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The similarities between the cryptocurrency bubble and the 2008 financial collapse are growing eerily similar, and regulators are sounding the alarm. Also: - 🛑 Elon took a big L last week.
- 📉 Charitable giving hits hard times.
- 💸 Trump’s cabinet pick wants health insurance companies to get richer.
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Regulators Warn Crypto Could Cause Another Financial Crisis
By Freddy Brewster
[View in browser] As the cryptocurrency industry scored massive electoral wins in November and skyrocketing crypto prices currently push the global valuation to more than $3 trillion, federal regulators have issued warnings about the nascent industry’s potential to cause widespread disruptions to traditional banking and financial markets. The reports, which highlight crypto’s volatility, lack of regulations, and growing ties to traditional markets, echo alerts issued about the subprime mortgage industry before the 2008 financial crisis. “I think you could sort of look at this… as a signpost for the future,” said Mark Hays, associate director for cryptocurrency and financial technology at the consumer advocate group Americans for Financial Reform. “If things go wrong, a report like this is one of those things that you look back on to say, ‘What were the early warning signs?’” The two reports, both from nonpartisan federal agencies, caution about the possible negative ramifications if crypto becomes more entwined with traditional financial institutions, among other concerns. One report also warns about the consequences of an increasing number of consumers taking out loans to finance risky cryptocurrency bets — a process called “leveraged trading.” Cryptocurrencies are a digital currency that are not associated with any governments. That lack of government control and regulation can lead to their volatility, which has already caused some consumers to lose their life savings during previous crypto crashes. In a new report from Federal Reserve Bank of New York, a branch of the U.S. central bank tasked with issuing interest rates, supervising private banks, and other responsibilities, economists warned that cryptocurrencies’ volatility and interconnectedness could have damaging effects on banking and financial markets as more people use loans to make risky bets on crypto prices. “The use of leverage by crypto investors appears widespread, amplifying investors’ exposure to shocks to crypto-asset prices and the feedback loop between leverage and crypto-asset prices,” the economists wrote in their Nov. 1 report, which follows a similar report issued in 2022. Crypto bets in general appear to be growing. According to one leading crypto analytics firm, new accounts for trading Bitcoin, the original cryptocurrency created by an anonymous person in 2008, rose 26 percent in the 10 days after Trump won the election. The report also debunked some of crypto’s core tenets — that is a hedge against inflation and free from government control — by highlighting the industry’s mounting efforts to become more entrenched within traditional markets and noting that crypto prices have been rising and falling due to interest rates.
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“Crypto assets rose sharply in value during 2020 and 2021 — a period of historically low interest rates — and began to fall in value as central banks began to raise interest rates to fight elevated inflation,” economists found. A second report from the Office of Financial Research, a nonpartisan independent bureau reporting to the Treasury Department, found that zip codes with the highest levels of cryptocurrency holders in recent years saw spikes in households taking out auto and mortgage loans. “The considerable increase in usage of crypto assets, the values of which are substantially more volatile than other asset classes, could present a financial stability risk if there are spillovers onto household balance sheets or sectors in the real economy,” researchers wrote in a Nov. 26 report. The researchers also stated that future monitoring should focus on low-income consumers with high debt and crypto holdings because economic distress within this group could signify future problems in banks and other financial institutions. Although the reports pose hypothetical possibilities and shy away from making overt recommendations, experts have likened the Federal Reserve report to similar alerts issued before the 2008 financial crisis. One of the earlier warnings highlighted a 2006 spike in delinquencies among subprime mortgage borrowers, detailing how those delinquencies led to foreclosures. “Contagions Can Spread Quickly”The new reports were released as the crypto industry spent more than a quarter of a billion dollars to help elect pro-crypto candidates to Congress and place key allies in the incoming Trump administration. More than 270 pro-crypto candidates were elected to the House of Representatives and the Senate will have more than 50 pro-crypto lawmakers — making it all but certain that a number of the industry’s demands for loose regulatory oversight will be enacted. President Joe Biden’s administration repeatedly cracked down on crypto. The Securities and Exchange Commission (SEC), one of the main agencies tasked with