Cryptocurrencies such as Bitcoin and Ethereum would face a crash if they lost all of their value, wiping out a large chunk of wealth. Long-term holders would lose only a tiny percentage of their total holdings, but those who bought just a year ago would give up massive unrealized gains. As of today, the average price of cryptos is around $37,000. Most institutional investors, including mutual funds, hedge funds, and university endowments, are heavily exposed to them. And if a collapse were to happen, the US economy would likely suffer, too.
Short-Term Investors Would Suffer Small Losses
The collapse of cryptocurrencies, like bitcoin, would wipe out a significant portion of wealth. Long-term investors would take small losses relative to price but cede enormous unrealized gains. Speculators would sell their crypto holdings in a panic and flee. Most institutional investors, such as hedge funds, mutual funds, and some companies, are exposed to crypto.
The cryptocalypse could also affect sentiment in a broader market, although the extent of the fall is still unclear. In a crash, short-term investors would sustain only minor losses. Banks largely immune to crypto-market crashes are unlikely to rush to hold bitcoin on their balance sheets. Recently, the Basel club of bank supervisors proposed that banks fund their bitcoin holdings with capital.
Even though institutional players have dabbled in crypto over the past couple of years, there’s no reliable way to forecast the impact of such a move. The cryptocurrency bubble has caught the attention of at-home traders, who deployed funds into the market and then watched it rise. A bitcoin crash that would impact the US economy would likely cause a slight loss for short-term investors. Still, the overall market’s losses would be relatively modest compared to US households’ $150 trillion net worth.
In the past few weeks, the cryptocurrency market has lost almost $2 trillion, which is just a fraction of the total value. As a result, this massive sell-off has triggered fears of a broader economic recession. This has been the cause of many financial crises, including the financial meltdown of the economy in 2007 and the subsequent recession.
Long-Term Holders Would Cede Huge Unrealised Gains
A massive crypto crash would wipe out billions of dollars in wealth, and long-term cryptocurrency holders would lose a small number of their unrealized gains relative to the price. However, investors who bought Bitcoin less than a year ago would be the biggest losers, ceding substantial unrealized gains.
Both external and internal shocks can trigger a massive cryptocurrency crash. An example is a major hack. Central banks or regulators could suddenly clamp down on cryptocurrency markets, erasing everything and leaving long-term holders with substantial unrealized gains. Long-term Bitcoin holders would cede substantial unrealized gains in a Bitcoin crash that hits the US economy.
The crypto market has been on a wild ride since 2009, with one Bitcoin rising to over $60,000 before plummeting to less than half its original value in weeks. Other cryptocurrencies, such as Dogecoin, have also experienced substantial price swings and are often priced on Elon Musk’s tweets. The combined market value of all cryptocurrencies is estimated to be more than $1.5 trillion.
In the United States, selling a Bitcoin for a profit is taxable. The IRS considers Bitcoin as a currency, not a commodity. While Wood was addressing the issue of long-term Bitcoin holders ceding considerable gains to the US economy, the fact is that the vast majority of buyers have made money from the cryptocurrency. In fact, by November 2020, 98% of all BTC addresses were expected to be in the black.
Cryptocurrencies Lack Scale To Pose Systemic Risk
Regulatory agencies have begun to address the emerging market for cryptocurrencies, including bitcoin, Ethereum, litecoin, and other cryptocurrencies. However, the nature of cryptocurrencies and the lack of a regulatory framework make regulation tricky, particularly in the US. Regulation is also a key issue in addressing the financial system’s traditional risk aversion and innovation, and cryptocurrency is no different.
The lack of regulation of cryptocurrencies is a concern, and it is unclear whether a digital currency will trigger a systemic risk to the US economy. Although cryptocurrencies do not have the scale to become a systemic risk, they may still harm investors. A recent spike in crypto asset trading volumes may have caused exchange rate market spillovers, resulting in the emergence of recent restrictions.
The global financial system is a diverse orchard containing many species of plants and trees. A problem may arise when a weed begins growing in the margins, affecting the entire orchard. Another problem is the risk of new organisms entering the ecosystem. In some cases, a new tree may encroach on an existing ecosystem and cause damage.
The crypto ecosystem has created many tangible benefits for the US economy, but there are also several risks. For example, the risks of inadequate reserves for some stablecoins are an essential concern for policymakers.
As cryptocurrency adoption continues to overgrow, authorities should implement interim measures to protect the interests of consumers and investors. These measures should include enhancing cross-border coordination in the supervision and enforcement of crypto assets. However, the government should also maintain a stable financial system and ensure that regulators implement regulations appropriate for the market’s specific circumstances. There is an urgent need for additional regulatory action in many countries, particularly those with high crypto asset adoption.
El Salvador’s Economy
While the US dollar will remain the currency of El Salvador for a long time, the country’s president has talked about integrating bitcoin into the economy. Regardless, the country has little control over its monetary policy, and the lack of a central bank will have repercussions. El Salvador’s President, however, has tweeted that Bitcoin adoption will benefit the country. The country’s GDP will be less affected than in other countries because many people don’t have bank accounts.
The country’s debt to GDP ratio is nearly 90%, and it has no plans to reduce its debt. El Salvador’s debt is around $20 billion, and its GDP is only $25 billion. It cannot afford to lose that much money in a single investment, especially as the country has little money to invest in the US dollar. As such, a Bitcoin-backed bond will not bring the country down.
While Bitcoin adoption is not likely to cause El Salvador’s economy to crash, it could lead to massive holdings among Salvadorans. It could also lead to increased foreign investment and trading. This could cause a network overload and a subsequent crash.
While the country is still a risk, bitcoin adoption makes it harder for El Salvador to borrow money and reduce its debt-to-GDP ratio. Even though Bitcoin is a volatile asset, the government is spending millions of taxpayer dollars on the project. The government is planning to create a ‘crypto city’ powered by volcanoes.
The International Monetary Fund and JP Morgan have expressed concerns over the country’s Bitcoin plans. Meanwhile, Strike, an American cryptocurrency startup that played a significant role in pushing for El Salvador’s law to support it, is publicly promoting the experiment. However, Strike does not hold a money-transfer license in any state, and transferring Bitcoin through it could cause legal complications.