s domiciled, instead directing U.S. customers to one of its branches in the U.S.) Firms like Morgan Stanley and Wells Fargo tend to offer few crypto products and invest almost nothing in cryptocurrencies and related businesses. The problem isn’t that banks don’t want to get involved, but that regulations prevent them from doing so, and regulators have explicitly warned them not to.

This situation limits the amount of money that can flow into cryptocurrencies. But it’s a smart move: It prevents companies from failing and wild price swings from disrupting the traditional financial system. Kelleher noted that cryptocurrencies lost $2 trillion of their $3 trillion market value in 2022. “If there was such a huge financial collapse in any other asset, there would be contagion. But it didn’t happen because you have parallel systems that have almost no connection to each other.”

Upcoming regulations will bring these systems closer together. Granted, no one knows exactly which laws Congress will pass and which Trump will sign. But the Financial Innovation and Technology for the 21st Century Act, or FIT21, provides a good reference. The bill, which died in the Senate after passing the House last year, is the focus of a massive lobbying effort by cryptocurrency advocates, including $170 million for the 2024 election. The law is the equivalent of an industry wish list.

FIT21 designates the Commodity Futures Trading Commission (CFTC) as the regulator of most crypto assets and companies, rather than the Securities and Exchange Commission (SEC), and requires the CFTC to collect far less information about crypto product structures and transactions than securities firms provide to the SEC.

In addition to looser rules, financial experts also expect lax enforcement. The CFTC primarily regulates financial products that companies use as hedges and trade between traders, rather than those peddled to individual investors. The CFTC has a budget about one-fifth that of the SEC and only one-seventh the staff. Overall, Washington is expected to ease restrictions, allowing traditional banks to put cryptocurrencies on their books and allowing crypto companies to access the U.S. financial infrastructure.

According to Prasad, such regulation would be a "dream" for cryptocurrencies.

Trump and his family have also invested in cryptocurrencies personally, and the president-elect has floated the idea of ​​building a “strategic” Bitcoin reserve to protect against Chinese influence. (In practice, that would mean siphoning off billions of dollars of taxpayer money into speculative assets that have no strategic benefit.) How many Chinese Communists will invest in cryptocurrencies because Trump does? How many young people will put money into Bitcoin because Trump’s son Eric says its price will soar to $1 million, or because the Secretary of Commerce says it’s the future?

No measure being considered by Congress or the White House will reduce the inherent risks. Cryptocurrency investors will remain vulnerable to hacking, ransomware, and theft. The research group Chainalysis counted $24.2 billion in illicit transactions in 2023 alone. If the U.S. government invests in cryptocurrencies, the incentives for countries like Iran and North Korea to intervene in the market will multiply. Imagine China launching a 51% attack on the Bitcoin blockchain, taking over and controlling every transaction. That scenario is a security nightmare.

No measure being considered by Congress or the White House will reduce the inherent risks of cryptocurrencies. Cryptocurrency investors remain vulnerable to hacking, ransomware, and theft. Research firm Chainalysis counts $24.2 billion in illegal transactions in 2023 alone. If the U.S. government invests in cryptocurrencies, the incentive for countries like Iran and North Korea to intervene in the market will increase dramatically. Imagine a country launching a 51% attack on the Bitcoin blockchain, taking over and controlling every transaction. This scenario is a security nightmare

Americans will also face more scams and frauds. The Securities and Exchange Commission (SEC) has taken enforcement actions against dozens of Ponzi schemes, charlatans, and frauds, including the $32 billion fake exchange FTX and a number of shoddy token companies. No one expects the CFTC to have enough power to do the same. And FIT21 leaves many loopholes for all kinds of dirty profit-making practices to exist. Crypto companies may legally run exchanges, buy and sell assets themselves and execute orders for clients, all while being legal despite conflicts of interest.

Simple volatility is the biggest risk for retail investors. Prasad stressed that cryptocurrencies, tokens and other coins are "purely speculative." "The only thing that supports their value is investor sentiment." At least gold has industrial uses. Or if you bet on the price of tulip bulbs, at least you might get a flower.

But in the world of cryptocurrencies, you might get nothing or even lose money. Many cryptocurrency traders borrow money to speculate. When traders who use leverage lose money on their investments, their lenders - usually exchanges - ask them for collateral. To provide collateral, investors may have to liquidate their 401(k) accounts. They may have to sell bitcoin in a market downturn. If they can't raise the cash, the companies holding their accounts may liquidate or seize their assets.

A report released last month by the Office of Financial Research, a government think tank, makes clear how dangerous this situation could be: Some low-income families "are using cryptocurrency proceeds to obtain new mortgages." When cryptocurrency prices fall, these families' homes are at risk.

Many individual investors don't seem to understand the dangers. The Federal Deposit Insurance Corporation (FDIC) has had to remind the public that crypto assets are not protected by it. The Financial Stability Oversight Council (FSOC) has also raised concerns that people don't realize that crypto companies are not subject to the same regulations as banks. However, if Trump also invests in them, how serious is this matter?

However, the main concern of regulators and economists is not the damage this new era will cause to individual families. They worry that the chaos in the cryptocurrency market will disrupt the traditional financial system - causing a credit collapse and forcing the government to step in, as it did in 2008.