regulating crypto, aggressively issued enforcement actions and lawsuits against companies and cryptocurrency creators who failed to properly register their exchanges and products. This approach is likely to change as President-elect Donald Trump has vowed to make the United States the “crypto capital of the planet,” and lawmakers revive a number of shelved crypto-friendly bills for a vote. The crypto market is currently worth more than $3 trillion. That’s nearly $2 trillion more than the 2008 value of the subprime real estate debt market, which played a major role in the 2008 financial crisis. What’s more, Trump just nominated someone who helped grease the skids for the 2008 collapse. Last week, Trump announced Paul Atkins as his nominee to lead the SEC, with crypto titans applauding the decision. Atkins is a “deregulation zealot and industry cheerleader” who as an SEC commissioner, appointed by former President George W. Bush, from 2002 to 2008 supported policies that helped contribute to the 2008 financial crisis, said Dennis Kelleher, president of the financial markets watchdog group Better Markets. During his time as a commissioner, Atkins pushed rule changes that weakened leverage ratios for Wall Street banks, making them more susceptible to economic collapse, and supported the repeal of a rule that prevented manipulative short selling of securities, Better Markets told The Lever. Trump also nominated Howard Lutnick to head the Commerce Department, another agency tasked with overseeing crypto. Lutnick is the CEO of Cantor Fitzgerald, a financial firm that allows clients to use Bitcoin as collateral for loans and deals in other crypto services. Additionally, Trump named venture capitalist David Sacks to be his White House artificial intelligence and cryptocurrency czar. Sacks has personal ties with billionaire Elon Musk,helped recruit a number of wealthy Silicon Valley investors to support Trump this past election cycle, and has been a crypto cheerleader for years. These crypto boosters could push Trump to further integrate the currencies into traditional financial markets by allowing banks and financial institutions to hold larger amounts of crypto and allow more banking investments into the crypto sector, among other policies. But the Trump administration should proceed carefully because crypto’s inherent volatility could have dramatic consequences on the broader economy, said Adam Rust, director of financial services at the Consumer Federation of America, a consumer protection group. “I hope that they will proceed cautiously with any integration of crypto into the banking system,” Rust told The Lever. “There’s no doubt that [crypto] is extremely volatile. There’s no way to disagree with that view, and it strikes me that it’s also pretty incontrovertible that contagions can spread quickly.” Crypto’s 100-Day AgendaThe new regulatory warnings come amid one of the most influential cryptocurrency trade associations issuing a 100-day policy agenda for the Trump administration. The 100-day plan issued by the Blockchain Association calls for the Trump administration and Congress to establish a more friendly market structure for the crypto industry, appoint new chairs at key government agencies and develop a crypto-focused advisory council to work with Congress and regulators. Perhaps most pressingly, the agenda also calls to “end the debanking of crypto.” “Crypto companies and users have been unjustly denied access to traditional banking rails critical to paying employees, vendors, and taxes,” the Blockchain Association wrote. “This practice should end immediately.” “Debanking” has become a hot-button issue for the industry. Venture capitalist and crypto funder Marc Andreessen recently highlighted the matter during an episode of the popular podcast, the Joe Rogan Experience, in which he claimed that tech founders were being denied access to banking services. Other tech founders, including crypto exchange Coinbase CEO Brian Armstrong, chimed in on social media, claiming they’ve experienced similar treatment. Regulators overseeing traditional banks and financial institutions have policies that restrict banks from doing business with companies or clients that are financially unstable and have sweeping financial risks, such as cryptocurrencies. One particular policy that has angered the crypto industry is an SEC staff bulletin that requires financial institutions, including crypto exchanges, to report their customer’s crypto holdings as liabilities — an accounting term that essentially means money owed — on their balance sheets. This would mean that crypto exchanges and other financial institutions that hold users’ cryptocurrencies would have to publicly disclose how much and what kinds of cryptocurrencies they are holding on behalf of their clients. The crypto industry has “strongly disagreed” with the policy because it could “constrain lending or other income-producing activities, making crypto custody services economically infeasible for many firms, among them banks with valuable experience offering custody services,” wrote DLA Piper, an international law firm that specializes in technology, finance, and other areas. These regulations helped prevent a more dramatic collapse when multiple banks working with the crypto industry failed in 2023, said Hays.
