Think Cryptocurrency Is Too Small to Cause a Recession? Its Toxicity Might Surprise You

Could cryptocurrencies cause the next recession?
By: | May 9, 2022

Scenario: Imagine, it’s 2050 and globally, digital currencies are having a moment.

Years before — as the world recovered from the COVID-19 pandemic and war raged in the Ukraine — people began moving money into digital assets. Cryptocurrencies like Bitcoin, which financier Warren Buffett once referred to as “rat poison squared,” experienced a boom in popularity as high inflation rates in the U.S. made investors wary of other assets.

Even Buffett got in the game, investing $1 billion in a crypto-friendly bank in 2022.   

A financial services sector sprouted up around these assets and soon everything from Bitcoin-backed loans to insurance contracts executed on blockchains were flourishing. The early days, when Bitcoin saw wild fluctuations in value, seemed to be a relic of the past. 

Until one day, when a rogue billionaire took to Twitter to announce that his company would no longer be accepting cryptocurrencies for its products; he only wants fiat currencies from now on. 

A few other companies follow suit and soon consumers are flooding banks trying to withdraw their money from digital currencies and exchange it for U.S. dollars. Economists start to wonder: Could crypto cause the next recession?  

The Growth of Cryptocurrency

Analysis: Over the past few years, cryptocurrencies have exploded in popularity and value. 

Last year, the cryptocurrency market grew to more than $3 trillion in value — more than quadruple what it was worth in 2020 — Time Magazine reported. 

These assets, which got their start when Bitcoin made its debut in 2009, seek to create a financial system free of the oversight of governments and big banks. 

In the wake of the financial crisis, early crypto-users fantasized of an economy free of the politicians and financiers whose actions led to the 2008 financial crisis. As Wired reported back in 2011, it’s not a coincidence that Bitcoin’s mysterious founder Nakamoto released his paper outlining how his currency would work in 2008 just as the U.S. government was bailing out big banks and automakers. 

Instead of a third-party maintaining its ledger, Bitcoin uses a collective network of cryptocurrency miners to keep track of its transactions and create new coins. Since transactions are recorded on databases on many different computers, users can keep track of one another and make sure no one is tampering with the system.   

“Bitcoin and cryptocurrency were created by Satoshi Nakamoto exactly when the economic crisis of 2008 kicked in,” said Alex Lemberg, CEO of the Nimbus Platform, a blockchain-based company that specializes in decentralized finance solutions.

Now, the Motley Fool reports there are more than 12,000 cryptocurrencies. The real-time blockchain ledgers that record transactions and keep track of how much cryptocurrency is out there, are being used to track everything from vaccine temperatures and outbreaks of foodborne illnesses to tracking supply chains and documenting the sale of digital art through non-fungible tokens (NFTs).  

In 2018, a group of software developers and entrepreneurs coined the term decentralized finance (DeFi) to describe financial services that are automatically executed on blockchains. 

Decentralized exchanges and lending systems allow people with digital wallets to trade assets, invest in a Roth IRA, take out loans or take out insurance policies, oftentimes using cryptocurrencies. These exchanges are often executed on smart-contracts, which are programs set to execute an agreement automatically if certain conditions are met.    

“Decentralized financial applications are the same as regular mobile applications with one addition — its back-end code is run on blockchain, thus creating working scenarios for smart-contracts,” Lemberg said. “This way a decentralized financial application eliminates a central intermediary, whose functions were automated.”

Parallels to the 2008 Recession

Though the cryptocurrency and decentralized finance sector at large isn’t currently big enough to cause an economic recession on its own, the industry is growing. And many of crypto’s creators and early backers have hopes that it will one day take the place of government-backed currencies. 

But economists can’t help noticing the ways in which cryptocurrency mirrors the subprime mortgages that played a key role in causing the Great Recession. 

Back when housing prices were on the rise in the early 2000s, borrowers with poor credit ratings — generally defined as those with a FICO score below 620 — would take on risky mortgages, anticipating that they would be able to refinance quickly with better terms as their property values increased. These types of financing schemes were known as subprime mortgages and in 2007 they accounted for about $1.3 trillion in outstanding mortgages.    

These homes were then used as collateral in a system known as “shadow banking,” in which global finance firms would rely on each other to borrow money. 

Under the shadow banking system, one commercial or investment bank would borrow money from another, usually a larger firm, after realizing its reserves were low and it was at risk of illiquidity if too many debtors or mortgage holders defaulted. As collateral, the bank seeking the loan might put up a house they hold the mortgage for in a process known as rehypothecation. 

Once it receives a loan from the lending bank, the loaning institution can either loan out the newly acquired cash with the hope of increasing its revenue through the interest generated or they can keep it in the vault to maintain its liquidity. 

When the mortgage-backed security market started imploding in 2007 due to subprime lending, shadow banks started recalling their loans and returning their collateral. From there, panic-ensued. Bear Stearns and Lehman Brothers went bankrupt. The economy endured an 18-month recession. Over six million American households faced foreclosure.  

