High-stakes institutional investors are increasingly exposing themselves to the volatile cryptocurrency market, raising fears that the digital asset industry could wreak havoc throughout the economy — a development that would harm people who can’t afford to own any financial asset, digital or otherwise.
One in seven hedge funds now hold between 10-20 percent of their entire portfolios in cryptocurrency and one in four hedge funds are on the verge of investing in the asset class, according to a recent survey conducted by the auditing firm PricewaterhouseCoopers. The cohort demonstrates that segments of the financial industry have a large appetite for risk. The survey also shows that 21 percent of all hedge funds own some cryptocurrency, with the average invested firm having just 3 percent of its portfolio in digital assets.
The statistic on firms with up to one-fifth of their portfolios invested in cryptocurrencies was referenced during a June 30 hearing on cryptocurrency before the House Financial Services Committee. Chair Maxine Waters (D-California) cited the findings after announcing that the panel has “begun a thorough examination of this marketplace.”
Waters said she is particularly interested in “the systemic risks presented by hedge funds rushing to invest in highly volatile cryptocurrencies and cryptocurrency derivatives.” The price of Bitcoin, the most popular cryptocurrency, has fluctuated wildly in 2021, including a 48.4 percent decline during nine days in May, when the price of Bitcoin plunged from $59,519.35 to $30,681.50.
Alexis Goldstein, a Truthout contributor and an expert witness called on by Democrats to testify, said cryptocurrency markets are particularly attractive to hedge funds because rules on disclosure don’t require them to reveal what cryptocurrency they own. Popular cryptocurrency exchanges also allow customers to borrow heavily to buy digital assets.
“Hedge funds are the perfect client to use those sorts of leverage,” Goldstein remarked. Lending in cryptocurrency, which is known as decentralized finance, has increased this year alone by a factor of 25, according to one measure: The value of assets pledged as collateral in decentralized finance loans has ballooned from $2 billion to $50 billion.
If the cryptocurrency market takes another nosedive — like it did in May, shedding some $1 trillion, or 40 percent of its global market cap — investors will scramble to cover their losses on leveraged bets. This could generate a ripple effect, bringing down commercial ventures outside of the financial sector, which would harm those least likely to own any financial asset, digital or conventional. Economic downturns disproportionately harm the poor, and 45 percent of Americans own no stock, according to a Gallup poll conducted last year, while only 14 percent of Americans own cryptocurrencies.
“What happens if a huge number of hedge funds who have prime broker relationships with too-big-to-fail banks all happen to be in similar crypto positions, whether it’s long or short, and there’s massive volatility in the market? They may have to sell some of their other assets,” said Goldstein, the director of financial policy for the Open Markets Institute and a former Wall Street banker who left the industry in 2010. She told the committee that losses on cryptocurrencies could lead to “forced liquidations” of non-crypto assets (stocks and bonds of other companies in hedge funds’ portfolios).
In March, for example, the failure of a private family fund called Archegos Capital dealt a blow to banks and non-financial firms alike, sending shock waves across the economy. Archegos had bet on the stock prices of certain companies to rise, including media conglomerates ViacomCBS and Discovery, by borrowing four to five times the amount of capital that it owned. When those bets started to go sour, Archegos’ creditors — major banks such as Credit Suisse, Morgan Stanley and Goldman Sachs — sold off some $35 billion in stock, as it became clear that their client would struggle to pay them back. The banks themselves also took hits: Credit Suisse lost more than $5 billion, and Morgan Stanley and Goldman lost about $1 billion each, The stock prices of ViacomCBS and Discovery fell 35 percent as Archegos’ creditors liquidated the shares they bought on behalf of the company.
As Goldstein warned, similar fire sales could happen because of hedge funds invested in wildly fluctuating cryptocurrency, especially considering rules on disclosure and leverage. Archegos didn’t have to reveal its stake in ViacomCBS and Discovery, like investors in cryptocurrency don’t have to do, because it had purchased derivatives based on the firms’ share prices, instead of directly investing in the companies’ stock. And while Archegos leveraged up to five times its capital, some cryptocurrency exchanges, like Binance, which has processed trillions in transactions this year alone, let clients purchase digital assets with $125 in borrowed money for every $1 of the client’s own money.
Financial markets may be able to weather a few major failures in normal times, but a sudden uptick in the number of hedge fund failures and corporate bankruptcies could lead to a wider crisis of confidence, increasing the potential for more asset sales, the failure of financial markets, mass layoffs and a recession. The potential for the broader economy to suffer from financial sector wheeling and dealing in any market is particularly acute at the moment. Corporate debt reached record levels in 2020 driven by promises of pandemic bailouts of bondholders from the Federal Reserve, and it climbed to new heights this year with “higher-risk, speculative-grade bonds … now on pace to set their own record,” as the Wall Street Journal said on June 14.
Goldstein told the committee that this market structure reminded her of working the derivatives trading desk at Merrill Lynch before the 2008 financial collapse — a catastrophe caused, in part, by exponential growth in the market for derivatives like credit default swaps that were traded “over-the-counter,” or without a central exchange to monitor excessive risk. Insurance giant AIG imploded in 2008 after entering into too many credit default swap agreements, which investors purchased as insurance to protect themselves from the failure of mortgage backed-securities. The contracts bankrupted AIG after the mortgage market collapsed in a failure that led to a $182 billion government bailout for the firm.