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“I think one can argue reasonably that [regulations] prevented the crash from spreading further, because there weren’t a lot of banks that had exposure to the crypto sector,” Hays said. “They weren’t investing in it, they weren’t holding assets that suddenly disappeared.” The new Federal Reserve report laid out what could happen if Congress and regulators allow the crypto industry to become more entwined with one another, he added. For example, the report warned that the interconnectedness of various cryptocurrencies makes them “fragile” to price swings, which could lead to a run on deposits if the crypto markets were to drop in value like it in 2022 and 2023. “The crypto sector really wants access to banking services, and they want banks to invest in crypto,” Hays said. “And so given that, this [Federal Reserve] report is kind of laying out what could happen if they get really close.” “A Crash Could Be A Lot Bigger”The Federal Reserve report detailed a variety of cryptocurrency concerns, including the use of loans to finance risky crypto transactions, crypto’s history of dramatic price swings, and scams associated with decentralized exchanges that are hard to police because there is no centralized governing body. Perhaps the most concerning aspect of the report detailed how consumers use loans to fund cryptocurrency purchases. The Federal Reserve economists highlighted how the practice “appears widespread,” which can leave users exposed to the dramatic price swings that are inherent to the cryptosphere and could make their debt harder to pay back. “When the value of the debt does not change based on the value of the asset (crypto swings), the borrower’s debt can be worth more depending on price swing, which can lead to greater exposure for the borrower,” economists wrote — adding that as debts come due, users will be forced to sell their crypto, which could lead to further price drops. Crypto prices are also interconnected, economists found, which means that when one cryptocurrency starts to drop, others tend to follow. Such price fluctuations are often based on popular enthusiasm for crypto that can spread like wildfire through social media. For example, a single Bitcoin hovered around $100,000 in value from Dec. 5 to Dec. 10. Then Google announced a major breakthrough in quantum computing on Dec. 9 with one of its processing chips solving a computational problem in five minutes that previous supercomputers couldn’t complete within the timespan of the known universe. The announcement caused crypto enthusiasts to post concerns about whether quantum computing could crack the passwords safeguarding their crypto accounts. This news coincided with a significant downturn in the crypto markets, with consumers selling off more than $1.7 billion in crypto and Bitcoin dropping to $94,100 in value. According to the authors of the Federal Reserve report, “The use of social media platforms, such as Reddit and X (formerly Twitter), by traders of crypto assets might increase the likelihood of asset price bubbles and crashes, since it accelerates the speed of dissemination of information and trading ideas.” This means that when people have faith in cryptocurrencies, their value will likely rise because people are buying it. When faith is low, it can cause people to sell off their crypto, further depreciating the value. This is in part why crypto-enthusiasts encourage buyers to “HODL” or “Hold On for Dear Life.” Another finding from the report detailed concerns about incorporating cryptocurrencies into the traditional financial sector. Banks tend to offer services to two kinds of crypto companies: Exchanges, which is where currency transactions take place, and so-called stablecoins — cryptocurrencies that are designed to hold a stable value and are often linked to a traditional currency like the U.S. dollar. But the reports’ authors noted that both of these operations can be unstable because stablecoins can collapse and exchanges can become over-leveraged — meaning they dole out too many loans to consumers. In 2022, the Celsius Network became over-leveraged, contributing to the exchange’s collapse; some consumers lost their life savings. Celsius’ collapse was viewed as the “Lehman Brothers moment” for the crypto industry. The economists highlighted the 2023 failures of Silvergate and Signature Banks, two institutions that were heavily invested in cryptocurrencies. California-based Silvergate offered crypto-backed loans to certain customers and received deposits from FTX, the bankrupted exchange formerly run by jailed fraudster Sam Bankman-Fried. The Federal Reserve report noted that a run on deposits during a crypto bubble collapse in 2022 contributed to the bank’s failure. Additionally, other government researchers found that 90 percent of Silvergate’s deposits were from crypto clients when it collapsed. Similar issues caused the collapse of New York-based Signature Bank, with “depositors withdrawing 20 percent of deposit balances on Friday, March 10, [2023], and regulators closed the bank on Sunday, March 12,” the Federal Reserve report found.
