The liquidity quake in crypto

A one-two punch in liquidity is hitting the economy and the prospect of a recession is surging as a result. I would expect that we will “discover” that we are in a recession in the next quarter or so. The Fed’s conviction that it needs to rapidly raise rates to control inflation is the main driving force. Indeed, Fed Chairman Powell in his 6/22/22 testimony to Congress announced that his commitment to controlling inflation was “unconditional.” I would expect an unconditional commitment from the Fed until we approach the midterm elections when the political realities of inducing a recession will probably cause the Fed to take its foot off the interest rate pedal.

The economy is getting a liquid drain from a much-underappreciated source: crypto and crypto fraud. The glamor of cryptocurrencies has been lost. Crypto was supposed to hedge against inflation. It has not and in some sense has lost an essential purpose for its being in the process. Not offering a hedge against the current rampant inflation is clearly a factor driving its price down. As the recession unfolds, the demand for crypto as a risk asset and its inability to hedge inflation will provide the headwinds against crypto, pushing the thermometer down in its crypto winter.

Crypto is a canary

It is also imperative that we remember that the weakest, not the strongest parts of the financial system, are the canaries in the coal mine for a fiscal crisis. The crypto market’s problem presages bigger problems for the larger economy.

Two weeks ago, I said that the collapse of the stablecoin Terra (UST) brought back memories of the Lehman Brothers collapse. It is well worth thinking about this again. The key concept here is “contagion.” How could an asset as small as Terra affect the broader US economy? The simple word is leverage.

The size of the Terra collapse was about $40-60 bn. But Terra was leveraged to an unregulated, and still unknown, amount. One might assume, given the nature of the trading, that a maximum, 99% leverage ratio applied. This would cause Terra’s collapse to reduce crypto liquidity by as much as $400-600 bn. Now, with numbers like this, we are talking about contagion for the larger economy. This Terra collapse plus the Fed raising rates seventy-five bp and other liquidity-reducing monetary policies all will have a compounding effect on economic activity. It will slow the economy more than the Fed expects.

Liquidity crunch

In a world of easy money, it is sometimes difficult to imagine a liquidity crunch. But that is indeed what is happening in crypto after the Terra collapse. The Terra problem happened because of a run on the bank. The essence of financial contagion is the connection between one liquidity problem and another. The direct linkages are not always clear or disclosed. Nevertheless, since Terra, we have now had at least two crypto exchanges limit distributions, and the market as a whole fear more liquidity problems.

Regulators and economists have been dismissive about the effect of crypto collapses, some saying that the crypto market is too small to affect the overall economy. This might be true if the two trillion dollars in losses in the crypto market this year were not leveraged. The Lehman Brothers’ losses would not have generated the financial crisis that it did without the enormous leveraged financing involved. But like Lehman, the crypto liquidity crisis will be enormous and slow-moving.

Crypto fraud pressure

The contagion effects of crypto illiquidity are compounded by the accelerating fraud in cryptocurrency. The range and ingenuity of the frauds is impressive, from pump and dump schemes and Ponzi schemes to more elegant varieties. The total effect, however, is a geometrically growing rate of fraud.

The fraud forces more leverage into the market as investors need to add leverage to their holdings to pay for the expected losses. Crypto fraud is a leverage problem that needs a regulatory solution.

The prospects for a recession are high and the failure to address the regulatory problems in crypto compound the Fed’s effect. It also introduces the potential for unforeseen liquidity problems, producing a quick recession. For the Crypto market, illiquidity is likely to grow to an even larger problem than it has already faced.

Investor Implications:

1. Expect an increased amount of fraud in cryptocurrency investments.

2. Demand crypto returns from coins to compensate for significant frauds.

3. All investors will face rising costs of liquidity.

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This article is not intended as investment, tax, or financial advice. Contact a licensed professional for advice concerning any specific situation.