Liquidity Encourages Speculation Which is Good For Cryptocurrencies
Whatever your take on cryptocurrencies, whether transformative new technology or fool’s gold, liquidity that is sloshing in the financial markets means that every thing has become “investable” and anything can become a new asset.
In the summer of 1998, Theodore “Teddy” Parnez was working out of a gas station in Clarksville, Tennessee.
With little more than a high school equivalency, Parnez had bounced from one dead end job to another when an old grammar school classmate told Parnez about this new invention out of California called “the Internet.”
Parnez was intrigued and with the little savings that he had, put it into an up and coming company that was involved in internet “searches” at the time, opening his first account with Charles Schwab to buy stock of that company.
Unfortunately for Parnez, the Dotcom Bubble burst soon after his investment and Parnez lost all of his invested capital.
And while Parnez swore off stock investing for some time after getting burned on his first internet stock, the persistence and struggle of the companies in the wake of failed internet search engines such as Excite, WebCrawler, AltaVista and the like, paved the way for companies such as Google, which have expanded to encompass so much more of what the world does online.
Because as destructive as bubbles can be, the carcasses of failed ventures also provide the fertile material for a host of improved technologies and more resilient companies to grow from.
But not all bubbles are productive.
Not All Bubbles Are Inflated Equal
For instance, the housing crisis that led to the 2008 Financial Crisis, did little more than redistribute wealth from the most vulnerable in society, to those who were the most well-connected and savvy.
Since 2008, successive rounds of monetary policy interventions by the U.S. Federal Reserve have inflated so many bubbles in our current time that it may be difficult to discern which will result in good long term outcomes and which will not.
Increasing its balance sheet by about 10% since last September to the end of 2019, the U.S. Federal Reserve has also injected US$400 billion to calm nervous repo markets and douse the ambers of overnight repo rate spikes.
And despite adding to its balance sheet, the Fed’s spin-doctors are trying to persuade markets that this recent balance sheet increase is not another round of “quantitative easing.”
To be sure, while the Fed is certainly not directly buying U.S. Treasury notes and bonds, it has made a sizeable uptake of short-term Treasury bills — which expands liquidity, relieves funding pressures and reduces systemic risks — all ostensibly good for markets.
Against this backdrop, prices of perceived safe haven assets such as the 10-year U.S. Treasury note have plunged, while risky assets such as stocks and deflationary assets such as gold have soared. Even Bitcoin and other cryptocurrencies have had a fantastic run recently.
But what has not been good is that liquidity injections into the repo markets do little to improve the global capital stock, or fuel innovation in a manner which would improve the quality of the global economy.
What does liquidity mean anyway?
Liquidity is measured from the funds that flow through both the traditional banking system and the repo and swap markets — and the global credit system increasingly operates through these latter wholesale markets, often with the active participation of central banks.
For some years now, wholesale money market pools have been fueled by vast inflows from corporate and institutional cash pools, from companies which have amassed large mountains of cash (think Apple and Google), asset managers and hedge funds, the cash collateral business of derivative traders, sovereign wealth funds and foreign exchange reserve managers.
Collectively, these pools have long exceeded what most investors understand to be the banking system.
In excess of US$30 trillion, the size of these liquidity pools easily exceeds the insurance thresholds for most government deposit guarantees, forcing these pools to invest in alternative, short-term but secure liquid assets — like repos.
For the uninitiated, repos are basically short for “repurchase agreements” and asset-backed commercial paper (basically a form of corporate debt).
What the repo mechanism does is that it bundles together “safe” and I use the parenthesis here liberally because of the 2008 Financial Crisis, such as government bonds, foreign exchange and high-grade corporate debt, using them as security or collateral, against which to borrow.
While credit risk is to some extent mitigated, the risk of not being able to roll over or refinance these positions is ever present.
And that’s not counting the fact that just because they are deemed “safe” doesn’t make them “safe” per se as huge tranches of triple-A rated securities were found to be worthless in the run-up to the 2008 Financial Crisis.
Yet against this backdrop, instead of focusing on the increase in capital stock and the funding of research and development that adds to the value of the economy, markets have instead remained fixated on policy interest rates which according to the best-intended textbooks, control the pace of real capital spending and the business cycle.
But the world has moved on.
The global financial system needs to be viewed from the lens of a capital redistribution mechanism, dominated by these giant liquidity pools that are used to refinance existing positions, instead of raising new money.
And capital spending itself has been eclipsed by the need to constantly roll over massive debt burdens.
When debts become due, there are only three things that can happen — the debt gets repaid, refinanced or repudiated.
Yet not only is much of the new debt taken since the 2008 Financial Crisis not going towards funding new investments, much of it is unlikely to ever be paid back and is worryingly, compounding even higher.
To put that in context, by some estimates, global debt levels now exceed US$250 trillion, or over three times the value of global gross domestic product and approximately double the US$130 trillion pool of global liquidity.
But because refinancing has taken urgency and precedence over other concerns — quantity, in the form of liquidity, has also trumped quality (price or interest rates).
And central banks play a key role in determining liquidity by both setting interest rates as well as expanding and shrinking their balance sheets.
Given that central banks have found it so difficult to not flood the markets with liquidity, it’s only natural that a rising tide of liquidity will float all asset boats, including for cryptocurrencies.
Not All Debt Is Created Equal
Satoshi Nakamoto’s seminal Bitcoin whitepaper alluded to the unsustainability of a global financial system fueled on debt, that either will never be paid down, or was never intended to be paid down.
Because these are unprecedented economic times, many of the old beliefs about macroeconomics no longer seem to apply. Long laid-down relationships between interest rates and inflation have been broken.
Correlations between interest rates, stocks and bond prices have been decoupled.
And against this backdrop, gold, an asset derided as producing zero yield, has risen on the back of global economic uncertainty.
Cryptocurrencies have risen this year as well.
Because when credit unravels, it’s hard to say which shoe will drop first.
In the last financial crisis, banks and households bore the brunt of the credit crisis. Since then, both banks and households have cleaned up their balance sheets, while companies have piled on debt.
Companies affect the global economy in a far more profound way, with their ripple effects being felt through unemployment and borrowing from banks — the systemic risks this time are far greater than at any time in the past.
If it was debt that got us here, then more debt can’t be the answer to get us out.
It’s like saying the way to beat a nicotine addiction is to smoke more cigarettes.
And because yield is so hard to find, liquidity has allowed bubbles to form in a broad scope of assets — including in cryptocurrencies.
But that’s not necessarily a bad thing.
Because some speculation is healthy and if investments in blockchain technology and cryptocurrencies can help to spur the next financial revolution, ultimately the world will benefit from it.
No doubt there will be many who will lose money from such investments — that is the nature of speculation and funding innovation.
And while it may be cold comfort to those investors who lose money speculating in new technologies, should those technologies add to the stock of the global economy, they can at least take some consolation in that their contribution was not in vain.
It’s a bit like venture capital investing, where good odds have one out of ten companies hitting it out of the park, two performing at a mediocre level and the other seven bombing out.
But that one company may have made all the difference.
So yes, excess liquidity is bad because it leads to speculation, but speculation in and of itself is not a negative.
Where liquidity is least productive perhaps is what it is being used to fund now — the rolling over of debt.
If excess liquidity is channeled to fund businesses that would otherwise never receive a dime in investment and these businesses ultimately transform the world for the better, then that is liquidity well spent.
But as investors, it’s important to note that because liquidity is a rising tide that floats all asset boats, when the tide is high, it’s sometimes safer not to swim too far from the shore.
Speculate if you must, hedge where you can.