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The report noted that spotty government regulation of crypto could contribute to some of the wider financial risks of crypto trading. But its authors added that “many features of the digital asset ecosystem are designed to avoid regulation or do not fit neatly into existing regulatory frameworks.” For example, the economists wrote that many crypto companies are headquartered in countries with few financial regulations. Silicon Valley Bank was another institution that failed in 2023 due its connections with cryptocurrencies — in particular stablecoins, which the report deemed are “funding risk vulnerabilities.” Stablecoins are often backed by traditional currencies like the U.S. dollar, as well as other crypto assets, which leave them vulnerable to valuation swings and could jeopardize banks that hold large amounts of them. “We argue that [stablecoins] create interconnections that can amplify shocks in the digital ecosystem and have the potential to spill over into the traditional financial system,” Federal Reserve economists wrote. The economists detailed the case of Tether, a stablecoin, that was backed by “risky assets, such as corporate bonds, precious metals, Bitcoin, other investments, and secured loans.” According to researchers, that made “Tether riskier than most prime [money market funds], a sector that experienced destabilizing runs in 2008 and 2020.” Money market funds — an investing practice where consumers can invest in “high-quality, short-term debt securities, such as U.S. Treasury bills” — contributed to the 2008 collapse of investment bank Lehman Brothers. Lutnick, Trump’s pick for Commerce secretary, has often vouched for Tether’s stability, although the stablecoin company has never conducted a third-party audit of its finances, Sludge recently reported. The federal government stepped in and bailed out Silicon Valley Bank and Signature Bank, but did not take such actions for Silvergate Bank. The economists noted that many crypto exchanges do not have “government liquidity backstops,” such as Federal Deposit Insurance Corporation (FDIC) insurance, meaning that when exchanges fail consumers are left without access to their savings and investments. Previous crypto crashes such as the ones in 2022 and 2023 mostly affected people who were invested in cryptocurrencies. But the potential victims of future crashes could balloon if the nascent industry is allowed to become more entrenched with traditional banks. “This time around, if more banks are helping people do highly leveraged crypto trading without [regulatory] guardrails, a crash could be a lot bigger,” Hays said. “And this report is saying the problems in the sector haven’t really gone away.” “Crypto Gains To Take Out New Mortgages”The Office of Financial Research, meanwhile, gathered data from 2021 tax filings and the following years to examine where the highest concentrations of crypto owners live and their income brackets, in order to assess potential risks associated with the crypto industry. The report notes that mortgage delinquency rates among households with crypto assets remain low — 4.3 percent for low income households — but researchers discovered that there is potential risk for banks and other traditional financial institutions if households with mortgages experience large losses due to crypto price swings in the future. “The increase in borrowing is especially striking among low-income households in high crypto exposure areas, where the share of consumers with mortgages increased by over 250 [percent], and average mortgage balances increased by over 150 [percent] between 2020 and 2024,” researchers found, adding that they have not seen a rise in delinquency rates. The increase of crypto trading among average consumers — also known as retail investors — has generated concerns among regulators and policymakers because of crypto’s volatility, the use of loans to finance crypto purchases, and minimal consumer protections if their risky bets don’t pan out. The report highlights how banks are indirectly exposed to crypto due to issuing loans to customers who trade cryptocurrencies. The authors note that this arrangement could “present a financial stability risk” if crypto losses start to affect household incomes and savings. Researchers found that it appears that “low-income households may be using crypto gains to take out new mortgages and to take out larger mortgages,” and that crypto gains have been used to pay off credit card debt. The report also hints at a need for future monitoring of low-income households that have crypto assets, since any distress in this group could highlight potential negative consequences for banks. “An important takeaway for future monitoring is the increased debt balances and leverage among low-income households with crypto exposure,” researchers wrote. “Rising distress in this group could cause future financial stress, especially if exposure to these types of high-leverage, high-risk consumers is concentrated in systemically important institutions.” While the current crypto price surges have brought in extra money for a number of crypto users, experts warn that the gains may not last — and in Trump’s “crypto capital of the planet,” the fallout from such a downturn could be felt far beyond the cryptosphere. “People need to watch out, because what goes up usually comes down,” said Hays with Americans for Financial Reform.
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