Can crypto-contagion infect traditional finance?

The crypto carnage has a silver lining: the broader financial system has been spared so far.

From Brussels to Washington, financial watchdogs are downplaying the risk of the turmoil spilling over to other markets and say their own actions have shielded banks from the crypto slide.

“This contagion has not spread to the traditional banking and financial sector,” acting US Comptroller of the Currency Michael Hsu told the Financial Times.

“This is due, at least in part, to federal banking regulators’ continued and intentional focus on safety, soundness and consumer protection,” he said.

On Thursday, global regulators in Basel went further by proposing stricter rules cap crypto exposure at 1% of a bank’s assets.

The Federal Reserve, which recently released the results of its annual stress tests showing that the largest US banks could suffer more than $600 billion in losses and still exceed government-imposed capital levels, sees limited exposure from banks to crypto markets, according to Fed officials.

Outside of banking, firewalls include investment guidelines for institutional investors that limit their exposure to digital assets, a Securities and Exchange Commission official noted.

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The official added that there were no signs that the crypto selloff had sparked a cash rush from investors seeking the buyback of traditional securities to cover crypto losses, although the SEC was still monitoring this activity.

“For traditional asset managers, the direct impact of selling crypto is pretty minimal,” said Anne Richards, chief executive of Fidelity International. “Bitcoin has made its way into a small number of institutional wallets, but for most groups it is still very marginal.”

Andrea Enria, the European Central Bank’s chief banking supervisor, told a European Parliament committee on Thursday that there were “still very limited” links between crypto and banks.

“But I’m seeing increased interest from banks to maybe enter these markets because they’re seeing potentially very interested younger populations. . . I’m also seeing, in general, more instability in the sector, so more the sooner we can regulate and give clear guidance, the better.

Paschal Donohoe, Ireland’s finance minister and chair of the Eurogroup of finance ministers, said officials were not concerned at this time, but added: “I can imagine that in a year’s time we will be as focused on crypto-currencies than on climate risk, which is one of our main concerns.

Large regulated banks have found ways to offer crypto products to their customers. JPMorgan Chase by Jamie Dimon helps crypto exchanges Coinbase and Gemini with deposit and withdrawal transactions; Goldman Sachs sold bitcoin-related derivatives while providing loan to Coinbase collateralized against bitcoin; and many banks offer wealthy investors access to crypto investment funds.

Smaller U.S. lenders have invested deeper in crypto, courting digital asset customers such as stablecoin issuers, crypto exchanges, and merchants. These include Signature Bank, which said more than a quarter of its roughly $120 billion in dollar deposits are tied to digital asset customers, and Silvergate, which took almost all of its its $29 billion in digital asset customer deposits.

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Fearing to dive too deep, banks have missed more than 95% of the estimated $4-5 billion in revenue for businesses and institutions generated in 2021 from digital assets, according to a report by Morgan Stanley and Oliver Wyman.

“Banks have to go where customers want them to go, so if there had been pressure from customers, they could have engaged more [crypto] said Mitch Eitel, managing partner of the financial services group at Sullivan & Cromwell.

In the absence of banks, dedicated crypto lenders stepped in for loans. These companies generally fall into two categories: decentralized lenders such as Aave, where funding activity is tracked on its blockchain, and centralized lenders such as BlockFi and Nexo.

Low direct exposure to banks would make them less likely to act as a conduit for financial stress from the crypto crash as they did in 2008, according to Clifford Chance partner Jeff Berman.

“Banks do not hold crypto and they have been very careful about lending against crypto. And in fact, most crypto lending has been done by crypto specialists. Overall crypto exposure is therefore low,” Berman said.

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Crypto hedge fund insiders also seem relaxed about how this could affect major traditional bank brokers and the broader financial system.

Since most of the mainstream banking brokers that service traditional hedge funds have yet to enter the crypto space, crypto funds tend to use brokers that specialize in digital assets, although they may still occasionally use banks when trading more traditional assets. This is seen as limiting the potential for banks to suffer significant losses when a fund blows up.

“I don’t see this spreading to the world of traditional finance,” said Edouard Hindi, chief investment officer at digital asset manager Tyr Capital. “The risk [of contagion] that exists in traditional finance does not exist in crypto.

Meanwhile, many large macro and quantitative hedge funds that have started trading cryptos have done so using futures contracts, for example on the Chicago Mercantile Exchange, rather than the underlying cryptocurrencies themselves. .

If they were to incur losses on such positions, they “should have had to show more margin with CME or incur cash losses with DeFi exchanges,” said Usman Ahmad, managing director of Zodia Markets, a platform digital asset trading platform owned by Standard Chartered. .

None of these are expected to impact banks’ prime brokers, unless these losses prevent the fund from meeting margin calls from banks that act as brokers for the fund’s other assets, a- he added.

All of this has led some Wall Street heavyweights to already conclude that the crypto mess poses no systemic risk for banks.

“I don’t think it’s big enough to be systemic,” said Howard Marks, co-founder and co-chairman of Oaktree Capital Management. “For something to have a systemic impact, I think it has to be part of the system and the institutions.”

Soothing statements from regulators have not always been prescient, especially in the run-up to the 2008 subprime mortgage crisis, when government officials downplayed the risks. And not everyone is reassured this time.

“I think the risk of systemic contagion from a crypto crash is real, although it’s hard to know for certain how deeply digital currencies are intertwined with hedge funds and other traditional financial firms,” ​​he said. said David Trainer, managing director of the investment research firm. New constructions.

“As the sell off continues, we will soon find out how much systemic risk there is.”

By Joshua Franklin in New York, Stefania Palma in Washington, Laura Noonan in Brussels and Scott Chipolina, Laurence Fletcher, Harriet Agnew and Owen Walker in London

About Kristina McManus

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