Financial contagions can be easily caused, if the conditions are right. First one financial institution falls and then the others follow, like a chain of falling dominoes.
The ember that sparked the global financial crisis in 2007 is believed by many to be a March 14 briefing by executives at the Lehman Brothers investment bank.
Under intense questioning from financial analysts, the executives admitted that the bank had overstated the value of billions of dollars in subprime mortgages.
This news saw the Lehman Brothers stock price crash and led investors to lose faith in the whole edifice of complex financial deals that had been so profitable for banks and brokers.
As stock prices fell, more investors rushed to sell their shares, driving prices down even further. The contagion spread through global equity, real estate and derivatives markets.
Of course it was waiting for a crisis. It took years to create the rickety system that collapsed under pressure. It would happen sooner or later. But it still needed a trigger.
We are at a similar point in cryptocurrency markets.
The Great Collapses of 2022
Last year saw several major crypto-related collapses.
In July, US-based lender Celsius, with assets worth $12 billion in May, went bankrupt.
Then, in November, FTX – one of the world’s largest cryptocurrency exchanges, worth $32 billion early 2022 – collapsed, taking the assets of 1.2 million customers with it.
Crypto owners are scared, waiting for the next exchange to drop.
Last month, it looked like that might become the largest cryptocurrency exchange in the world after customers, Binance $1.9 billion withdrawn of assets in 24 hours.
But the panic was real enough – apparently caused by some big savers interpreting a trading halt for one of Binance’s exchange-listed coins as a sign of something more serious.
Centralized exchanges pose a risk
In any market crisis, there is always an underlying problem that provides the fuel for an ember to ignite.
In this case, the problem is that Binance and other centralized crypto exchanges (known as CEX) are more risky than other ways of storing crypto assets.
There are good reasons for any crypto owner, after seeing what happened with FTX, another centralized exchange, to list their assets.
The lesson from FTX is that if you don’t have self-custody over your crypto assets, you have no real control.
Centralized cryptocurrency exchanges are more like banks than exchanges. They act as custodians and hold customers’ crypto or fiat currency, similar to holding money in a bank account.
But banks are regulated – in part to minimize the disastrous “bank runs” that have been a regular occurrence in the past.
This includes a global regulatory framework known as the Basel prudential guidelines, introduced in 1988 to ensure that each bank maintains sufficient capital and sufficient liquidity to cover withdrawals. It also requires banks to regularly report financial information.
We all take this for granted. But it didn’t magically happen. It is a function of careful planning based on strict minimum liquidity and capital requirements imposed by banking regulators.
Containing the next crisis
Banks are closely supervised as they hold the bulk of the money in the economy. For the economy to function, it is vital that people can store money securely and have it accessible when needed.
We need the same oversight of cryptocurrency.
Any centralized crypto exchange is at risk if customer withdrawals exceed liquid assets. If it cannot cover the withdrawals, it must freeze customers’ accounts. At that point, the end is near. Here’s what happened with FTX – although the person who did the most problematic withdrawals was founder Sam Bankman-Fried.
The next major crypto collapse is not a matter of “if” but “when” – and whether governments can work quickly enough to build up the regulatory buffers to prevent the collapse from leading to contagion.
A crisis may not be averted, but it can be managed.
- Paul MazzolaLecturer Banking and Finance, Faculty of Business Administration and Law, University of Wollongong