Why Wall Street Survived the Crypto Crash
As cryptocurrency prices fell and funds failed, Wall Street firms were able to avoid the worst by enforcing strict rules on risky assets. Retail investors were not as fortunate.
In the midst of an ecstatic cryptocurrency market last November, analysts at BNP Paribas, compiled a list of stocks. These were 50 stocks they thought were overpriced, including many with strong ties to digital assets.
This collection was dubbed the “cappuccino basket,” a reference to the volatility of the stocks. The bank went ahead to convert these stocks to a product. This allowed its most important clients — pension funds, and hedge funds, to bet on the assets.
Bitcoin’s sudden crash
In the past month, the froth around Bitcoin and other digital currencies has dissipated. It took down some cryptocurrency companies that had sprung up to aid in their trading, and the value of the cappuccino basket shrank by half.
BNP’s Wall Street clients who bet on that outcome are now rich. Small investors who piled into overpriced crypto assets and stocks during a retail trading boom are reeling on the other side of the trade.
The moves in crypto coincided with retail money flooding into US equities. And equity options equities and derivatives strategy group, which put the trade together. There is a significant difference between retail and institutional positioning. Wall Street is victorious in the great cryptocurrency bloodbath of 2022.
It’s not that the financial titans didn’t want to join in on the fun. However, Wall Street banks have been forced to wait it out. Alternatively, like BNP, they needed to approach crypto with caution. At the same time, large money managers used strategies to limit their direct exposure to cryptocurrencies. As a result, when the market crashed, they were able to limit their losses.
You hear of the stories of institutional investors dipping their toes, but it’s a very small part of their portfolios.
Lessons from 2008
Unlike in the financial crisis, when the failure of subprime mortgages backed by complex securities brought down both banks and ordinary people, causing a recession, Wall Street and Main Street fortunes have diverged more dramatically this time. (Bailouts saved the banks the last time.) Collapsing digital asset prices and struggling crypto start-ups did not contribute significantly to the recent financial market convulsions, and the risk of contagion is low.
However, while the crypto meltdown has been a footnote on Wall Street, it has been a traumatic event for many individual investors who poured money into the cryptocurrency market.
Many retail investors were drawn in by the promise of quick returns, astronomical wealth, and an industry not controlled by the financial establishment, and they purchased newly created digital currencies or stakes in funds that held these assets. Many were first-time investors who, while stuck at home during the pandemic, invested in meme stocks such as GameStop and AMC Entertainment.
They were bombarded with advertisements from cryptocurrency start-ups, such as apps that promised investors massive returns on their crypto holdings or funds that gave them Bitcoin exposure. These investors occasionally made investment decisions that were not based on value, egged on by one another on online discussion platforms such as Reddit.
The cryptocurrency industry grew quickly, fueled in part by the frenzy. At its peak, the market for digital assets was worth $3 trillion, which is a large sum but not as large as JPMorgan Chase’s balance sheet. It existed outside of the traditional financial system, in a space with little regulation and an anything-goes attitude.
The meltdown began in May, when TerraUSD, a cryptocurrency meant to be pegged to the dollar, began to fall, dragged down by the collapse of another currency, Luna, to which it was algorithmically linked. The two coins’ death spiral sank the broader digital asset market.
Bitcoin, which was worth more than $47,000 in March, fell to $19,000 on June 18. Celsius Networks, a cryptocurrency lender that offered high-yield crypto savings accounts, had suspended withdrawals five days prior.
Martin Robert is worried that he will never see his two Bitcoins again because they are stuck on Celsius Networks. He intended to use the coins to pay off debt.
Martin Robert, a day trader in Henderson, Nevada, was getting ready to celebrate his 31st birthday on the day Celsius froze withdrawals. He had promised his wife that he would take a break from the market watch. Then he saw the headlines.
Beth Wheatcraft, a 35-year-old mother of three from Saginaw, Mich., who relies on astrology to guide her investment decisions, said trading in cryptocurrency required a “stomach of steel.” Her digital assets are mostly Bitcoin, Ether, and Litecoin, with a few Dogecoins that she can’t recover due to a corrupted hard drive on a computer.
Ms. Wheatcraft avoided Celsius and other companies offering similar interest-bearing accounts because she saw red flags.
The Bitcoin Trust, a popular fund among small investors, is also in turmoil. Grayscale, the cryptocurrency investment firm behind the fund, marketed it as a risk-free way to invest in cryptocurrency by eliminating the need for investors to buy Bitcoin themselves.
However, the fund’s structure does not allow for the creation or elimination of new shares quickly enough to keep up with changes in investor demand. When the price of Bitcoin began to fall rapidly, this became a problem. Investors trying to get out drove the fund’s share price well below Bitcoin’s price.
Grayscale asked regulators in October for permission to convert the fund into an exchange-traded fund, which would facilitate trading and thus align its shares more closely with the price of Bitcoin. The Securities and Exchange Commission denied the request on Wednesday. Grayscale promptly filed a petition to overturn the decision.
Role of regulation
When the cryptocurrency market was booming, Wall Street banks sought ways to participate, but regulators refused. Last year, the Basel Committee on Banking Supervision, which helps set capital requirements for the world’s largest banks, proposed giving digital tokens such as Bitcoin and Ether the highest risk weighting possible. To offset the risk, banks would have to hold at least the equivalent value in cash if they wanted to include those coins on their balance sheets.
Bank regulators in the United States have also warned banks to avoid activities that would result in the inclusion of cryptocurrencies on their balance sheets. That meant no loans secured by Bitcoin or other digital tokens, and no market making services in which banks took on the risk of ensuring that a particular market remained open.
Goldman Sachs displayed Bitcoin prices on its client portals so that customers could monitor price movements even if they couldn’t use the bank’s services to trade them. Both Goldman and Morgan Stanley began offering some of their wealthiest individual clients the option of purchasing shares of funds linked to digital assets rather than tokens directly.