In the late 1990s, it was widely understood that Beanie Babies – a line of miniature stuffed animals – were in the midst of a speculative bubble. At one point, Beanie Babies made up 10% of eBay’s sales and over 60% of American households owned at least one Beanie Baby. Yet, there were no calls to ban Beany Babies, and no concerns that the Beany Baby bubble threatened financial stability.
In the mid 2000’s, several prominent academics and market participants argued that the country was in the midst of a housing bubble that was bound to end badly. Some regulators even pushed for stricter regulations and reporting requirements in an effort to remove some air from the bubble. When the housing market collapsed and took the financial system down with it, the consequences were devastating – close to 9 million Americans lost their jobs.
The impact of a popped asset bubble depends on where it lies between these two extremes. In our previous post, we made the case for why the cryptocurrency market is currently in the euphoria phase of a traditional asset bubble. In this post, we identify the key features of the cryptocurrency market that will determine its broader impact when the bubble bursts. We find that the cryptocurrency market is currently more Beany Baby than housing market circa 2006, and that a cryptocurrency bubble may actually be a good thing.
How Can a Bubble Be Good?
We are inclined to think negatively of bubbles. After all, we know that many people will suffer financially when a bubble bursts, and we are hardwired to fear losses more than we value gains. Loss aversion leads many to argue for aggressive government intervention to either prevent bubbles from forming or to take the air out of existing asset bubbles. But not all bubbles are created equal, and the impact when a bubble bursts, what’s called the ‘crisis phase,’ depends on a variety of factors.
The economic impact can vary depending on the time horizon. In the short-term, the pain associated with financial losses can be acute, while in the long-term, society can benefit if the innovation which gave rise to the bubble is put to beneficial use. Before we assess the potential long-term benefits of a cryptocurrency bubble, we need to take stock of the present market so that we can better understand the more immediate risks the bubble poses.
It is no surprise that the size of a given asset class will influence the severity of the crisis phase if that asset class collapses; the sub-prime housing market was orders of magnitude larger than the market for Beanie Babies. So where does the cryptocurrency market rank relative to other prominent asset classes? The following data points will help put things in perspective:
- The total market capitalization for all cryptocurrencies (excluding ICOs) is over $330 billion (Almost $4 billion has been raised all-time through initial coin offerings.)
- In 2006 alone, $600 billion of subprime loans were originated.
- The leveraged loan market in the U.S., which regulators have previously expressed concern over, reached over $900 billion in loans outstanding at the end of May.
- At the end of last year, the high yield bond market in the U.S. totaled $1.5 trillion.
- At the end of June, the global over-the-counter credit default swaps market stood at $9.6 trillion in notional principal outstanding.
- The Venezuelan government, which is in default on its sovereign debts, has approximately $63bn of foreign bonds outstanding.
- Snap, the parent company of Snapchat, which has seen its stock price steadily decline since its IPO in March, has a market cap of roughly $16.3 billion.
- When the Dotcom bubble burst in the early 2000’s, the market value of Nasdaq companies declined by $5.1 trillion.
Compared to more traditional asset classes, we see that the cryptocurrency market is relatively small. However, these asset classes have developed over the course of many years, whereas over 90% of cryptocurrencies current market cap was achieved within the past year. Such astounding growth, coupled with extreme volatility, is indicative of an extremely fragile asset class.
For a fragile asset class, the cryptocurrency market is not so small; it is 5 times larger than what is currently owed by Venezuela’s government, and 20 times Snap’s market cap. If the cryptocurrency market were to experience a sudden downturn, this would be a major market event. However, it is difficult to assess how widespread the damage would be due to limited information on who owns cryptocurrency. Anecdotal evidence suggests that most cryptocurrency investors are young, tech savvy individuals. Therefore, the pain associated with a market collapse would likely be concentrated, but this assumes there is limited overlap between the cryptocurrency market and the broader economy.
The severity of the crisis phase will depend on the presence of amplification mechanisms, which have the ability to “increase the magnitude of the correction in the part of the economy that was aﬀected by a bubble and spread the eﬀects to other parts of the economy.” One common amplification mechanism is interconnectedness within a network of institutions, the scope of which may not be clear until the bubble bursts. Such was the case with the financial crisis, when it became apparent that many large non-bank financial institutions had significant exposure to the U.S. housing market through the use of derivatives. By using derivatives, these firms also exposed themselves to counterparty risk. Thus, when the housing market soured, it led to the collapse of Lehman Brothers, which further accelerated the crisis as other financial institutions had significant counterparty exposure to Lehman. It took unprecedented government intervention to stop other too-big-to-fail firms from toppling like dominoes.
