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To the best of my knowledge, no bank will allow a borrower to provide crypto as collateral for a loan. So, if the price of crypto crashes to zero, there shouldn't be any liquidity issues because no fiat backed by crypto had been created.

All that would happen with a crash would be a redistribution of wealth: the people who sell first get the most, and the people who sell last get nothing.

So, why are bankers claiming a crash would cause liquidity problems for the financial sector?

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  • $\begingroup$ "All that happens" in any crash is a "redistribution of wealth". $\endgroup$ – Hot Licks Feb 13 '18 at 2:15
  • $\begingroup$ @HotLicks Yes. Redistribution of wealth doesn't cause liquidity problems. Money would have to disappear for that to happen, money created with the backing of a worthless asset (such as homes during the 2008 meltdown) $\endgroup$ – CDM Feb 13 '18 at 2:24
  • $\begingroup$ Suddenly my \$100M Bitcoin is worthless. Wouldn't be such a big deal except that I've borrowed \$90M in real money against the value of the Bitcoin. Now the bank's demanding their money back. Wouldn't be such a big deal except some other Bitcoin investors are clamoring to get their savings out of the bank to pay their current bills. So I'm in deep yogurt, and so is the bank and some of the bank's depositors. $\endgroup$ – Hot Licks Feb 13 '18 at 2:29
  • $\begingroup$ @HotLicks No bank accepts Bitcoin as collateral. So, you wouldn't be able to borrow real money against Bitcoin. You would have to convert the 100M in BTC to cash to use the value of it as collateral. So, no liquidity issues. $\endgroup$ – CDM Feb 13 '18 at 2:37
  • $\begingroup$ The bank doesn't necessarily know that I'm relying on the Bitcoin to cover my loan -- I also "own" Trump Tower, but (if they really looked) it's already mortgaged to the hilt. The point is that I have a cash flow problem that I was counting on the Bitcoin to carry me through. $\endgroup$ – Hot Licks Feb 13 '18 at 2:40
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As an initial note, I have not seen any plausible claims that a crypto crash would cause liquidity problems for the financial system. As a reult, I would need to guess to the mechanism.

I do not think “liquidity” is what anyone should worry about right now. For a firm we need to distinguish between illiquid and insolvent.

  • Illiquid: the firm does not have enough short-term assets (“cash”) to meet short-term liabilities.
  • Insovent: the net worth (equity) of the firm drops below zero.

A bank loan is an illiquid asset. As a result, loan losses do not directly cause illiquidity; they cause insolvency. Of course, people will not normally lend short-term to an insolvent bank, so it will be illiquid later. (If the concern is about money creation, impaired deposit growth would only be a consequence of insolvency.)

Can a crypto crash cause a general wave of insolvencies? That is difficult to answer, but we can look at the possibilities.

The credit risk at the time of writing appears to from individual investors borrowing to buy cryptocurrencies. The only business borrowing that I am aware of is by the crypto exchanges - they borrow to support customer borrowering. Such loans are covered by two parties - the customer, and the exchange. We cannot double-count these debts as a result.

As for customers, banks either lend against collateral, or cash flow.

No sensible bank would lend against most crypto-currency collateral: most of the cryptocurrencies are designed so that authorities cannot seize them. Unless there is an exchange-traded fund (which can be used for margin debt), such crypto-based lending will be negligible.

Banks could lend against other collateral, such as a second mortgage. However, such loans are backed by both the home as well as household cash flow. People take out second mortgages to go on vacation or to fund small businesses (which mainly fail); there is always a safety margin for the banks in such lending.

Unsecured lending is lending against income. The recent wave of banks blocking cryptocurrency purchases via credit cards is a sign that some are getting uncomfortable with such risks. However, losses would only materialise if the involved investors are cash-flow impaired (lose their job in most cases). Although such cases will happen, any losses need to be looked at in the context of other sources of loss, such as those caused by medical emergencies in the United States.

In order for these losses to pose a systemic risk, it would probably require large job losses, which by itself poses a risk.

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