Bitcoin is an emerging systemic risk: more and more people are entering the market, and the bubble may be getting bigger

Recent news reports have made it clear that people who are new to investing in Bitcoin have no idea what it is.

Bitcoin is a powerful tool for large transactions.

The cypherpunks who love it don’t care about money. They choose to hold Bitcoin for a long time, so they are not afraid of Bitcoin price fluctuations.

These newcomers are different. The only reason they invest in Bitcoin is to make money. They are very afraid of price fluctuations.

When we consider that new, naive laymen are entering the profession at the rate of millions every month, we should also understand that these laymen are more susceptible to the influence of animal spirits than their stoic, vulgar, socially awkward, battle-hardened ancestors.

They will tend to sell.

For example, a shock to the system: like trading in a necessary and delayed enforcement action, could lead to a loss of confidence in the entire cryptocurrency ecosystem and a stampede out of it, something that has yet to happen with Bitcoin.

A recent post on my blog pointed out that Bitcoin, as a distributed bank, also creates an unreasonable expectation for new “depositors” - that they will always be able to cash out part of their assets based on its $200 billion market cap and new investors’ funds, which creates a huge mismatch - obviously a scary number.

Such expectations are dangerous, meaning that in a liquidity crunch, people will not act as they would if stocks fell sharply, but rather will hold Bitcoin for the long term when the solvency of banks is in question. Remember the bank runs during the financial crisis?

The Bitcoin decentralized bank is running a fractional reserve that is chronically short of USD, so a shock would have the potential to not only drive the Bitcoin price lower, but also cause a major liquidity crunch and extreme panic.

Credit enters the cryptocurrency market

I wrote in my article:

“In the current environment, there are a number of areas where disruptions could occur. First, I highly doubt that intermediaries and dealers would be able to accumulate USD quickly enough to catch up with the funds that depositors and counterparties are making from Bitcoin. It is also possible that in a corrective event or enforcement action, risk-averse banks would withdraw credit or banking services to key service providers, refusing to allow service providers to convert Bitcoin into USD, provide them with margin loans, or even hold fiat deposits.”

I have a hunch that people will take out loans to get into this business. I just don't know the level of activity that will happen.

Luckily, I was reading a report released this afternoon by CoinDesk and the Consensus: The Investment Conference:

Responding to those speakers during a morning panel discussion, Dan Matuszewski, head of trading at Circle Internet Financial, said there is “real strong demand for lending” in the market.

He said the credit not only benefits short sellers, but also provides trading platforms with working capital to expand the market.

At the same time, B2C2's Boonen agreed that Bitcoin was created to satirize the 2008 subprime mortgage crisis.

He said that 'Bitcoiners really don't like credit,' but he added that 'for better or worse, credit is an essential part of the functioning and flow of financial markets.'

He noted that major exchanges were already offering leverage to early retail investors even before institutions committed money.”

So some people are lending directly into the market, we just don't know who these credit lines ultimately come from, how much they are, or the liquidity of these credits.

Others have infiltrated the ecosystem in other ways: Coinbase, for example, accepts credit cards, which is basic margin trading for moms — no collateral, 20% APR.

Because so many people appear to be interested in buying Bitcoin this way, and the platform is adding hundreds of thousands of new users each week, there is undoubtedly a systemic risk.

Then there are Bitfinex and Tether, which I am not going to discuss except to share this quote from the New York Times:

“One critic who goes by the name Bitfinex wrote several very detailed essays on Medium arguing that Bitfinex appears to be creating Tether out of thin air and then using it to buy Bitcoin and drive up the price.”

Simply put, these emerging industry giants, who are too young (or too busy like developers working in California) to know what a financial crisis feels like, and have a hard time figuring this out, have successfully (a) gotten buyers to buy coins using leverage - which in some cases works, or (b) convinced institutions to ease off on this one-way, unilateral, $300 billion crazy trade, and are trying to convince more people to do the same.

This could get serious

There are two, not necessarily mutually exclusive, reactions to the great bubble of 2017: one is anticipation of schadenfreude and the other is extreme fear.

So far, the response from mainstream finance has been the former, with the Wall Street Journal viewing it as more or less a long-running joke.

But while retirees try to show how hip they are by taking a “younger, younger”, “big coin” stance, the fact that they do so creates a lot of serious bubble risks (and attendant negative social externalities) that deserve further attention. The notional value of the cryptocurrency industry is currently about a third of what it was at the peak of Long-Term Capital Management.

Admittedly, cryptocurrency is much smaller than the subprime bubble that occurred a decade ago, and it is two orders of magnitude larger than Bitcoin is today. However, Bitcoin has repeatedly and relentlessly grown by orders of magnitude in less than 12 months to refute detractors like me. If it continues like this, it will be three times larger than Long-Term Capital Management, the company that nearly destroyed the world in 1998.

This is a market where financial institutions can get into serious trouble very quickly if we are not careful (imagine the risks involved with trading Bitcoin contracts like Nick Leeson or Kweku Adoboli – and the upcoming CME and rumored Nasdaq).

The crypto market is writing checks that can't be cashed; most of these systems are not capable of functioning as the backbone of global finance. It's only a matter of time before the disillusioned investor on the street turns into a cranky blockchain software entrepreneur like me. It's just that none of the new guys know what they're doing, and most of the old timers who do know are keeping their mouths shut for their own benefit.

In other words, a disaster waiting to happen. Fortunately for us, 2008 is not ancient history, and Bitcoin is a classic mania bubble, and it is so obvious that someone with a heart must have another solution. There is no reason to ignore the society and taxpayers who bailed out the financial services industry last time.

Reject it

So, banks, shadow banks, and any other systemically important institutions, I implore you: for the good of everyone, and I mean for the good of all humanity, get this garbage and anything associated with it off your balance sheets.

Just for once, please understand, don't accumulate in frothy financial assets that are frothing. What you have done so far has predictable patterns, like the European Central Bank can simulate it, and wrote a 52-page document that is very interesting to read.

That way, when regulators finally take the party to the bitter end of its well-deserved mess, the rest of the ship won’t go down with it.