Although the picture is hardly clear, at present, the cryptocurrency market is relatively insulated from other parts of the economy. Traditional financial institutions have yet to wade into the cryptocurrency waters, refusing to trade cryptocurrency themselves or on behalf of clients. Additionally, the cryptocurrency derivatives market is quite limited, further restricting avenues for contagion.
The use of leverage is another amplification mechanism. Investors who borrow in order to buy the asset will be forced to sell when the market turns in order to meet margin calls. This dynamic was on full display during the financial crisis, as households and businesses alike were forced to sell assets to stay afloat, which led to further price declines and forced sales (referred to as fire sales.) Until now, investments in cryptocurrencies have largely been conducted on a cash basis, as few firms have been willing to provide credit to cryptocurrency investors for a variety of reasons.[i]
Things May Change
The above analysis indicates that if the cryptocurrency market faced a severe contraction, the spillover effects would be negligible. But this analysis is based on a static market – the cryptocurrency market is far from static. The market is continuously evolving, and becoming larger and more interconnected every day. Large financial institutions are considering how they may facilitate cryptocurrency trades on behalf of clients, high frequency trading firms are now trading cryptocurrencies, and the first regulated Bitcoin futures will begin trading next week. These moves will usher in a whole new class of institutional investors who, until now, have been sitting on the sidelines. The introduction of regulated instruments also provides investors the opportunity to borrow to purchase Bitcoin. More leverage, and more investors, mean Bitcoin and other cryptocurrencies have room to run. It also means the market is becoming more interconnected, which will increase the severity of the eventual crisis phase. There is no telling how far the market will develop before the bubble bursts. That said, the cryptocurrency market will not credibly threaten financial stability for the foreseeable future.
Bubbles Can Create Valuable Infrastructure
One source of value in a bubble according to Daniel Gross, author of the book Pop! Why Bubbles Are Great For The Economy, is the underlying infrastructure which, post-bubble, gets consolidated and put to long-term use. For example, the creation of “Web 2.0” post-dotcom bubble led to the development of social media and the Internet as we currently know it.
When the cryptocurrency bubble bursts, it will not mark the end of cryptocurrencies or the blockchain technology underpinning them, just like the dotcom bubble did not mark the end of the Internet. Instead, these new technologies will be deployed in a way that can reduce costs and generate efficiencies for existing businesses. Already, we’re seeing blockchain technology being used to track supply chains and reduce the time it takes to clear and settle financial instruments. It is also being used to fund early stage investment in new companies, allowing innovators to access capital and take the risks necessary to grow the economy. These use cases, and more, will continue well after the bubble bursts.
Gross also suggests that bubbles can lead to the development of “mental infrastructure,” meaning that the public will continue grow more comfortable with the underlying technology, even after the bubble bursts. As Gross states, some of the money raised during bubbles is “spent on marketing, advertising, promotion, hype and brand awareness.” As more people learn about Bitcoin and blockchain, they will grow more comfortable utilizing the technology going forward.
Bubbles Can Lead to Greater Investment in Research and Development
Of course, the valuable infrastructure bubbles create requires investment. John Cassidy, author of How Markets Fail: The Logic of Economic Calamities and Dot.con: How America Lost Its Mind and Money in the Internet Era, wrote that bubbles can facilitate research and development in areas that end up being very useful post-bubble (such as advancements in fiber optic cabling during the dotcom bubble). This idea is echoed by economist Steven Fazzari, who has also argued that market bubbles lead to greater levels of research and development, as there is a “link between access to finance and the amount of research and development that firms, particularly young ones, carry out.” Blockchain expert Peter Van Valkenburgh labels this research into speculative technologies “socially productive” as it “allocates capital to long-shot paradigm shifting innovation.”
It is not just the amount of investment that matters but also who receives the investment. A Journal of Financial Economics study by Ramana Nanda and Matthew Rhodes-Kropf (2013), looked at “seed or series A investment” in technology start-ups from 1985 to 2004 (a total of 12,285 firms), and showed that venture capital (“VC”) activity in the United States during “hot markets” led to risky investing by VCs but also “a mindset of experimentation and a willingness to fail” that facilitated investments in innovative companies that may not have otherwise received funding during a ‘normal’ market.
