2. Ripple effects for the larger financial system and macroeconomic update

The Facts:

• The troubles surrounding Silvergate, Silicon Valley Bank (SVB) and Signature Bank caused greater fear and contagion beyond institutional-servicing banks, and spread into the broader financial system, with clients of major retail / deposit banks initiating bank runs.
• There are overall stringent macroeconomic and monetary conditions, including tight liquidity, high interest rates and sustainably elevated inflation levels.
• Although not directly related to the demise of the three banks, deteriorated market sentiment also hit Credit Suisse, a major industry and retail bank, and the first European banking entity to be affected in a major way.

Our Take:

• Following years of zero interest rate policies, substantial quantitative easing (QE), effectively flooding the financial system and the economy with cheap liquidity, last year marked the beginning of the steepest interest hike ever, raising interest rates by roughly 60x from their lows in less than a year, combined with quantitative tightening (QT) effectively removing liquidity from the system.
• As a result, bond prices saw extremely steep declines in their valuation, amongst other troubles, revolving around increased financing costs for major parts of the economy, that were operating largely on cheap access to funding, which are slowly but steadily being priced out of the market by the current monetary policy regime.
• The consequence for financial institutions and banks that held these bonds are substantially high, unrealized losses on their balance sheet, that if they had to be realized would force them into bankruptcy, as they cannot return all their customers’ deposits in whole.
• The troublesome part is that the banks are factually solvent, if they would be able to hold the bonds until maturity, at which point their value returns to the original face value, whereas the temporary price decline is due to interest rate hikes, this is known as a typical asset liability mismatch, induced by a (bond) maturity duration mismatch.
• The dilemma stems from behavioral and game theory that is causing the bank run: if all clients were to withdraw their money, the bank is forced to realize their losses, causing some depositors to not have their funds returned, whereas if all held out, all would be made whole, yet every one´s individual most beneficial decision, is to withdraw their funds as fast as possible, initiating the infamous bank run that bankrupts banks.
• Going forward, it is highly likely that all the effects of the current monetary regime have not yet rinsed through the entire financial system or the economy, implying that the overall risk remains elevated in the interim.
• A troublesome finding is that the FDIC, which is supposed to fund the bailing out of banks, covers a mere 1.3% of the entirety of deposits with banks, though it has to be noted, that it is highly unlikely that all banks simultaneously realize substantial losses on their deposits.
• Generally, the trust in banks and the financial system is even more disturbed and has substantially decreased as of recent, with major depositors withdrawing their funds from more risky banks, amidst rating agency Moody downgrading the entire U.S. banking system.
• Fortunately, the crypto market itself has so far has only been affected in a moderate way by the financial troubles surrounding the financial system and the broader economy.
• Going forward, the issues surrounding the financial system are unlikely to be stopped at any point, unless the current interest rate will be cut, and inflation will decline further, which will ease the overall stress on the economy.
• Though it would be favorable to see the financial conditions ease, it seems unlikely that a potential rate cut and liquidity injection, and or potential overall QE, will not cause inflation to pick up again, reigniting the vicious spiral our economy finds itself in.

Our take: Where is crypto going?

Crypto will survive.

• The current economic and financial conditions are tough for the financial system, the economy, and citizens, but nevertheless, there are various reasons to point towards the light at the end of the tunnel and observe the optimistic trends and developments for the crypto industry going forward.
• Firstly, the troubles and headwinds the crypto industry is facing in the U.S. currently are not shared unanimously, with U.S. States such as Missouri legally protecting Bitcoin mining, or Arizona, Texas, Florida for example having very positive, endorsing attitudes towards crypto.
• The European Union, the United Kingdom, the United Arab Emirates as well as major Asian economic and financial hubs such as Singapore and Hong Kong moved forward substantially in providing proper regulatory frameworks and ground for business for the crypto industry recently.
• “Foot voting” is the economic concept of businesses, capital and individuals moving to where the ease of business is highest, which is especially the case for the dynamic crypto industry, enabling it to easily adapt to a changing economic and business environment.
• It is highly likely, that major crypto adoption will continue in those jurisdictions that create friendly and open environments for the crypto industry to operate on.
• Furthermore, the largely “unbanked” crypto industry still has major crypto endorsing banks, amongst them BNY Mellon, JPMorgan, Cross River or BCB Group, while the incentive for new banks to step in, and capture tremendous revenues by servicing the crypto industry is very high.
• With crypto businesses having a high motivation to find new banking partners, it is plausible that new partnerships will be entered soon, and that the current restrictions of on- and offramp liquidity will be temporary.
• The current effects of the financial troubles and contagion in fact had the opposite effect of what would be expected for crypto adoption, as it actually increased with more than one million BTC wallets being created last weekend alone.
• Lastly, financial crisis and times of economic turmoil in the past have offered extremely attractive investment opportunities and “cheap” prices, historically, which is why the current situation should counterintuitively be seen as a chance, not as a crisis.

In other news

• Abritrum Airdrop announced (via Arbitrum)
• Euler Finance exploited for $197 million (via Decrypt)
• Binance to buy $1 billion worth of crypto (via Coindesk)
• EU passing smart contract regulation (via Cryptoslate)
• U.S. governments request to delay Voayager – Binance deal rejected by bankruptcy judge (via Cryptoslate)
• Buyers of Signature must agree to give up all crypto business (via Coinmarketcap)

Curious what the year 2023 will look like? Read our 2023 Outlook, which has been published recently.

The latest episode of Decrypt titled “The Shanghai Upgrade and what is means for investors” focusses on the upcoming Ethereum upgrade dubbed Shanghai/Capella and its possible volatility implications. Will we see a bullish unlock?