Could Crypto Spark the Next Financial Meltdown? Here’s What to Know!
As the cryptocurrency landscape continues to surge, marking historic electoral victories in November and propelling global valuations beyond a staggering $3 trillion, federal regulators have sprung into action, voicing serious concerns about the potential upheaval this volatile market could unleash on our traditional banking systems and financial markets.
These newly released reports echo ominous warnings reminiscent of the alerts sounded regarding the subprime mortgage crisis ahead of the 2008 financial meltdown. They spotlight crypto’s notorious volatility, its regulatory gaps, and its increasingly cozy relationship with conventional financial mechanisms, raising red flags that demand our attention.
“Consider this a signpost for the future,” stated Mark Hays, associate director for cryptocurrency and fintech at Americans for Financial Reform. “If the situation deteriorates, these reports will serve as a crucial reference for identifying early warning signs.”
The two reports, produced by impartial federal agencies, present a sobering outlook on the risks posed by the deepening intertwining of crypto and traditional banking. One report highlights the alarming trend of consumers resorting to loans to chase risky cryptocurrency investments—a practice known as leveraged trading.
Cryptocurrencies, being decentralized digital assets, are entirely unregulated by governmental authorities, a factor that contributes to their extreme price fluctuations. Sadly, these oscillations have led to catastrophic losses for many consumers in previous crypto market crashes.
A recent analysis from the Federal Reserve Bank of New York, which oversees interest rates and supervises private banks, warns of the dangerous ramifications of cryptocurrencies’ volatility and their interconnections with traditional banking as more Americans leverage loans for crypto investments.
“The extensive use of leverage among crypto investors could amplify their vulnerability to sudden price shocks, creating a dangerous feedback loop,” the economists warned in their November 1 report, following up on a similar concern raised last year.
Interest in crypto trading appears to be on the rise. After the recent election, a major crypto analytics firm noted that new Bitcoin trading accounts surged by 26 percent in just ten days.
The report dismisses some of crypto’s foundational claims—such as its role as a hedge against inflation and its immunity from governmental influence—by revealing the industry’s increasing efforts to penetrate traditional markets and its susceptibility to interest rate fluctuations.
“Crypto values soared during 2020 and 2021 amidst historically low interest rates, only to plummet as central banks tightened their monetary policies,” experts observed.
Further analysis from the Office of Financial Research, a nonpartisan bureau under the Treasury Department, indicates that neighborhoods with high concentrations of cryptocurrency holders are witnessing a surge in auto and mortgage loan applications.
“The significant uptick in crypto asset usage, characterized by extreme volatility, could threaten financial stability if these risks spill over into household finances or the broader economy,” the researchers asserted in a November 26 report.
Moreover, the researchers emphasized the need for stricter scrutiny of low-income consumers with substantial debt and crypto holdings, as economic distress within this demographic could signal troubling trends for banks and financial institutions at large.
While the reports speculate on potential risks without issuing direct recommendations, experts liken the Fed’s warnings to those sounded before the 2008 crash, pointing to a troubling increase in delinquencies among subprime mortgage borrowers as an early indicator of the impending crisis.
These reports surfaced as the crypto industry poured over a quarter of a billion dollars into the election of pro-crypto candidates, effectively reshaping the makeup of Congress. With over 270 pro-crypto lawmakers now seated, the stage is set for crypto-friendly policies and regulations to flourish.
In stark contrast, President Joe Biden’s administration has implemented a rigorous crackdown on cryptocurrency, with the Securities and Exchange Commission (SEC) launching a series of enforcement actions against companies that skirt regulations.
However, with president-elect Donald Trump aiming to position America as the “crypto capital of the world,” this regulatory environment is poised for a dramatic shift. Many shelved crypto-friendly bills are likely to resurface for discussion.
The crypto market is currently valued at over $3 trillion, dwarfing the $2 trillion worth of the subprime real estate debt market that contributed to the 2008 financial disaster.
Adding to the intrigue, Trump has appointed Paul Atkins as his nominee to lead the SEC. Atkins is known for advocating policies that paved the way for the 2008 crisis. His selection has drawn cheers from crypto leaders alike.
Atkins, labeled a “deregulation enthusiast,” previously served as an SEC commissioner under President George W. Bush and was a proponent of policies that weakened leverage ratios for banks, making them more vulnerable to economic downturns. During his tenure, he also supported the elimination of rules designed to prevent manipulative short selling.