Though with a market that was recently worth only a little more $3 trillion globally, there are certainly fewer people invested in cryptocurrencies than in housing. (For comparison, just the U.S. housing market was worth $6.9 trillion in 2021). The similarities between crypto investors and those who took out subprime mortgages are enough to give economists a pause. 

“I’m seeing uncomfortable parallels with the subprime crisis of the 2000s,” New York Times opinion columnist Paul Krugman wrote in January of this year. Krugman is a distinguished economics professor at the City University of New York and a 2008 Nobel Memorial Prize in Economic Sciences winner. 

“No, crypto doesn’t threaten the financial system — the numbers aren’t big enough to do that. But there’s growing evidence that the risks of crypto are falling disproportionately on people who don’t know what they are getting into and are poorly positioned to handle the downside.”

In his article, Krugman pointed out that crypto-investors differ from those who typically put money in risky assets, like stocks. Stock market investors tend to be college-educated white people, with 77% of college graduates and 65% of white people owning stocks, per the most recent Gallup research. In contrast, 44% of those invested in cryptocurrency are non-white and 55% don’t have a college degree, per a survey by NORC.

These are some of the same groups of people who were targeted for subprime mortgages, which were heralded at the time for opening up the benefits of homeownership to those who had previously been excluded, Krugman writes. Today, crypto has been praised for bringing people who have been traditionally eschewed the stock market into the world of investing. 

“I may not think I have the ability to enter the stock market and purchase stocks if I’m a single mom and make $40,000 a year,” Angela Fontes, a vice president in the economics, justice and society department at NORC, told CNBC Make It in 2021. “But I may think I can get some cryptocurrency. I don’t need a broker to do it and I don’t need a 401(k) account.”

With their sharp dips and leaps in value, Krugman questions why such a risky asset class is being sold to people who may not have previous experience investing or a lot of money to lose in a crash. 

“Maybe the rising valuation (although not use) of Bitcoin and its rivals represents something more than a bubble, in which people buy an asset simply because other people have made money off that asset in the past,” Krugman writes.

“But these investors should be people who are both well equipped to make that judgment and financially secure enough to bear the losses if it turns out that the skeptics are right.” 

As Crypto Grows, So Too Do Its Risks

Crypto may be too small to cause a recession now, but if the digital currencies achieve their creator’s highest ambitions and become a critical part of the economic system, their fluctuations in value may have the ability to create a run on the bank. 

These concerns are especially acute for stablecoins, which are pegged to a fiat currency like the U.S. dollar. 

“If all of a sudden, everyone is flooding out at the same time from crypto, they have to redeem those stable coins for the value that it’s been pegged to,” said Jacob Decker, vice president and director of financial institutions at Woodruff Sawyer.  “So you can cause this kind of run on the bank type effect.”

It’s not just startups getting involved with these risky assets either. In April, Goldman Sachs announced it is now offering its first Bitcoin-backed loans, Bloomberg reports. 

“We’re seeing big players in Wall Street — like the traditional financial institutions, the endowments, the pension trusts — looking at this as a hedge against put from USD or fiat currencies,” said Benjamin Peach, associate director, digital assets at Aon.

As more consumers and financial institutions invest in digital assets like cryptocurrencies, there is evidence that speculators are beginning to borrow money to buy crypto assets, deputy governor Sir Jon Cunliffe of the Bank of England has warned, per reporting from the Guardian. 

That same report noted that surveys suggest that spending on cryptocurrencies is backed by about $40 billion of borrowed funds.   

Hopefully, banks would avoid rehypothecation with crypto assets — the market is so unstable right now it would be highly unlikely — but if the finance industry writ large begins to view digital currencies as a more stable asset class this could change, potentially resulting in the same knock-on affect the housing market crash had during the Great Recession. 

Regulators Eye Cryptocurrency

Governments are already turning an eye to the risks cryptocurrencies pose to financial markets.

In March, President Joe Biden signed an executive order directing the federal government to draw up a plan to regulate cryptocurrencies, as digital assets are becoming more popular and they have the potential to destabilize traditional financial systems. 

Other countries have already started regulating cryptocurrencies. The United Kingdom has adopted regulations that cover  cover anti-money-laundering, counter-terrorism-financing, and other rules and in September of 2021 El Salvador became the first country to recognize Bitcoin as a legal tender — despite the protest of its citizens

Still others have completely shunned digital assets. China enacted a flat-out ban of crypto and other private currencies in 2021, Fortune reported.  

“I think you see a couple of different camps developing around the globe,” said Vanessa Savino, deputy general counsel for tZERO, a digital securities and cryptocurrency trading platform.   

“You have countries like El Salvador, and they passed the law to declare Bitcoin legal tender. On the other side of the spectrum, you have countries like China who have almost banned any kind of privately issued cryptocurrency.” &

Courtney DuChene is an associate editor at Risk & Insurance. She can be reached at [email protected]

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