Another expert witness called by the Democrats to testify — Sarah Hammer, managing director of the Stevens Center for Innovation in Finance at the Wharton School of Business — echoed Goldstein’s concerns. Hammer said the lack of central clearing mechanisms remind her of the market conditions that allowed AIG to accumulate so much exposure to credit default swaps. Rules requiring derivatives to go through central clearing exchanges have been strengthened by Congress and the executive branch since the crisis. Hammer also warned that the market for cryptocurrencies is larger now than the market for subprime mortgages was before the 2008 financial crisis. She called for an interagency body created after that crisis to examine the cryptocurrency situation.
“I do believe systemic risk is a key concern. I do believe that the Financial Stability Oversight Council (FSOC) is the proper authority to consider systemic risk,” she said, noting that FSOC “has a specific mandate to do so.”
“The fact is that cryptocurrency has really infiltrated many different aspects of our financial system,” Hammer added. “Regardless of what we may think the benefits and costs of that may be, that is the reality of the situation today. Not only do investors hold crypto in their individual portfolios, we see it in private funds,” like hedge funds, and “we see it in banks.”
One major concern with cryptocurrency surrounds questions about its true value, with many people believing that the current price of popular digital assets like Bitcoin is wildly inflated on the back of irrational speculation. Cryptocurrency, for example, doesn’t pay out regular dividends like stocks and bonds. Michael Burry, the hedge fund manager made famous for predicting the 2007-2008 collapse of the mortgage market (he was portrayed by actor Christian Bale in the 2015 film The Big Short) recently predicted that cryptocurrency will lead to the “mother of all crashes.”
“If you don’t know how much leverage is in crypto, you don’t know anything about crypto, no matter how much else you think you know,” Burry also said, in a series of deleted tweets.
Some, including world-renowned economist Nouriel Roubini, have questioned whether cryptocurrency has any inherent utility.
However, because cryptocurrencies are based on “blockchain” — public ledgers that keep records of transactions and asset ownership with encrypted information — they can offer users privacy protection, if nothing else. Federal Reserve Vice Chair of Supervision Randal Quarles, who said in late May that regulators were engaged in a “sprint” toward a framework for cryptocurrency regulations, said on June 28 that Bitcoin’s “attractions are its novelty and its anonymity.”
Hedge funds appear to have seized on the latter benefits, according to Goldstein, who told the committee that it’s incredibly difficult for regulators to discern who is investing in cryptocurrencies. Institutional investors aren’t required to reveal cryptocurrencies holdings in mandated quarterly disclosures because digital assets aren’t “seen as an ownership interest,” she said. In the words of the Securities and Exchange Commission, the disclosure reports “generally include equity securities that trade on an exchange,” other assets based on company equity, “shares of closed-end investment companies, and certain convertible debt securities.”
“Regulators are essentially totally in the dark about what hedge funds’ cryptocurrency positions are,” Goldstein said. “They have to rely on the financial press or try to figure out based on the transactions on the blockchain,” she added. Hammer also noted that the federal government currently lacks an official data source for cryptocurrency activity, saying that, without one, “we’re a little bit in the dark about what the proper regulatory framework should like.”
Despite the opacity and the leverage allowed by cryptocurrency exchanges, conservatives were indignant at the thought of telling the financial industry what to do.
“It really frustrates me when I hear members of this committee imply that Americans are not smart enough to know that investing in cryptocurrencies carry risk,” said Rep. William Timmons (R-South Carolina), an incredible statement that glosses over the collateral damage done by the financial sector over the past 40 years. Wall Street has caused a crisis about once per decade since the 1980s, when the Reagan administration solidified the consensus in Washington around neoliberalism and deregulation, leading to the failure of 1,043 savings and loan associations later in the decade and in the early 1990s.
A hands-off approach to the financial industry also fueled the dot-com bubble around the turn-of-the-century, and the Great Recession a few years later. The latter, a much more severe crisis, was characterized by rosy pronouncements about the benefits of financial innovation. In 2005, then-Federal Reserve Chair Alan Greenspan declared that subprime mortgages brought credit to “once more-marginal applicants” because “lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately.”
“Especially in the past decade, technological advances have resulted in increased efficiency and scale within the financial services industry,” Greenspan said. “Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants.”
Still, the cryptocurrency industry and its allies appear to be approaching the matter of regulation with a techno-utopian view of financial innovation. During the June 30 congressional hearing, Republican witness Peter Van Valkenburgh, director of research for the D.C.-based think-tank Coin Center, said that cryptocurrency counters rising inequality because “an open blockchain network is accessible to people that banks and tech companies ignore rather than serve,” neglecting to acknowledge that it requires capital to acquire digital assets in the first place.
Research indicates that the average crypto investor has an income of $110,000, which is about three times the size of the median personal income in the United States. As Goldstein noted in her opening statement, blockchain records show cryptocurrency markets themselves reflect gaping levels of wealth inequality.
“The concentration of particular cryptocurrency assets into a small handful of addresses raise concerns about power concentrations,” Goldstein said, pointing to Dogecoin, a digital asset that started out as a joke but increased in price earlier this year by 12,000 percent before. It [dogecoin] lost about one-quarter of its value during a 24-hour period in May, during cryptocurrency sell-offs, and is now worth about 25 percent of what it was at its peak. “As of February, the top 20 largest Dogecoin addresses held half of the cryptocurrency’s entire supply,” Goldstein said.