[Market Info] Credit — the Parallels and Disparities of Crypto and Real World Monetary System
Cryptocurrency market has boomed over the last few years and it has been, as a minimum, a viable alternative to our existing fiat-based monetary system. The crypto monetary system is similar to the fiat system in many aspects, and I often compare the crypto monetary system as the financial system of an emerging country: lately, I have been using Macau as an analogy. However, it’s also different in term of credit creation, as the crypto system is a overcollateralised system and there’s no credit creation process.
No Credit Creation in Cryptocurrency System
In most economies today, central banks manage economies by adjusting monetary supply (M2). Money multiplier is the monetary effect that explains how credits are created in a financial system.
In the picture above, credits are created when Bank A (in line 1) lends out to a person B $90, and the monetary supply in the economy goes from $100 of issued capital (m1) to $190 (m1+credit, m2). As such practice repeats amongst multiple banks and persons, any $1 injection of basic monetary supply into the financial system can be multiplied several times. In reality, central banks like Fed adjusts the level of interests rates by buying or selling of government bonds, rather than injecting cash, for the same purpose of managing monetary supply levels.
In the fiat system, credit is created when a loan is extended to Person B (and other person onwards). The evaluation of credibility is the key to the health of any fiat financial system. Financial crisis happen when credit evaluation fails. Economic contractions happen when there’s less than needed credit; inflation, and potentially financial crisis, take place when there’s more credit than necessary.
The cryptocurrency system does not create credit in the process. When you pledge ETH into MakerDao for DAI, the amount of DAI can be taken out is less than the collateral. In Aave, you can only borrow less than what you deposit. As the cryptocurrency space is based on anonymity, there’s no credit based on the track record of the borrower, as least not yet on a large scale*.
This would mean there’s no systematic risk in the cryptocurrency system. Your risk, whether you are an individual or institution, is only limited to the amount of your assets. In fiat system, you can potentially borrow more than your assets, e.g. excessive mortgage loan. But in crypto system, this is not possible. In the crypto system, if a crypt equivalent of Lehman Brother fails, its damage is only limited its own assets, and will not extend to other players in the market.
Not All Crytpocurrency Can be Redeemed into Fiat at the Same Time.
You may argue there’s no need to redeem any crypto into fiat. Well, miners of BTC and ETH do pay electricity bills. In a larger sense, if the cryptocurrency system is to merge into the real world of goods and services circulation system, cryptocurrency must have a real world value reference. If a Big Mac is $4, and McDonald will not accept any cryptocurrency payment less than that.
Nonetheless, it’s also true that not all the cryptocurrency will be redeemed, at the same time, into fiat. It’s just like not all the US dollar will be redeemed into gold; or all the CNY holders cash out to foreign reserves. This is proven by the modern central banking system that a financial system only need to keep a certain level of reserve to ensure its stability. A full collateralisation is not needed, i.e. there’s no need for gold standard.
So, cryptocurrency system will function stably when there’s enough fiat available in the system, serving as a reserve. Then, the question is, what’s the level of fiat reserve now in the cryptocurrency system? And what should be the ideal or necessary level?
It’s hard to answer, as the cryptocurrency system is not a country; whilst all data on the cryptocurrencies are on chain and thus transparent, the fiat part is not. So we have to make an estimate.
We estimate that most fiat reserve directly relating to the cryptocurrency system are in: 1) fiat-backed stablecoin collaterals; 2) centralised exchanges where fiat-trading pairs are mojority.
As of March 2022, there’s approximately $154 billion fiat-based stablecoins in circulation. Exchange fiat reserve is hard: Coinbase announced in its annual report it had $10.5 billion, and applying its estimated market share in fiat-denominated crypto exchanges of 50%, we estimate the total fiat reserve in all fiat-trading exchanges are $21 billion. That gives a total of $175 billion of fiat in the cryptocurrency system today.
The next step relates to our observation in the first topic. Since there’s no credit creation, we can take the market capitalisation of the cryptocurrency as the total supply of cryptocurrency. According to Coingecko, it’s at $2.2 trillion as of March 2022. The ratio is 12.7, dividing total cryptocurrency supply by fiat reserves in the cryptocurrency system. In other words, one dollar of cryptocurrency can be redeemed for 12.7 cents.
Whilst mass simultaneous redemption will not happen in a $2.2 trillion industry, we can make some comparison with real world countries, if we think the entire cryptocurrency system as a country.
The picture above shows the M2 supply and reserves (gold and foreign currency) in USA, China and Japan**. The M2 over Reserve ratios are from 1.37 to 5.35 for these major economies in the world.
Cryptocurrency’s supply-reserve ratio is higher than M2-reserve ratios in major economies, but this can be the result of several reasons, including, not all BTC and ETH are still in circulation (lost of private key or other reasons), not all cryptocurrencies can be redeemed to fiat, the prices of cryptocurrencies are subject to trading volumes, etc. Neither did we study in depth complex instruments in the cryptocurrency space, e.g. cross-chain bridges.
Notwithstanding the above qualifications, if the supply-reserve ratio of cryptocurrency is high, then the industry is on a boom, justifying the inflow of capital and human resources as well as the the emergence of numerous innovations in this space. Monitoring the change of this ratio is an effective indicator of sentiments in this industry.
If the supply-reserve ratio is normal, we should have a higher level of confidence on the utility of cryptocurrency. No credit creation in the cryptocurrency system reduces the systematic risk, and this is a plus for cryptocurrency to become an alternative or a supplement to the existing fiat financial system.
(Kane, Serenity Team, 29 Mar 2022, Twitter: https://twitter.com/SerenityFund )
Notes and References
- Credits should be given to TrueFi and Maple Finance for creating cryptocurrecny loans using fiat credit evaluation metrics. Fei Protocol had attempts to create under-collateralized stablecoins but did not work as designed.
- Source: Gold Reserves https://worldpopulationreview.com/country-rankings/gold-reserves-by-country ; Foreign Reserves https://en.wikipedia.org/wiki/List_of_countries_by_foreign-exchange_reserves ; Gold Price https://www.bloomberg.com/markets/commodities/futures/metals ; M2 https://tradingeconomics.com/country-list/money-supply-m2?continent=america ; Exchange Rate https://www.bloomberg.com/markets/currencies/cross-rates