Cryptoassets Pose Existential Threat to the Financial System and It’s Not in the Way You Might Think
The ascension of cryptoassets exposes an inherent weakness of the current financial system — the feedforward dynamic between marginal price change of assets and the size of the total balance sheet in the financial system.
In financial systems that rely on mark-to-market pricing of assets on balance sheets, even a small rise in marginal price of an asset results in a large expansion of the aggregate balance sheet (i.e. paper gains). That expanding balance sheet serves as increasing collateral for potential leverage and as demand capacity for other assets (seeking additional returns, safety, diversification, rebalancing, wealth effect, etc.), which represents potential upward pressure on the marginal price of other assets (or itself).
While many factors including reflexivity and market psychology can contribute to asset price momentum, the positive feedback loop between increasing marginal price of individual assets and the expanding aggregate balance sheet (demand capacity) can also contribute to a feedforward inflationary momentum across asset classes. Conversely, a marginal decline in the price of an asset in a mark-to-market system results in a greater degree of contraction of the aggregate balance sheet (amplified by deleveraging and collateral contraction), representing potential deflationary momentum across asset classes.
This perverse procyclical relationship between a marginal change in the price of assets and the aggregate demand capacity for assets is explored in the context of cryptoassets. Here are some of the inherent features of the system:
Feature (A): Marginal trade of an asset reprices the entire asset class in a mark-to-market system, causing amplified effect on asset balance sheets, which in turn can generate a positive feedback loop in the degree of demand for assets.
Feature (B): In the case of rising prices, (A) contributes feedforward upward momentum to mark-to-market asset prices as balance sheets expand and demand capacity increases.
Feature ©: In the case of declining prices, (A) contributes feedforward downward momentum to mark-to-market asset prices as balance sheets contract and demand capacity decreases.
Feature (D): Many other factors also influence price, sometimes contributing to the momentum and at other times causing stochastic reversals in price from time to time.
Feature (E): Feature (A) combined with (D) promote pricing volatility.
Feature (F): The limitless potential to issue new cryptoassets and the difficulty of ascertaining fair value of cryptoassets promote pricing volatility.
Feature (G): Combined effects of (E)+(F) promote extreme volatility of cryptoasset prices.
Feature (H): The limitless potential to issue new cryptoassets, combined with (A) (feedforward pricing momentum) creates a general upward bias to the size of total system balance sheet. That expanding total balance sheet can be used to price newly issued cryptoassets in a recursive fashion. In the long run, the perception among investors that the supply of cryptoassets is unlimited may mitigate this upward momentum.
Feature (I): The combination of (A) and (H) promotes a massive expansion of the total cryptoasset balance sheet. It currently stands at $320 billion but could grow to $1 trillion or $10 trillion quickly.
Feature (J): The increasing size of the cryptoasset balance sheet will likely promote its legitimacy in the real economy, leading to increasing co-mingling of cryptoassets and real assets.
Feature (K): Features (G) + (J) will lead to heightened volatility of real world asset prices and heightened economic instability.
Now let’s play out a scenario.
At time zero, let’s say a person creates 1 million units of a new cryptoasset X (synthetic digital assets in the blockchain system). Let’s say another person buys 1 unit of cryptoasset X for $1. Note that this dollar isn’t entering that cryptoasset’s ecosystem; it simply changes hands from one person to another in the tradition financial system. Based on mark-to-market accounting of balance sheets, a total balance sheet of $1 million emerges in the cryptoasset X ecosystem.
Now imagine someone synthetically creates 2 million units of cryptoasset Y in the ether. Let’s say an owner of cryptoasset X pays the equivalent of $3 for a single unit of cryptoasset Y. Based on mark-to-market accounting of balance sheets, a balance sheet equivalent of $6 million in total assets emerges in the cryptoasset Y ecosystem. Now imagine $7 equivalent of cryptoasset Y is used to buy a single unit of cryptoasset Z. If we assume that someone synthetically created 8 million units of cryptoasset Z, then based on mark-to-market accounting, a balance sheet equivalent of $56 million in total assets emerges in the cryptoasset Z ecosystem. At this moment in time, a total balance sheet of $1 million + $6 million + $56 million = $63 million has emerged in the combined ecosystems of cryptoassets X, Y, and Z based on mark-to-market accounting of balance sheets.
This $63 million in cryptoassets represents demand capacity for other assets. Imagine an owner of cryptoasset Z, feeling wealthy, uses $2 worth of cryptoasset Z to buy a unit of cryptoasset X, previously priced at $1. Every unit of cryptoasset X gets marked up to $2, and the total balance sheet of cryptoasset X has expanded to $2 million based on mark-to-market accounting. Feeling wealthier, an owner of cryptoasset X uses $8 worth of cryptoasset X to buy a unit of cryptoasset Y. Every unit of cryptoasset Y gets marked up to $8 and the total balance sheet of cryptoasset Y is now $16 million. Let’s say this cycle of balance sheet expansion and price increase continues in circular fashion among cryptoassets X, Y, Z until their total balance sheet is $10 billion based on mark-to-market accounting.
Now let’s say the upward momentum of prices of cryptoassets starts to draws the attention of bystanders who, observing the momentum, start creating new types of cryptoassets at accelerating rates. Soon the total balance sheet of the ecosystem of cryptoassets reaches $10 trillion based on the mark-to-market prices of the cryptoassets. The total balance sheet of US currency was held constant (US dollar simply changed hands from one person to another), yet a $10 trillion in balance sheet of cryptoassets has been created in the ether. The increasing size of the cryptoasset balance sheet will likely promote its legitimacy, adoption and use in the real economy, leading to increasing co-mingling of cryptoassets and real assets.
But what is the total cryptoeconomy actually worth at the end of the simulation? In the case of the traditional economy, assets can be valued according to a set of generally understood metrics such as cashflows or yield. In the case of cryptoassets, there is no easy agreeable framework for valuation due to their nascent nature, and the widely different assumptions about their value make them difficult to value. With such divergent frameworks for valuation, the cryptoasset market is much more vulnerable than traditional markets to supply-demand dynamics and technical factors such as momentum in determining marginal price. Unfortunately, in the case of the cryptoasset market, the supply-demand dynamic is subject to the highly distortive effects of the phenomena described in this paper, which could create runaway feedforward increases in the price of cryptoassets and balance sheet sizes during upswings, runaway feedforward decline of cryptoasset prices and balance sheet sizes during downturns, resulting in extreme volatility. In the event of a sudden, accelerated downward momentum in cryptoassets prices, which has happened with some regularity in the short history of cryptoassets, cryptoassets held on the balance sheets of financial intermediaries would be wiped out quickly, causing cascading effects throughout the financial system. Thus, with mark-to-market accounting of assets, increasing size of the cryptoeconomy and its integration into the traditional financial system poses destabilizing risk to the future of the overall financial system.