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Why the crypto crash could hit stocks

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Contrary to popular belief, Nayib Bukele isn’t completely off the pace.

The youthful, handsome and hipster president of El Salvador — who sports a close-cropped beard and gets about in baseball caps turned backwards — has copped a great deal of flak from global monetary authorities and raised eyebrows even amongst his neighbours.

As the first country in the world to legitimise bitcoin after adopting it as legal tender last September, El Salvador’s timing was, to put it delicately, unfortunate.

That was made worse by Mr Bukele, sometimes described as the “world’s coolest dictator”, and his decision not only to buy a large pile of the digital currency last year, but to continue throwing the impoverished nation’s finances at it even as the price tanked.

But his plans to build a bitcoin city, in the shape of a coin and with the currency’s emblem festooned in the central square, was not without foresight.

El Salvador's president wears a black suit speaks while standing at a lectern.
El Salvador’s President Nayib Bukele decided to buy a large pile of bitcoin last year.(AP: Salvador Melendez)

Located beneath a volcano, the city was to be powered by geothermal energy and become a “haven of freedom from a world of tyranny”.

Instead, the plans — which have been engulfed in a firestorm as digital currencies have cratered and El Salvador’s $100 million bet has more than halved — have become emblematic of the rapidly unwinding fantasy that underpins the crypto world.

It is a reality shock likely to have much broader and more serious repercussions on the global economy than many believe.

Millions of investors, most of them unsophisticated, have been lured into pouring trillions of dollars into what primarily appears a hoax, overseen in many instances by anonymous entities, some criminal, in a completely unregulated environment.

It has been a breathtaking sight to behold.

That’s not to say that the technology underpinning digital currencies is without merit. Nor are all digital currencies bogus. But many are and exist with no underlying purpose other than to fleece innocent bystanders of their cash.

Of the more than 19,000 cryptocurrencies in existence, a mere handful offer any kind of purpose, utility or business plan. And in the meantime, bitcoin continues to burn a hole right through the heart of Antarctica.

Brave new world or slave to the past?

The irony is breathtaking.

Bitcoin, supposedly founded by the mythical Satoshi Nakamoto, or someone posing under that pseudonym, was designed to make traditional currencies redundant, to create a bold new world free from government and central bank control.

After 13 years, it has been an abject failure.

Instead, it has become captive to global central banks.

The great bitcoin boom since the global financial crisis, and particularly since the pandemic, has been driven almost entirely by central banks spraying huge amounts of cash across the global economy.

With interest rates at zero, investors reached further out along the risk curve for anything that might deliver a return.

First, it was unprofitable high-tech companies with promises of riches way into the future. And when cryptocurrencies began going crazy, even sane and sage minds thought, why not jump aboard?

Now, the opposite is in full swing.

As central banks rein in the cash and hike interest rates, the appetite for risk is evaporating. That’s created a full-scale crisis within the crypto world. Liquidity is drying up, clearing houses are being squeezed and traders are nursing enormous losses.

Those losses are spilling over into the mainstream.

Bitcoin and its mini-me imitators have been tentatively embraced by the financial establishment, particularly in the past three years. The temptation was just too great, given the amount of cash washing through them.

Investment banks, pension funds and even established banks all dipped their toes into the water, adding to the supposed credibility of these “investments”. Most merely engaged in a commission-based service, clipping the ticket on transactions.

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Calls for crypto regulation after ‘stablecoin’ collapse.(ABC: David Chau)

But that crossover into the mainstream built a correlation between traditional investments, such as stocks and digital currencies, helping the meteoric rise in crypto valuations to more than $US3 trillion  ($4.3 trillion) by November last year.

The interest rate pull started the rot late last year.

Since then, more than two-thirds of the market has been obliterated, exposing the fantasy at the heart of the crypto world: that in many cases, there is simply nothing there.

The losses, however, are real. And the concern is that they could accelerate the decline on global stock markets as punters try to recover cash wherever they can, thus providing a broader hit to spending and, ultimately, economic growth.

Collapses building momentum

At its peak, terra was valued at around $US40 billion.

A so-called stablecoin, it was meant to maintain its value against the US dollar, to easily enable transfers between crypto and traditional currencies.

But it didn’t hold greenbacks or gold as security. Instead, it relied upon “smart contracts” and algorithms operating between its sister crypto luna. When the tide suddenly went out last month, it was left horribly exposed.

Its collapse was accompanied by accusations that dark forces deliberately had undermined the operation.

Instead, it has helped expose the stark similarities between the revolutionary, brave new world of cryptocurrencies and traditional banking and finance.

There’s just one difference — no regulation and no protection for investors.

Almost a fortnight ago, Celsius, a digital platform that lured in its 1.7 million customers by asking, “If you don’t have access to your funds, are they really your funds?” suspended all transactions as crypto markets tanked.

It first ran into trouble in April, when regulators questioned whether its business model — where it paid interest of up to 18 per cent to holders of up to 40 cryptocurrencies including bitcoin and ethereum and on-lent them at 20 per cent — was a traditional securities lending business.

Those claims were denied, even if it sounded like the same model for every moneylending business for the past 3,000 years.

Given official interest was barely above zero, the premiums indicated risk clearly was very high. But those involved were deluded into believing they were part of a bold new world that didn’t conform to financial norms.

To make matters even worse, the platform staked currencies against others to turbocharge returns — a strategy that worked a treat when everything was running hot.

But now it’s not.

Celsius chief executive Alex Mashinsky — who made a virtue out of castigating banks and the financial system — hasn’t been heard from since the platform “paused withdrawals” a fortnight ago. The self-aggrandising tweets have stopped.

Once again, conspiracy theories are surfacing. The claims are that nefarious forces have been at work, undermining what could have been a threat to the established global financial order.

This, however, has been nothing more than the fallout of a traditional liquidity squeeze and the financial model built around cryptocurrency trading is as old as the hills.

The only difference is that the hype and hysteria around cryptocurrencies have been allowed to build into the most overblown bubble since the Dutch went crazy for tulips back in the 17th century.

Just like tulips, digital currencies, tokens and the technology surrounding blockchain won’t disappear. But digital assets that have no purpose other than as a vehicle for speculation will continue to come under pressure as interest rates rise. And that will inflict ongoing pain on many millions of investors.

Unlike other financial crises, however, the US Federal Reserve won’t ride to the rescue on this one.



Read More:Why the crypto crash could hit stocks

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