Contagion | Dechert LLP – JDSupra
What I know about cryptocurrency can be inscribed on a head of pin with a jackhammer. But I know it’s a thing; I know it’s a big thing and getting bigger. So, these past few weeks I have been reading with interest (interest, to be clear in this context, is the emotion one experiences watching a NASCAR pileup, whilst not being in one of the cars) the breathtaking collapse of Terra’s stablecoin. Having previously been entirely bereft of any knowledge of the topic, I read with considerable interest that the Terra coin was pegged to the dollar and backed by “algorithms.” Algorithms? The Terra peg was protected, theoretically (let’s emphasize that theoretical part) by allowing Terra’s owners to “burn” coins and buy another cryptocurrency which was designed not as something pegged to the dollar but as a repository of value which would rise and fall on market sentiment (backed by those marvelous algorithms again). A shock absorber to protect the peg. The companion cryptocurrency in this case was called Luna. As Terra lost its peg, you would burn Terra and buy Luna. And if Luna went down, you would burn Luna and buy Terra. Apparently, this all worked as long as everyone firmly believed it worked. Now, apparently, they don’t and it doesn’t. Terra tanked to fractions of pennies on the dollar, as did Luna. How’s that for a hedge? Ouch!
I learned that these pegged currencies are used in the crypto-verse as an easy way to trade in and out of Bitcoin and other cryptocurrencies which are repositories of value without having to actually acquire and deliver pesky actual governmental currencies.
Cryptocurrencies (with an exception of those backed dollar for dollar by liquid, conventional financial assets) are fiat currencies that have been subject to extraordinary volatility in terms of value over the past decade. Now, of course, government currencies since the elimination of the gold standard early in the 20th century have indeed also been fiat currencies as well, albeit fiat currencies backed by folks with armies, police and taxation powers. That makes a difference.
If you are a crypto aficionado my apologies for perhaps a simplistic and unsophisticated summary of the value proposition, but my purpose here is not to validate or demonize cryptocurrencies but just to make an observation about contagion. When I started reading stories about Terra these past weeks, I had a recovered memory event from 2008 (blessedly buried in the intervening years). And it wasn’t good. I clearly remember in the early stages of the Great Recession reading about the meltdown in the residential subprime lending market and its knock-on effects on resi conduit securitizations, CDOs and SIVs. I distinctly remember assuring my colleagues that while this mess in the subprime market was indeed horrible and causing enormous losses, it had nothing to do with our safe and sound commercial real estate finance market. Thank God that we missed that train wreck. Ha!
Of course, we didn’t miss the train wreck. Like an old Laurel and Hardy movie, the proverbial piano had been shoved out the window, but had not yet hit us on the heads. When the emperor’s new clothes were stripped away and billions of dollars of securities were clearly no longer (and probably never had been) par assets and liquidity was entirely washed out of the system, one market segment after another experienced cascading failure. In an environment whose common currency was leverage, we all learned that leverage can be a harsh mistress when the herd needs to exit the building.
Contagion is reality.
The detritus of the Great Recession consigned many great names to the dustbin of history and significantly impaired the financial health of banks, great and small, and other financial institutions for over a decade. The consequence of the riptide which began in the subprime lending world scarred our financial markets for years.
I really don’t want to do that again.
I’m not here to say that what just happened in the crypto space is Lehman redux but there is an echo of past pain here, isn’t there? Crypto-related losses have already exceeded $1 trillion. Worldwide regulators are reportedly worried that they don’t know where these losses lie and they worry about the amount of leverage provided on these positions through the banking system. Even if all is just fine, it’s a reasonable thing for regulators to worry about. The losses to date are certainly not nothing.
As I started thinking about contagion, crypto is where my thought processes began, but it’s not where it ends. Give a thought to the entire derivatives market. It never fails to startle me when I think of it, and I don’t often, but in our complex financial markets today where financial engineering is commonplace, billions of dollars of risk can be bought and sold on tiny cash positions serving as reference securities which perhaps either party to the trade actually owns (and probably doesn’t). In this synthetic market, the ability to take a position on an asset neither you nor your counterparty owns, is a massive force multiplier.
It’s been common for years to muse about the large and opaque synthetics market and the ebbs and flows of risk through credit default swaps, total return swaps and other arcane and generally bespoke synthetic arrangements between and amongst financial institutions and other users of capital. Don’t you sometimes wonder whether there’s an institution out there that through a long and elaborate chain of bilateral arrangements has ended up with trillions of dollars of unhedged risks on its balance sheet? More seriously, we know, or suspect, that there are plenty of enterprises, funds, operating businesses and perhaps even governments that hold derivatives positions which, under certain circumstances, generally deemed to be remote, could result in devastating losses. What confluence of disparate (remote?) circumstances could cause that to happen? It’s an unknown, but remote has happened before. And we know that losses cascade across counterparties and can grow as they cascade. What happens if that’s the case and what happens when the butcher’s bill comes due?
So, as I said I’m neither here to bury or praise cryptocurrencies (nor swaps) but simply use them as a place to start a conversation around contagion. Virtually all massive financial disruptions are accelerated or turbo-charged by contagion. Generally, the match that lit the conflagration, something that no one or very few expected to incandesce before it happened. As the late and unlamented Donald Rumsfeld said “It’s the unknown unknowns, baby!” (or something like that). Remote is not never.
Also, the thing which lights the spark does not have to be momentous. Chaos theory gave us the butterfly effect. Flapping wings in Hong Kong caused the nor’easters in New York. A small-scale event can trigger another and another and another, until a cascade of events actually becomes material. A well-known mathematician once said (I actually don’t know any mathematicians which might say something about my lack of numeracy) according to Mr. Google, small changes in one state in a deterministic non-linear system can result in large differences in a later state. How’s that for burying the lede?
The modern world and its financial structure are the very model of a major non-linear system whose interconnectivities are both obvious and hopelessly beyond the ability of people to understand and unwind. This gives reality to the notion that remote happens more often than we like.
Now as I’ve said, I’m not here to suggest that crypto’s meltdown is such an event although a trillion-dollar loss in the past six weeks is not nothing. A big friggin’ butterfly, right? It could be.
My broad point here is that it’s a great time for a serious heads up on the possibility of unanticipated risk and contagion. We are now entering an environment where not everything works and not everyone’s a genius and not every risk is worth running. It’s hard to really think about and take concrete steps to adjust to a very much enhanced and altered risk profile in our marketplace after 10+ years of quietude. But if nothing else, the meltdown in the stock market, the uncertainty in the bond market and raging inflation are tells that not all is right. Could this uncertainty be nudged into fear and flight by a meltdown in crypto or in some obscure corner of the financial market as the knock-on effects begin to spread through the economy like concentric circles progressing from the stone in dropped into a pond? Yeah.
Look, it doesn’t strike me as a time to grab the go bag, canned food, guns and find a hole, but it strikes me that we’re closer to a point where the systemic risk rambling around our financial markets could actually light the fire. Things have been lovely for the last decade. It’s time to get a little George Santayana and embrace his prescription that those who cannot remember the past are condemned to repeat it. 2008 was not that long ago.
Oh well, sorry for the gloomy take on the state of the world. Maybe it’s something I ate, but being reminded that there really are unknown unknowns out there that can destabilize the complex financial systems on which our business life depends is not comforting.
Enjoy the rest of the week. The center will probably hold until Monday.