Furthermore, Trump has selected Howard Lutnick to head the Commerce Department, a key agency in overseeing crypto. Lutnick is the CEO of Cantor Fitzgerald, a financial firm that enables clients to utilize Bitcoin as collateral for loans and other crypto services.
Additionally, Trump appointed venture capitalist David Sacks as his White House “crypto czar,” a move that has raised eyebrows given his close ties to billionaire Elon Musk and his longstanding advocacy for cryptocurrencies.
These appointments may signal an aggressive push towards integrating digital currencies into mainstream finance, allowing banks to hold larger crypto reserves and engage more heavily in crypto investments.
However, experts warn that this integration must be approached with caution, as the volatility of cryptocurrencies could unleash widespread economic turmoil. Adam Rust, director of financial services at the Consumer Federation of America, cautions, “I hope they tread carefully with any integration of crypto into the banking system. Its volatility is undeniable and poses a risk of rapid contagion.”
The regulatory alarms come amidst the influential Blockchain Association presenting a bold hundred-day policy agenda for the Trump administration. The plan calls for a friendlier market structure for the crypto industry, the appointment of new chairs at vital agencies, and the establishment of a crypto advisory council to collaborate with Congress and regulators. Most pressing is the demand to “end the debanking of crypto.”
“Crypto companies and users have been systematically denied access to traditional banking systems vital for operational functionality,” stated the Blockchain Association. “This discriminatory practice must cease immediately.”
The issue of “debanking” has gained traction within the industry. Venture capitalist and crypto supporter Marc Andreessen publicly lamented the situation on The Joe Rogan Experience, revealing that tech entrepreneurs are being denied banking services. Other notable figures, including Coinbase CEO Brian Armstrong, echoed similar sentiments on social media.
Regulators overseeing banks have policies limiting institutions from engaging with clients or companies deemed financially unstable, including those tied to cryptocurrencies.
One contentious policy from the SEC mandates that crypto exchanges report customers’ crypto holdings as liabilities on their balance sheets—essentially categorizing these digital assets as debts owed. This regulation would force exchanges and financial institutions to disclose the nature and quantity of cryptocurrencies held on behalf of their clients.
Opponents argue this policy could stifle lending and income-producing activities, making it unfeasible for many firms, including banks experienced in crypto custody services.
Despite the stringent regulations, experts contend they prevented a more catastrophic collapse when several banks engaged with the crypto sector faced turmoil in 2023. “One could argue that these regulations mitigated the crisis by limiting the number of banks exposed to the crypto market,” noted Hays.
The Federal Reserve report details potential repercussions if Congress and regulators allow the crypto sector to intertwine more closely with traditional finance. For instance, the interconnected nature of cryptocurrencies can lead to fragility during price fluctuations, which may incite bank runs similar to those witnessed during previous market downturns.
“The crypto sector is eager for banking services and wants increased investments from banks,” Hays highlighted. “This report underscores the risks involved if that desire is fulfilled.”
The Federal Reserve report outlined a host of concerns surrounding cryptocurrencies, including the use of loans to fund high-risk trades, the sector’s historical price volatility, and the prevalence of scams associated with decentralized exchanges lacking oversight.
One particularly worrisome revelation was how borrowers are increasingly using loans to fund their crypto purchases. The economists observed that this practice appears widespread, heightening borrowers’ vulnerability to the erratic price fluctuations characteristic of the crypto landscape.
“When the value of the debt doesn’t shift in tandem with the volatility of the underlying asset (like crypto), the burden on the borrower can increase significantly,” the economists warned. This situation often forces users to liquidate their crypto assets at losses as debts mature, potentially triggering further price declines.
The report also noted the interconnected nature of crypto assets, indicating that when one cryptocurrency falls, others typically follow suit. Many of these price movements are propelled by social media dynamics, which can create frenzied buying and selling behaviors.
For instance, Bitcoin saw its value hover around $100,000 until a groundbreaking announcement by Google regarding quantum computing sparked fears over crypto security. This news coincided with a selloff, causing Bitcoin’s price to plummet to $94,100.
“The use of platforms like Reddit and X (formerly Twitter) by crypto traders may elevate the likelihood of price bubbles and crashes, due to the rapid spread of information and trading sentiments,” the report suggested.
This means that as public confidence in cryptocurrencies rises, so does their market value. Conversely, when confidence wanes, panic selling can occur, exacerbating declines. This phenomenon is why crypto enthusiasts often urge others to “HODL” or “Hold on for Dear Life.”
