Cryptoassets and the crypto ecosystem as a whole has to face many of the same challenges as conventional assets and the regular financial system do. The same classic problems which are staple of economics textbooks (and history books), such as maturity mismatch, liquidity shortages, credibility, and collateral feedback loops. But whereas the conventional system has learned from the past and evolved to deal with them, much of the crypto ecosystem seems to have overlooked them. In this post I draw out the parallels between previous issues in the traditional financial system and recent crypto turbulence. I argue that when crypto goes wrong, it often goes wrong in strikingly conventional, even old-fashioned ways.
Alina Barnett, Sinem Hacioglu Hoke and Simon Lloyd
Since 2007, macroprudential policymakers have grappled with a broad set of vulnerabilities. While regulators cannot be sure what risks the next decade will feature, they can be sure that the set of issues will continuously evolve. In this post, we explore threetimely challenges that financial stability policymakers are likely to face in the coming years, including risks associated with: non-bank financial intermediation, cryptoassets and decentralised finance (DeFi), and climate change. These challenges have been noted by many, and are already stimulating development of macroprudential frameworks. But while some of this development can build on well-grounded principles for financial stability policy, other aspects are likely to come up against threetimeless challenges, requiring novel and innovative thinking to overcome.
Speculative buying can drive cryptocurrency prices down. This is contrary to the usual laws of economics. Blockchain technology limits how quickly transactions can be settled. This constraint creates competition for priority between different users. The more speculative activity there is, the longer it takes to make a payment. But the future value of cryptocurrency depends on its usefulness as a means of payment. Speculation therefore affects price formation through a channel that does not exist for other asset classes. This can explain the high price volatility of cryptocurrencies, and is consistent with the low adoption rate so far.
To consider Bitcoin volatility, we
look at 10-day returns (capital standards typically estimate market risk over a
10-day period) since 19 July 2010, when Bloomberg’s Bitcoin data start. We
compare Bitcoin with assets in three categories – currency pairs, commodities
and equities – and for each we have picked one low-volatility asset and one
more volatile asset. For currency pairs and commodities, we chose the most and
least volatile ones (in terms of standard deviation of 10-day returns) out of
the most liquid in each category. And we chose the most and least volatile FTSE
100 equities (again, in terms of standard deviation of 10-day returns).
For stable assets we expect a peaked distribution with short tails, as returns cluster near 0%. Figure 1 shows that Bitcoin has been more volatile than any other asset in our sample.
Figure 1
But people are often interested in the downside risk of assets. We therefore consider how Bitcoin’s Value at Risk (VaR) compares to other assets. VaR is the maximum loss over a given time interval under normal market conditions at a given confidence interval (eg 99%). A 10-day 99% VaR of -10% tells you that 99% of the time your 10-day return on the asset would be no worse than a 10% loss.
Figure 2 shows Bitcoin’s VaR is high, but the VaR of the other most liquid crypto-assets is higher. TRON’s VaR to date (-84%) is almost twice Bitcoin’s (-44%).
Figure 2
Giulio Malberti and Thom Adcock work in the Bank’s Banking Policy Division.
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Cryptoassets (or ‘cryptocurrencies’) are notoriously volatile. For example, in November 2018, Bitcoin – one of the more stable cryptoassets – lost 43% of its value in just 11 days. This kind of volatility makes it difficult for cryptoassets to function as money: they’re too unstable to be a good store of value, means of exchange or unit of account. But could so-called ‘stablecoins’ solve this problem and finally provide a price-stable cryptoasset?