Once Wall Street saw it as fool's gold, but now it sees it as a gold mine. Ray Dalio of Bridgewater Associates called cryptocurrency a “bubble” a decade ago; now he considers it “an incredibly great invention.” Larry Fink of Blackstone Group once called Bitcoin “the index of money laundering”; today he sees it as a “legitimate financial instrument” — one that his firm has begun offering to clients, albeit indirectly.

In early 2024, the Securities and Exchange Commission began allowing fund managers to sell certain cryptocurrency investments. Blackstone launched a Bitcoin exchange-traded fund in November; a public pension fund has already put retirees’ hard-earned money into it. Barclays, Citigroup, JPMorgan Chase and Goldman Sachs are also trading cryptocurrencies. Billions of dollars in traditional finance are flowing into decentralized finance markets, and more will come as regulations ease.

Will there be any problems? If Wall Street firms assess the risks of these high-risk assets correctly, that’s fine. If they don’t, everything could go wrong.

Even the most seemingly solid instruments are fraught with danger. Stablecoins, for example, are crypto assets pegged to the U.S. dollar: One stablecoin is equal to one dollar, which makes them a medium of exchange, unlike Bitcoin and Ethereum. Stablecoin companies typically maintain their pegs by holding an equal amount of ultra-safe assets, such as cash and Treasury bonds, for every stablecoin issued.

Supposedly. In the spring of 2022, the widely used stablecoin TerraUSD collapsed, with its price falling to just 23 cents. The company had used an algorithm to keep TerraUSD’s price stable; as long as enough people withdrew their funds, the stablecoin would lose its peg. Tether, the world’s most traded crypto asset, claims to be fully backed by secure deposits. But the U.S. government discovered in 2021 that this wasn’t actually the case; moreover, the Treasury Department is considering sanctions on the company behind Tether for allegedly serving as a conduit for “North Korea’s nuclear weapons program, Mexican drug cartels, Russian arms companies, Middle Eastern terrorist groups, and a Chinese manufacturer of chemicals that make fentanyl,” the Wall Street Journal reported. (“It is outrageous to suggest that Tether is somehow assisting criminals or circumventing sanctions,” the company responded.)

If Tether or another large stablecoin went wrong, financial chaos could spread immediately beyond the cryptocurrency market. Concerned investors would sell stablecoins, leading to “self-fulfilling panic redemptions,” as three academics put it when modeling this possibility. Stablecoin issuers would sell Treasuries and other safe assets to provide redemptions; a fall in the price of safe assets would affect thousands of non-cryptocurrency companies. At the end of 2021, these economists estimated that the risk of a run on Tether was 2.5%—not exactly stable!

Other disasters are easy to imagine: bank failures, exchange collapses, giant Ponzi schemes going bust. Yet the biggest risk to cryptocurrencies has little to do with cryptocurrencies themselves.

If Congress passes FIT21 or a similar bill, it would create a new asset class called “digital commodities”—essentially any financial asset managed on a decentralized blockchain. Digital commodities would not be regulated by the Securities and Exchange Commission (SEC), and “decentralized finance” companies would not be under its purview. Under FIT21, any company or person could self-certify a financial product as a digital commodity, and the SEC would have only 60 days to file an objection.

The loophole is big enough for an investment bank to exploit.

Wall Street has begun discussing “tokenization,” putting assets on programmable digital ledgers. The nominal reason is capital efficiency: Tokenization can make it easier for money to move around. Another argument is regulatory arbitrage: Blockchain-based investments will no longer be subject to the SEC’s jurisdiction and may face fewer disclosure, reporting, accounting, taxation, consumer protection, anti-money laundering, and capital requirements. Risk will accumulate in the system; the government will have fewer ways to control companies.

Gary Gensler, outgoing SEC chairman and crypto industry arch-enemy, believes that crypto regulation could ultimately undermine “the broader $100 trillion capital markets.” “It could encourage noncompliant entities to try to co-opt the regulatory regime they want to be subject to.”

We’ve seen a similar play before, not long ago. In 2000, President Clinton signed the Commodity Futures Modernization Act near the end of his presidency. The law placed strict limits on exchange-traded derivatives but left those traded over the counter unregulated. As a result, Wall Street created trillions of dollars in financial products, many of which were backed by mortgage income streams and traded over the counter. These products bundled subprime loans with prime loans, masking the true risk of certain financial instruments. Consumers then suffered under the weight of rising interest rates, weak wage growth, and climbing unemployment. Mortgage defaults rose and house prices fell, first in the Sun Belt and then across the country. Investors panicked. No one even knew what was in those credit default swaps and mortgage-backed securities. No one was sure what anything was worth. Uncertainty, opacity, leverage, and mispricing contributed to the global financial crisis that ultimately led to the Great Depression.

Today's cryptocurrency market is ready to become the derivatives market of the future. If Congress and the Trump administration do nothing—still leaving the Securities and Exchange Commission (SEC) as the primary regulator of cryptocurrency and requiring crypto companies to follow existing rules—then the chaos will continue to be isolated. There is no reasonable reason to think that digital assets should be treated any differently from securities. According to the simple standard that governments have used for more than a hundred years, almost all crypto assets should be considered securities. Yet Washington is creating loopholes instead of making laws.

As cryptocurrency supporters like to say, "Hold on tight, don't let go." "A lot of bankers, they're dancing in the streets," said Jamie Dimon of JPMorgan Chase at a conference in Peru last year. "Maybe they should. Bankers will never be the ones to take the blame.