Moreover, the report raised alarms about the possible risks of assimilating cryptocurrencies into the conventional financial ecosystem. Traditionally, banks cater to two types of crypto entities: exchanges and stablecoins—cryptocurrencies designed to maintain stable values often pegged to traditional currencies.
However, both these operations are inherently unstable due to the potential collapse of stablecoins or excessive leverage in exchanges—a situation that can lead to catastrophic failures. The Celsius Network’s collapse in 2022, for instance, resulted in users losing their life savings, marking a pivotal moment for the industry.
Highlighting the 2023 failures of Silvergate and Signature Banks, which were heavily involved in crypto, the report noted how a rush to withdraw deposits during a bubble burst contributed to their demise. Silvergate, for example, was significantly impacted by its association with FTX, the now-defunct exchange.
The report also pointed out the sporadic nature of government regulation in crypto, suggesting that this could exacerbate overarching financial risks. However, it added that “many characteristics of the digital asset ecosystem are designed to elude regulatory oversight or don’t align neatly with existing frameworks.”
Silicon Valley Bank also succumbed to failure in 2023, largely due to its ties to cryptocurrencies, particularly stablecoins, which the report identified as carrying “funding risk vulnerabilities.” These stablecoins often rely on traditional currencies and crypto assets, making them susceptible to market volatility that could threaten banks holding significant amounts.
“We contend that [stablecoins] create interconnections that can amplify shocks in the digital ecosystem, potentially spilling over into traditional financial systems,” the Federal Reserve economists wrote.
They specifically highlighted Tether, a stablecoin backed by “risky assets,” as more precarious than most money market funds, which are known for their destabilizing runs in previous financial crises. Despite backing from various assets, Tether has never undergone a third-party financial audit, raising further concerns about its stability.
While the federal government intervened to rescue Silicon Valley Bank and Signature Bank, Silvergate Bank did not receive the same support. The report noted that many crypto exchanges lack “government liquidity backstops,” like FDIC insurance, which means that consumers risk losing their savings entirely when these exchanges fail.
Though previous crypto downturns primarily affected dedicated investors, the fallout from future crashes could resonate across a wider economic spectrum if the industry gains deeper integration with traditional banking.
“If more banks engage in highly leveraged crypto trading without the necessary regulatory safeguards, the ramifications could be extensive,” Hays cautioned. “This report indicates that the problems within the sector are far from resolved.”
Meanwhile, the Office of Financial Research analyzed data from 2021 tax filings and subsequent years to pinpoint the geographic distribution and income levels of crypto owners, assessing potential systemic risks linked to the burgeoning crypto industry.
The findings reveal that mortgage delinquency rates among crypto-holding households remain relatively low—4.3 percent for low-income households—yet researchers identified a troubling potential risk for banks if these households encounter significant losses due to crypto price volatility.
“The surge in borrowing among low-income households in areas with high crypto exposure is noteworthy, with the proportion of consumers holding mortgages increasing by over 250 percent and average mortgage balances climbing by over 150 percent between 2020 and 2024,” the study reported, despite no uptick in delinquency rates.
The growing engagement of average consumers—often referred to as retail investors—in crypto trading has raised alarms among regulators and policymakers due to the inherent volatility of these assets, the reliance on loans for crypto purchases, and the scarcity of consumer protections if investments falter.
The research underscores how banks are indirectly exposed to cryptocurrencies through loans issued to clients trading in these assets, with implications that could “pose a financial stability risk” if crypto-related losses begin to affect household incomes.
Interestingly, researchers noted that “low-income households appear to be leveraging crypto gains to secure new and larger mortgages,” using profits to pay down credit card debt. They emphasized the importance of monitoring low-income households with crypto investments closely, as any distress in this demographic could foreshadow adverse effects on banks.
“An essential takeaway for future monitoring is the increased debt levels and leverage among low-income households involved in crypto,” the researchers concluded. “Financial strain within this group could trigger broader financial instability, especially if high-risk consumers are concentrated in key financial institutions.”
While recent surges in crypto prices have enriched many investors, experts caution that this wealth may be fleeting. In Trump’s envisioned “crypto capital of the planet,” the repercussions of any downturn could echo far beyond the crypto realm itself.
“People should remain vigilant, as historically, what goes up often comes down,” warned Hays from Americans for Financial Reform.
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