An interesting observation from their study, and one that has a direct cryptocurrency application, is what happens in the “tails of the distribution of outcomes” of start-ups that obtain funding during bubbles. The authors report that although companies that were started during a “hot period” are “significantly more likely to go bankrupt than those founded in periods when fewer start-up firms were funded”, other companies funded during these periods end up being “extremely successful and innovative”. In other words – there may be evidence that a bubble has the effect of extending both sides of the distribution “tail” – there will be more failure, but there will also be more instances of “extreme success” (or outliers), and if a company succeeds (Nanda and Rhodes-Kropf defined success as an “IPO or acquisition”) it will “simultaneously create more value.”
VCs sometimes refer to this ideal of “extreme success” on the outer tail of the distribution as the “Babe Ruth Effect,” meaning the best VCs have “more home runs of greater magnitude.” This may at least partially explain the willingness of VCs to test the volatile ICO market – even if they suspect it to be a bubble – in an attempt to nab an early stage extreme outlier. One could argue that investments in a hot market are socially beneficial because they allow VCs to fund high-risk, high-reward companies (which often results in a greater net benefit to society), whereas in a regular market these companies would never receive funding.
Weighing the Costs with the Benefits
Public policy is typically made after carefully considering potential costs and benefits. When deciding how aggressively to intervene in the cryptocurrency market, governments must weigh the potential consequences of an ever-growing bubble bursting in dramatic fashion, against the long-term technological benefits this bubble may create. An ideal policy would be one that facilitates the technological gains while also reducing any negative externalities when the bubble pops. This balancing act becomes even more difficult when you consider it is a multiplayer game, to use the parlance of game theory. If one country moves to crackdown on the cryptocurrency market, then activity and investment may simply move to another jurisdiction. In September, when the Chinese government banned initial coin offerings (ICOs), coin exchanges, commercial trading and even one-on-one or peer-to-peer trading, the cryptocurrency market barely blinked before carrying on its upward trajectory.
The Chinese example may demonstrate the futility of governments attempting to regulate an activity that occurs solely online across a decentralized global network of computers. The ability to operate outside governmental control is exactly what attracted libertarians and crypto-anarchists to cryptocurrency in the first place, fueling its initial growth.
Other jurisdictions have adopted a more conciliatory stance, perhaps in the hopes of harnessing cryptocurrency’s technological benefits and capturing any first mover advantages that come with it. This past April, Japan passed a law that made Bitcoin legal tender and in September, the Japanese Financial Services Authority recognized 11 companies as registered cryptocurrency exchange operators. In addition, Dubai recently launched a government-backed cryptocurrency called “emCash,” while Sweden’s Riksbank is considering its own versions of digital currencies.
The United States’ Response
The United States’ fragmented regulatory structure prevents any kind of coordinated response to the cryptocurrency market. The SEC, acting as securities market regulator, has primarily been focused on rooting out fraud, an inherent feature in every asset bubble. In September, the SEC created a new Cyber Unit to investigate, among other things, misconduct involving distributed ledger technology and initial coin offerings. Earlier this week, the unit filed its first charges against an individual and his company for making false representations regarding “a fast-moving Initial Coin Offering.”
As prudential supervisors, the Federal Reserve and OCC are focused on the safety and soundness of the banking system. Because cryptocurrencies are primarily traded outside the banking sector, these agencies have been relatively silent on the topic. However, the Fed is also responsible for maintaining the safety and efficiency of the payments system, and it is under this capacity that they have begun thinking about a Fed backed digital currency.
The Financial Stability Oversight Council (FSOC) is the one agency capable of bringing more order to the government’s response to the cryptocurrency market. The FSOC has a clear statutory mandate for identifying risks and responding to emerging threats to financial stability. However, the Trump administration appears to be more focused on neutering the FSOC than on ensuring it fulfills its statutory mandate. Even if the FSOC finds the cryptocurrency market poses a material threat to financial stability, it lacks the authority to do anything about it, absent designating specific firms as systemically important and subjecting them to enhanced supervision.
Innovators operating in the cryptocurrency space frequently complain about having to deal with multiple regulatory agencies and their often-conflicting guidance. However, overall, U.S. agencies have responded on a limited basis to the still nascent cryptocurrency market. This has allowed the market to grow in the U.S., driven by a steady stream of investment. More importantly, it has led to the further development of technologies that will have a lasting impact long after the cryptocurrency bubble bursts.
While our fragmented regulatory structure has thus far prevented heavy handed intrusions in the cryptocurrency market, it could also someday prevent an appropriate and necessary response should the cryptocurrency market grow to such a degree that the cost-benefit calculus changes in favor of greater intervention. But that is a problem for another day.
[i] These reasons include concerns around the unregulated status of cryptocurrency, price volatility, a lack of infrastructure, and counterparty risk.