Planning for the fall: what a cryptocrash would look like

The exuberant growth of the cryptocurrency market has led many to conclude that the market is in the midst of a bubble and, with a currency based on a meme about Japanese dogs (dogecoin) trading with a market cap above $1.67bn, it’s hard to disagree.

The severity of the 2008 financial crisis has left the world fearful of bubbles, and the dotcom crash remains fresh in our minds. At the time of writing, total cryptocurrency market cap is about $580bn (according to coinmarketcap.com) of which approximately $200bn is bitcoin. That’s down from more than $700bn only a day ago.

Before examining the consequences of a crash in bitcoin’s value, let’s examine how such a crash could occur. What could stop the $200bn digital juggernaut?

Given the fact that the bitcoin’s main appeal remains its propensity to increase in value, rather than its dubious merits as a payments system or store of value, it is incredibly vulnerable to shocks.

There is a hard core of bitcoin fanatics who believe in the cryptocurrency’s potential to remove the need for banks and central banks and who will probably refuse to sell under any circumstances. These are an increasingly marginalised segment of the investing population, who adopted early, and will probably provide a price floor much lower than present levels.

However, should price growth stall, the extremely limited utility of bitcoin means that it is likely to see an immediate crash in price, as momentum followers drop it. They will be pitted against those that have been sitting on the sidelines, feeling they have missed out and waiting to buy the dip. 

Even if it never regained its former glories, in this case price declines would probably be slow and without great pain as people gradually cash out.

A sudden crash would probably require something more dramatic than a tailing off of interest.

JP Morgan CEO Jamie Dimon’s (since retracted) comments that bitcoin is “a fraud” coincided with bitcoin’s price dropping around $1,500 to $3,500. Bitcoin quickly retraced the losses and may, in any case, have outgrown sensitivity to such quotes. 

However, should a regulator take a stand and restrict trading and activity in the currency to professionals or qualified investors — or even ban it outright — we might see a more lasting knock to bitcoin’s appeal. 

This week, the possibility of South Korean regulators cracking down on cryptocurrency trading sparked a $2,000 price fall (to around $12,500) in 24 hours, wiping hundreds of billions off the market cap.

The current sell-off is dramatic but by far the most dangerous eventuality for the bitcoin price would be something known as a 51% attack. While the robberies and frauds perpetrated by or on various exchanges have done little to dampen enthusiasm, a 51% attack could destroy confidence in the system utterly.

The security of the bitcoin network relies utterly on the impossibility of a single actor controlling 50% of the network.

Its security is predicated on the assumption that no actor will control 51% of the processing power and therefore will not be able reliably to find a hash function to validate a fraudulent block before the consensus. 

Given that the bitcoin mining network is the most powerful in the world, this makes it a remarkably secure system.

But if someone were to seize control, they would be able to “double-spend” bitcoins, validating transactions but not changing the amount in their account. Such an attack would destroy faith in bitcoin and put an end to its mass-market appeal.

Roughly 75% of the world’s bitcoin mining power is in China. Last week, China announced that it would begin shutting down mining centres.

Imagine if, rather than shut down the systems, either the Chinese government or a single private entity were able to seize control of this vast mining network. 

When you consider that the top four bitcoin miners already control more than 50% of the hash rate, the possibility doesn’t seem quite so far-fetched.

In the event of a 51% attack and a drop of, say, 95% in the bitcoin price, what would be the result?

First, the cryptocurrency market as a whole would suffer. Cryptocurrencies are a fairly strongly correlated asset class. When bitcoin crashes, altcoins tend to fall too (although recovery tends to be more sporadic). 

Unless bitcoin were to crash as a result of a mass switch to another coin, factors that hurt bitcoin’s value also bring down a huge section of the cryptocurrency market.

For the broader financial system, however, while the crypto-marketcap is impressive, it is not necessarily of a magnitude that could destabilise an economy.

Futures markets, first introduced late last year, change the game a little. Total exposure to fluctuations in the price of bitcoin is no longer limited to the market cap.

Memories of complex structured products causing massive loses for the world’s biggest banks and economies make the prospect of institutionalised cryptocurrency trading terrifying.

While futures are the only bitcoin derivative currently available, more complex structured products could eventually hit markets, making risk models work overtime as they try to determine appropriate margin payments.

Even bitcoin futures are hardly a simple matter.

Commodity Futures Trading Commission chairman Christopher Giancarlo has warned on the murky spot market that marks Bitcoin futures. 

Kraken, one of the three exchanges the Chicago Mercantile Exchange uses to price its futures, went down for nearly 48 hours last week.

Important questions about the bitcoin futures market remain unsettled.

Can margin models calculate appropriate levels of collateral? Should these products be cleared in central counterparties alongside less volatile asset classes?

Cryptocurrencies are unlike any asset class in existence, which could mean that modelling for appropriate collateral levels is difficult, with the short look-back period of available data potentially inappropriate. 

The changing regulatory environment will makes this type of modelling tougher still.

Since some brokers facilitate a long bias, demanding a huge collateral pay-off to go short, those financial institutions involved could be vulnerable, should cryptocurrencies collapse.

That being said, margin requirements seem to be high, many banks are still on the fence about acting in a broking capacity, and institutional interest is still nascent. 

Regulators are following cryptocurrency developments very closely, leading to delayed adoption by big players in conventional markets. 

These are not the circumstances that lead to a broader financial meltdown. It may be quite some time before bitcoin could become sufficiently integrated into the mainstream financial system to cause meaningful damage.

For now, the real pain in a crypto crash would be suffered by retail investors, attracted by the promise of incredible returns in record time.

In December, Joseph Borg, the president of the North American Securities Administrators, told CNBC that he had seen people take out mortgages to buy bitcoin and participate in the bull run.

While the cryptocurrency spot market doesn’t facilitate the level of market surveillance afforded by other asset classes, according to Dimcoin, there are 457,000 addresses richer than $10,000. 

These individuals or institutions are spread across the world and the loss of their investments would be unlikely to cause a material effect on any economy.

But ultimately, the level of bitcoin exposure taken by small investors will not be revealed until the music stops and the market suffers a purifying crash.

We can only hope that such a crash comes sooner rather than later and that the cryptocurrency is rebuilt from the ashes with a firm regulatory foundation and a commitment to stability and transparency.