Islands No More: Crypto Hedge Funds Bring Cryptocurrency Risk Into Mainstream Financial System

Tweet This

With each new crypto hedge fund created, financiers are building bridges from relatively isolated islands of cryptocurrencies to the mainstream financial system, opening additional pathways for the transmission of risk.  (Photo from Shutterstock)

You've seen that movie.

You know, the one with the ghastly virus that kills each person it touches in some hideous way, but there's no known cure, and there's a race against time to save civilization before everyone on earth dies.

The opening scenes show the first cases of the virus developing on some remote island, and the audience watches in horror as The Carrier Of The Virus heads across the bridge to the mainland to seek help, knowing that this fateful journey could spell the end of humankind. If only someone could stop The Carrier from reaching the mainland to spread the virus. Brad Pitt? Matt Damon? Anyone?

Well, grab a seat and watch the show, because financiers are busy building bridges to link the grand experiment of cryptocurrencies to the broader financial system.

In case you've missed it, "crypto" (short for "cryptocurrency") hedge funds are popping up every day, with research company Autonomous Next tallying 75 at last count. With the creation of each of these investment funds, new links are being built to transmit the risks of the cryptocurrency space into the mainstream economy. Risks that have been relatively contained to the fringe worlds of Bitcoin, Ethereum, Zcash, Monero and other fantastically-named cryptocurrencies, are reaching their tentacles into the broader financial system, one hedge fund at a time.

Which is another way of saying that the world is watching the transformation of cryptocurrency risk into systemic risk. That’s right – the creation of each crypto hedge fund makes it more likely that the decisions of crypto-anarchists, feuding software developers (some anonymous) and China-based mining conglomerates could jeopardize Grandma's retirement savings.


Worried now? Let me explain.

Since Bitcoin began operating in 2009, numerous other cryptocurrencies have been created. Among the best known are Ethereum, Zcash and Monero. Ecosystems have grown up around these cryptocurrencies, comprised of software developers, users, participants in the transaction validation network (often called "miners"), service providers (e.g., exchanges, wallet providers, payment processors, niche news venues) and some adventurous early investors. If you wanted to participate in one of these systems, you had to navigate their rather challenging user interfaces, affirmatively venturing out on your own. Thus, the cryptocurrency world has existed largely as an island; opting out of the existing financial system has been its raison d'être.

While Bitcoin and its underlying blockchain technology have received copious media exposure in the past several years, it hasn't been essential for most people to understand much about these currency systems or their underlying technology. These alternative systems just haven't been relevant to the average person on the street. (Just as it seemed unnecessary for the average person to understand the intricacies of subprime mortgages before they were folded into mortgage-backed securities that sprinkled their risks throughout the financial system. But I digress...)

That situation is rapidly changing with the suddenly frantic pace of integrating Bitcoin and other cryptocurrencies into the financial system through new financial products. Practically every day, it seems, there are reports of a new crypto hedge fund. (See here, here, and here for examples from just the last few months.) These are coupled with reports of the creation of crypto index funds, the launch of Ether-tied exchange-traded notes (ETN) on Nasdaq Stockholm and that the venerable Goldman Sachs is considering starting trading operations in cryptocurrencies.

Why the rush? Quite simply, because the price of cryptocurrencies has skyrocketed over the past year, and financiers and their clients are salivating over attractive returns. The volatility of cryptocurrencies is also attractive to hedge funds, who attempt to make money on any big swing in price -- rise or fall. CoinDesk, the dominant niche news site for cryptocurrencies and blockchain technologies, is introducing a new conference in November focused on investments by "sophisticated investors" that will "bring...institutional investors, hedge funds, money managers, banks, and family offices ... the chance to get connected with how to invest, store, trade and judge value in th[e] new asset class [of digital assets]." The conference overview prominently features a graph showing the 2017 year-to-date returns on gold (10.1%), U.S. equities (11.5%), Bitcoin (181.3%) and all digital assets (448%). Hard to resist.

There are two reasons why the flood of crypto hedge funds is significant for the financial system as a whole. First, because in the past few years, there has been a growing understanding that hedge funds can be a source of systemic risk for the financial system. And second, because prudential regulators tasked with furthering financial stability have stated that cryptocurrencies pose little systemic risk to the financial system because of their relatively small scale.

Let's take these point by point.

Hedge funds can be a source of systemic risk -- even if they are not gargantuan beasts like Long Term Capital Management. Indeed, a 2014 publication from the Federal Reserve Bank of San Francisco stated that, "A surprising finding from this study is that hedge funds may be the most important transmitters of shocks during crises, more important than commercial banks or investment banks." And the Financial Stability Oversight Council (FSOC) has been actively working to better understand hedge funds' potential impacts on financial stability and how to contain them. (Though, worryingly, that work seems to be ending under the Trump Administration.)

