Crypto: A Nightmare Scenario | Seeking Alpha

The Financial Times gets the week going today as it discusses in its main editorial piece the challenges facing the G20 finance ministers at the past weekend’s meetings.

One of the most prominent issues the G20 has to deal with is financial regulation: setting global rules for managing cryptocurrencies.

No major changes in regulation were announced. But agreement to accelerate monitoring and to find regulatory gaps that need filling, are welcome first steps in the journey to ensure speculation in crypto remains an individual, rather than a socialized risk.

Policymakers used to assume that crypto, while problematic for a number of reasons would not threaten the health of the financial system.

This assumption may not be safe for much longer as cryptocurrencies and related assets become more mainstream.

The nightmare scenario would be a crypto version of the 2008 financial crisis.

Is This A Real Possibility?

Could the world possibly expect a “crypto version” of the 2008 financial crisis?

This crisis is connected with what is now called the “Great Recession.”

Could we have another Great Recession?

The answer to this question, I would argue, should be yes! We certainly could have another Great Recession.

The foundation for such a result is captured by some figures contained in a speech by Governor Lael Brainard of the Board of Governors of the Federal Reserve System.

Ms. Brainard has served on the Board of Governors for eight years now and has just been nominated by President Joe Biden to serve another eight years on the Board, this time as the Vice Chair of the Board. She is waiting for the U.S. Congress to approve her nomination.

She just spoke at the 2022 U.S. Monetary Policy Forum in New York City on “Preparing for the Financial System of the Future.”

“In recent years, there has been explosive growth in the development and adoption of new digital assets that leverage distributed ledger technologies and cryptography.”

Ms. Brainard then recites these numbers.

“The market capitalization of cryptocurrencies grew from less than $100 billion five years ago to a high of almost $3 trillion in November 2021 and is currently around $2 trillion.”

Wow!

Since November 2021, the market capitalization of cryptocurrencies dropped by one-third.

What seems to have caused this drop?

Well, a lot of analysts are looking at the fact that the price of Bitcoin (BTC-USD) and other currencies have been moving more and more with other market assets like stock prices.

Let’s take a look.

Stock Prices and Bitcoin Price

I am only going to go back to early 2020 to pick up this argument.

Near the end of April, 2020, the price of one bitcoin was around $7,750.

On November 9, 2021, the price had risen to a peak of over $67,000.

On Friday, February 18, 2022, the price has dropped to around $40,000.

And, there you have the drop of about one-third from last November to the current time.

What happened during this time period?

Well, let’s take a look at what the Federal Reserve did during this time period.

First of all, the spread of the Covid-19 pandemic really hit the United States in late 2020 and early 2021.

Then there was the occurrence of an economic recession that began in February 2021 and lasted through April 2021.

The Federal Reserve reacted very strongly to these events and moved aggressively to keep the economy from going into a deeper financial crises and a severe economic downturn.

The Fed moved to err on the side of aggressive monetary ease.

In April, the Federal Reserve began to purchase on a monthly basis, $120.0 billion in securities to hold in its portfolio. It allowed its policy rate of interest, the Federal Funds rate, to float.

The Federal Reserve continued this policy approach until September 1, 2021.

Since September 1, 2021, the Federal Reserve has kept its policy rate of interest constant at 0.08 percent. The Fed did not want its Federal Funds rate to drop into negative territory.

The Fed continued to buy $120.0 billion of securities every month up until January 2022. But, it began to sell securities in the “repurchase” market in the fall of 2021 and it continued to use reverse repurchase agreements through the rest of the year into 2022.

Before this action, the “excess reserves” in the commercial banking system were about $0.1 trillion, and had been varying somewhere between $0.1 trillion and $0.5 trillion.

The consequence of this action was that the “excess reserves” in the banking system topped out and began to decline. These “excess reserves” topped out on September 8, 2021 at about $4.3 trillion and remained at this level until about the middle of December.

Since the middle of December, these “excess reserves” dropped to about $3.8 billion on February 16, 2022.

In terms of stock prices, the S&P 500 Stock Index closed on September 2, at a new historical high of 4,536.95.

In late October and early November, the S&P 500 hit eleven new historic highs.

This was right around when the market capitalization of cryptocurrencies hit around $3.0 trillion.

Seems as if the price of Bitcoin followed stock prices.

Note that stock prices became much more volatile in November and December. This helped to account for the S&P 500 hitting a new historical high, its last one, on January 3, 2022.

But, with all the talk about how inflation seemed to be taking off and how the Federal Reserve was going to “taper” its security purchases to zero in March and that the Fed was going to raise its policy rate of interest, also in March.

Since the start of January, stock prices have declined, as have bitcoin prices.

Where We Are Now

Right now, the Federal Reserve has been tapering its purchases of securities for two months.

Everyone is ready for the rise in the Federal Funds rate in March and people are now talking about the possibility that there might be up to five increases coming this year.

To get the Federal Funds rate rising by this much, the Fed is looking to further reduce the amount of “excess reserves” that are now in the banking system, possibly by reducing the amount of securities on the Fed’s balance sheet.

That is, monetary policy could really “get tight”!

Jerome Powell, Fed Chair, and the other Federal Reserve leaders have not been clear here about what exactly they are going to be doing next.

But, if inflation is to be fought, some combination of a smaller Fed securities portfolio, a higher Fed Funds rate, and lower excess reserves in the commercial banking system is going to have to take place.

When this happens, stock prices will fall. They may drop fairly far.

And, will the price of bitcoin drop?

The bitcoin price is much more volatile than stock prices.

So, if stock prices drop by twenty percent, how much will the price of a bitcoin drop?

Fifty percent?

Or, more?

Would this “nightmare scenario” be the crypto version of the 2008 financial crisis?

Would this be the end of bitcoin?