Can crypto contagion infect traditional finances?

The crypto carnage has a silver lining: the wider financial system has been spared.

From Brussels to Washington, financial watchdogs downplay the risk of the turmoil spilling over to other markets and say their own actions have shielded banks from the crypto slide.

“This contagion has not spread to the traditional banking and financial sector,” acting US Comptroller of the Currency Michael Hsu told the Financial Times.

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“This is due, at least in part, to the continued and deliberate focus of federal banking regulators on safety, robustness and consumer protection,” he said.

On Thursday, global regulators in Basel went a step further by proposing stricter rules to limit crypto exposure to 1% of a bank’s assets.

The Federal Reserve, which recently released the results of its annual stress tests showing that the largest US banks could incur more than $600 billion in losses and still exceed government-imposed capital levels, sees limited exposure of banks to crypto markets. said Fed officials.

Outside of banking, the firewall includes investment guidelines for institutional investors limiting their exposure to digital assets, noted a Securities and Exchange Commission official.

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The official added that there was no sign that the crypto sell-off had triggered a cash rush from investors looking to repurchase traditional securities to cover crypto losses, although the SEC continued to monitor this activity.

“For traditional asset managers, the direct impact of selling crypto is quite minimal,” said Anne Richards, chief executive of Fidelity International. “Bitcoin has made its way into a small number of institutional wallets, but for most groups it is still very marginal.”

Andrea Enria, the European Central Bank’s chief banking supervisor, told a European Parliament committee on Thursday that there are “still very limited” privileges between crypto and banks.

“But I’m noticing a built-up interest from banks in maybe entering these markets because they’re seeing more young people who are probably very much preferable.” † † I also see more acceleration in the sector in general, so the sooner we can regulate and provide clear guidance, the better.

Paschal Donohoe, Ireland’s finance minister and president of the Eurogroup of finance ministers, said officials were not concerned at this point, but added: “I imagine a year from now we will be just as focused on cryptocurrencies as well as climate risks, that’s one of our biggest concerns.

Major regulated banks have found ways to offer crypto to their customers. Jamie Dimon’s JPMorgan Chase helps crypto exchanges Coinbase and Gemini with deposit and withdrawal transactions; Goldman Sachs sold bitcoin-related derivatives while making a loan to Coinbase backed by bitcoin; and many banks give wealthy investors access to crypto investment funds.

Smaller US lenders have invested more deeply in crypto, courting digital asset customers such as stablecoin issuers, crypto exchanges and merchants. These include Signature Bank, which said more than a quarter of its approximately $120 billion in dollar deposits are tied to customers with digital assets, and Silvergate, which took in nearly all of its $29 billion in deposits of customers’ digital assets.

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Afraid to dive too deep, banks have lost more than 95% of the reported $4-5 billion in corporate and institutional revenue generated from digital assets in 2021, according to a report by Morgan Stanley and Oliver Wyman.

“Banks need to go where customers want them to go, so if there had been customer pressure they could have done more [crypto] said Mitch Eitel, associate director of the financial services group at Sullivan & Cromwell.

In the absence of banks, dedicated cryptocurrency lenders stepped in for loans. These companies generally fall into two categories: decentralized lenders such as Aave, which track financing activities on the blockchain, and centralized lenders such as BlockFi and Nexo.

Low direct exposure to banks would make them less likely to act as a conduit for financial stress from the crypto crash, as they did in 2008, according to Clifford Chance partner Jeff Berman.

“Banks don’t have crypto and they have been very careful about lending against crypto. And in fact, most crypto loans are done by crypto specialists. Overall crypto exposure is therefore low,” Berman said.

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Crypto hedge fund insiders also seem relaxed about how this could affect mainstream banking courtiers and the wider financial system.

Since most of the major traditional phone brokers serving traditional hedge funds have not yet entered the crypto sector, crypto funds tend to use brokers that specialize in digital assets, although they may still occasionally use banks when trading more traditional ones. assets. This is seen as limiting the potential for banks to incur significant losses if a fund explodes.

“I don’t see this expanding into the world of traditional finance,” said Edouard Hindi, chief investment officer at digital asset manager Tyr Capital. “The risk [of contagion] that exists in traditional finance, does not exist in crypto.

Meanwhile, many major macro and quantitative hedge funds that have started trading cryptos have done so using futures contracts, for example on the Chicago Mercantile Exchange, rather than the underlying cryptocurrencies themselves.

If they take losses on such positions, they will have to “show more margin with the CME or take cash losses with DeFi exchanges,” said Usman Ahmad, director of Zodia Markets, a trading platform. Chartered by default. †

None of these are expected to impact prime brokers at banks unless these losses prevent the fund from meeting margin calls from banks that risk acting as brokers for the fund’s other assets, he said.

All of this has led some Wall Street heavyweights to conclude that the crypto mess poses no systemic risk to banks.

“I don’t think it’s big enough to be systemic,” said Howard Marks, co-founder and co-chair of Oaktree Capital Management. “To have a systemic impact, I think it has to be part of the system and the institutions.”

Reassuring statements from regulators have not always been far-sighted, especially in the run-up to the 2008 subprime mortgage crisis, when government officials downplayed the risks. And this time, not everyone is reassured.

“I think the risk of systemic contagion from a crypto crash is real, although it’s hard to know for sure how deeply entwined digital currencies are with hedge funds and other traditional financial firms,” said David Trainer, director of the investment research firm. . New constructions.

“As the sell-off continues, we will soon discover just how much systemic risk there is.”

By Joshua Franklin in New York, Stefania Palma in Washington, Laura Noonan in Brussels and Scott Chipolina, Laurence Fletcher, Harriet Agnew and Owen Walker in London

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