Wall Street Comes to Crypto
Let’s talk about the concept of hypothecation. This is when an asset is pledged as collateral to secure a loan, without giving up title, possession or ownership rights, such as income generated by the asset, to the underlying asset. It’s something that’s common in mortgage lending, but it can complicated.
Let’s say I have a chocolate bar and I don’t want to give it to you. Instead of handing you the chocolate, maybe I can give you a piece of paper saying I owe you a chocolate bar in the future. That’s hypothecation.
Now you have that piece of paper and you can say: “Hey, I have an asset. Someone owes me a chocolate bar.”
You could even give that piece of paper to somebody else. Then you would be owed a chocolate bar from me, and you also owe one to someone else. When it reaches the second step like that the concept is known as rehypothecation.
Hypothecation is they way that I’m going to put a paper claim to an asset. Rehypothecation is the way that I’m going to give it out again, and again, and again, and again.
Basically, multiple parties are reporting owning that same asset. I owe you a chocolate bar. You are owed a chocolate bar. And you owe it to somebody else, on and on.
Maybe that piece of paper gets sent down the line 10 times, before I decide to eat my chocolate bar. Just like that, 10 chocolate bars in the system are wiped out just because I ate my chocolate bar.
That’s the danger. It’s using collateral to cover exposure to several parties. These are IOUs that just piled on top of each other.
What it does is it creates money out of thin air. I created 10 chocolate bars that weren’t there. There was only one but now there’s 10 chocolate bars that are owed.
This is a basic analogy of how derivatives work.
And the scary thing is we don’t even know how large the derivatives market is globally. It’s believed to be in the range of $600 trillion-plus, but no one can be sure.
Because this is all money that has been created out of thin air.
But this won’t work with Bitcoin. There are only ever going to be 21 million Bitcoins in existence.
That’s it.
To put that into perspective, there are over 11 million millionaires just in the United States alone today. There’s not even enough Bitcoin in the world for every millionaire in the U.S. to own two.
Financialization will be creating Bitcoins out of thin air. Bitcoins that don’t exist. That will never exist.
Soon, maybe one of my Bitcoins will be owned by 10 different people.
How do we know this is the plan? Because Wall Street has been doing this with gold for years.
There’s a limited amount of physical gold in the world, of course. So institutions have created more gold with paper. Gold ETFs, gold futures, etc. These are paper trades that involve gold but aren’t really of gold. And these paper trades dwarf physical gold trades right now.
They’ve taken one piece of gold and they’ve given it out, hypothecated it, rehypothecated it over and over.
Estimates are that there are between 300 to 500 claims for every ounce of real gold. Basically 99.6% of the gold market is now paper.
This is bad for a lot of reasons. It’s not going to protect your savings. If you really needed gold for the reason you bought it for, for a chaos hedge, it wouldn’t be there.
But this practice also devalues the asset.
Price discovery comes from supply and demand. As demand goes up, supply comes down and the price goes up. That’s simple. But if instead people are putting their money into paper gold they aren’t impact that supply and demand ratio. Instead it devalues the real gold that’s out there. And that’s what financialization will do to Bitcoin.
Is this a good thing? Good is relative, so it depends. If you’re Wall Street, it’s definitely a good thing. If you’re an individual investor, it depends on your situation. Let’s look at the good and the bad and you can figure out which side you’re on.
The financialization of Bitcoin can be good because it makes an asset investible. Once that asset becomes investible, then more people will come to invest in it. That’s going to bring more money into the market and create a big liquid market where there are enough buyers and sellers to facilitate transactions. We’ll be able to get in and out of trades very easily, and of course we want that.
That’s all good.
And we’re already starting to see the effects. We’ve seen two different multi-hundred million dollar institutions get into crypto. We’re seeing hedge funds and family offices getting in. We’re starting to see pension funds and mutual funds getting in.
This is driving prices up and lifting all boats.
New crypto investors are also creating a network effect. That’s the idea that the more people are out there using something, the more valuable it is.
For example, if you had the only fax machine in the world, how valuable would it really be? You wouldn’t be able to fax anything to anyone. But when everybody has a fax machine then they’re worth something.
The more people that are using Bitcoin, the more merchants will accept it and the more usable it will become.
It will also become more secure. More people using Bitcoin will lead to more miners working on the network by mining for new coins. The more miners that are there, the more secure the network is.
The trouble with leverage
What’s the bad news?
The problem is in this idea that someone can create money out of thin air. That benefits Wall Street firms, of course, but at the expense of every other Bitcoin user and investor.
What I really don’t like is how financialization creates leverage across the entire asset base. Leverage can be really, really bad. It dilutes everything, bringing down the value while adding to the risk.
Leverage is like playing with fire. It can keep you warm, or it can burn your house down.
That’s definitely bad.
What does that mean on a global level? We saw some of it in 2008 when the whole housing market crashed, taking down banks worldwide. Leverage caused that (or at least made it much worse than it had to be).
There is such a thing as good debt. Like when someone owns an asset and then they lend it out, like renting out your vacation home. That’s a debt asset that’s generating more assets.
Bad debt is when I don’t own asset and I lend it out anyway. Like taking out a huge mortgage on that vacation home and thinking that my rental income will make up the difference.
In the financial system this goes back to that idea of creating money out of thin air, because people think they own that asset when really all they have is an IOU. It’s like a game of musical chairs that’s spread across trillions of dollars and millions of people. , it becomes a massive problem. That’s what leverage does to the financial system.
We saw it happen in 2008, and there really hasn’t been much of an effort to change the system since then, so it will probably happen again.
As a matter of fact, it’s really only gotten worse.
A perfect example of the risk we’re facing comes from Dole Foods. In 2013, the company decided that it wanted to buy all of its stock back, and it calculated that there were 49.2 million claims of stock out in the market. OK, but there were only 36 millions shares in existence.
There was 33% more. One out of everything three stockholders didn’t actually have the stock they thought they did.
And this isn’t even uncommon.
According to the International Monetary Fund, there are 2.8 assets pledged to every physical asset in the market today. That’s shocking. But the crazy thing is even that isn’t enough. Wall Street wants more. It needs more lubrication in the financial system.
We’ve been here before.
In 2008 there were actually as many as four assets pledge for every physical asset, and we know how that ended.
Crypto is not a debt-based asset at this point, but Wall Street is getting there. They really want to start piling on and adding more Bitcoins.
That’s why we’re starting to see things like crypto exchange traded funds (ETFs).
In order to make this happen, they’ll have to create derivatives around it.
All these people will think they own Bitcoin, but the ETF institution will just loan the money they take in to somebody else, count that as an asset, and loan it out again and again. This will create multiple claims against each individual Bitcoin.
We haven’t seen that happening yet, but we’re getting there. That’s what these crypto ETFs are all about.
Eventually I think that regulators are going to approve Bitcoin settled derivatives. We’re going to see crypto ETFs. It’s going to happen. It’s only a matter of time.
Hopefully these regulations will make a difference. Hopefully cryptocurrencies will remain hard to borrow. But the one way we can be sure of this is simply to hold our coins. Individual investors can fix this.
We can protect the crypto markets.
This is Part 2 of a 3 part series.
Check out Parts 1 and 3
Part 1: Is the Crypto Space Really Ready for Its Wall Street Close-Up?
Part 3: How Bitcoin and we can protect ourselves from this