Even clusters of relatively small hedge funds can, because of their overlapping investments, be sources of systemic risk. As Professor Cary Martin Shelby recently argued in the Boston College Law Review, even

"a series of smaller funds can create and transmit systemic risk given the industry’s significant participation in various sectors of the financial markets. If a group of interconnected funds simultaneously sells assets in order to fund redemption requests and/or margin calls, such asset classes can experience significant price declines. Hedge funds can also contribute to the inflation of a toxic bubble given their unfettered access to derivative markets."

Thus, hedge funds can serve as a two-way transmitter of risk between cryptocurrencies and the financial system. They bring risk into the cryptocurrency world because the liquidity they provide in buying cryptocurrencies can help to inflate a bubble in prices in these assets, while at the same time, their correlated withdrawals can just as quickly deflate prices. They also bring risk from the cryptocurrencies into the financial system, as shocks in cryptocurrency prices could affect obligations that hedge funds owe to other actors within the financial system, potentially sending ripples of broken promises far and wide.

Just what are the risks of cryptocurrencies that could enter the financial system through hedge funds and other crypto financial products? A list of those would fill its own encyclopedia, but those most significant to me are their operational risks, meaning the risk that they could just stop working. Operational risks stem from their most fundamental features, including their experimental governance, vulnerability to bugs and 51% attacks, and the fact that they are immature and generally poorly understood. Indeed, myths about the technology's core characteristics (e.g., its immutability) are widely held, meaning that investments in cryptocurrencies may be based on misunderstandings rather than realities. (Securitized subprime mortgages flashback, anyone?)

Of course, simply having bridges does not mean that undesirable elements will travel across them. There are no guarantees that a crash in the crypto-markets will cause a crash in the financial system, just because the hedge funds are there. But, each link between the economies does make risk transmission a possibility, depending on how these crypto-funds become integrated into the financial system.

It's worth noting that the latest crop of crypto hedge funds are not the first links cryptocurrencies have to the larger financial system. Exchanges that swap government issued currencies for cryptocurrencies provide bridges between these economies, as do attempts at "stablecoins" like Tether (ably critiqued by Izabella Kaminska of FT Alphaville), and ETFs like those proposed by the Winklevoss twins. Further, venture capital funds have invested significantly in companies related to cryptocurrencies or their underlying blockchain technology. But the crypto hedge fund mania, coupled with the rush to other crypto-based financial products, feels like a sea change in the financialization of cryptocurrencies.

All of this means that regulators and policy makers who monitor financial stability risks need to update their risk analyses of cryptocurrencies pronto. In its June 2017 report on "The Financial Stability Implications of FinTech," the Financial Stability Board (FSB) stated that cryptocurrencies do not pose (and probably will not pose) systemic risk to the broader financial system because they are so small, comparatively:

Because of the relatively small size of [cryptocurrencies], they do not currently pose a systemic risk. Similarly, given the difficulties of a [cryptocurrency] ever accounting for a significant proportion of transactions in a jurisdiction, the likelihood of a [cryptocurrency] ever becoming systemically important is judged to be low. Should one or more of them achieve widespread adoption, however, various financial stability issues could emerge and are discussed below.

Interestingly, the FSB contemplates that cryptocurrencies could only pose systemic risks if they became widely used. This misses the fact that financialization of these niche currencies enables them to pose risks to the broader financial system even if they never achieve wide adoption. The effect of financialization is to allow the wider world to gamble on the winners and losers within the small crypto systems. It is financialization that can magnify and ripple these risks throughout the financial system, bringing cryptocurrency risks out of their small walled gardens into the wider economy.

There is some irony in the present situation, as the opt-out financial systems of cryptocurrencies have been seen as a reaction to the financial crisis. Participants in the crypto world see themselves as escaping the corruption, risks, and bailouts of the legacy financial system. They don't want complex debt structures with their attendant risks of default. As economist Perry Mehrling succintly put it, "Cryptos fear credit."

Well, sorry, crypto rebels, but the bankers and their credit structures are following you. Those pesky financiers now want a piece of crypto's (presently) highly lucrative action, so are building financial products to take advantage of the alternative systems that are fleeing them. It would be a cruel irony indeed if cryptocurrency systems spawned a crisis that rippled through the mainstream financial system through financial products assembled by the very same bankers who brought us the 2008 crisis.

In sum, as the financial world discovers this new, enticing asset class, folks need to be thinking about more than just the incredible returns these cryptocurrencies can bring investors. With every new link, cryptocurrencies pose a more significant threat to the broader financial system.  Prudential regulators need to wake up and smell the crypto-risk.

Follow me on Twitter.

I’m an associate professor at St. Mary’s University School of Law and a research fellow at the Centre for Blockchain Technologies at University College London. I researc...