After a tumultuous 2022, where crypto was taken to the woodshed, things have changed.
Now we are getting another crash course in traditional finance.
It’s remarkable that this happened on the anniversary of Bear Stearns in 2008 and the pandemic announcement in 2020.
Three banks down in a week isn’t something you see often these days.
And the steps taken show us the consequences of policy decisions and actions.
Then there is crypto, right in the thick of it.
And when you look at what is shaping up, there are a variety of theories.
But one thing is clear; it will take a while for this to shake out.
So we’re going to take a look at what happened, why it matters, and what we can learn from the event. Then we’ll explore where crypto fits in. Lots of the old narratives are giving way to the role crypto may be assuming.
Now, in case it isn’t clear, what follows is not trading or investing advice. This is designed to be thought-provoking. And hopefully, it opens your mind to a different way of viewing what you are seeing.
All right, let’s get to it.
The first Fed rescue of 2023
On Sunday, March 12, the Fed and FDIC came up with a special announcement. The announcement was that they would keep the depositors of two banks whole. They would set up a special fund to allow banks to access liquidity in exchange for discounted assets marked at par. And the share and bondholders would be wiped out.
They explicitly stated that it wasn’t a bailout.
In the pre-market on Monday, the regional banks were getting demolished, so they were halted.
When they reopened, several were down significantly. And that’s where they closed the day.
Now, for clarity, two of the three banks that closed were byproducts of the rotting corpse of FTX. They had been intimately involved with FTX and no doubt, may have had a role in some of the nefarious activities that the company is alleged to have engaged in.
Silvergate (SI) shut down on its own on Wednesday. But Signet (Signature Bank) was shut down on Sunday. Silicon Valley Bank’s (SVB) closing by California regulators was on Friday March 10.
The extent of this mess will take some time to play out. However, in the meantime, we are watching what happens when confidence fades, risk management fails, and policy mistakes are revealed.
Crypto still front and center
Crypto has been in the crosshairs since the many mushroom clouds in 2022. Several of these were material in nature. And they highlighted numerous failings in the responsibilities of various founders in their duties to users of their platforms.
And unfortunately, a lot of people got sucked into these services, attracted to eye-watering returns and easy passive money. Many discovered that there is no free lunch, even in crypto.
The losses associated with Celsius, Terra, FTX, and others were substantial. And the bankruptcy proceedings and some criminal cases remain ongoing.
And yet Bitcoin, Ethereum, and most of the other platforms continue to operate without interruption.
However, the extent of the crypto blowups has attracted the ire of regulators. Regulators are always working on the problems that have already happened to prevent them in the future. And they have been particularly aggressive so far in 2023.
Part of this is the battle for control over crypto assets by various federal agencies. But it is also believed by some that the aggressive stance is also to clear the way for a CBDC.
Because, of course, the one main benefit of crypto is that, at least in the case of various blockchains, they are their own system. They are outside of the financial system, and that’s not ideal if a CBDC is, in fact, designed as a stealth control grid.
A lesson in traditional banking
Silicon Valley Bank (SVB) was shut down because of a liquidity event. The event was precipitated by a huge volume of deposits being pulled and transferred in a single day.
The bank had assets to cover demand deposits, but these assets would have to be sold first.
The problem was that the assets are trading at a significant discount. And when you sell assets at a significant discount, you have to book the loss, and you send a signal to the market. Both of these signals create a risk for further deterioration.
SVB had already sold some assets at a loss and tried to raise money days prior to being shut down.
The assets SVB has are in fixed income, most of which were and remain safe assets. But even safe assets have risks. For government treasuries and mortgage bonds, there is interest rate risk, and these assets have taken a beating because of rapid rate hikes.
Which doesn’t matter if you can hold to maturity. But when you have demand for deposits from customers now, you have a problem.
Now, SVB also let their interest rate hedges run off. So they were unhedged coming into the year. This may have reflected a belief that the Fed would have to pivot. But it also left them fully exposed.
And like many businesses, they’ve enjoyed a long period of cheap easy money. This has a way of creating habits that become a problem when conditions change.
They aren’t the only ones. Everyone carrying bonds and debt securities at low yields from the low-interest rate environment of 2021 are exposed as well. The unrealized losses don’t have to be reflected unless there is a demand.
And that’s why the Feds stepped in.
How confidence in banking is shaped by events
Several events, all driven by policy, changed the picture resulting in the problem we now see.
Economic shutdowns interfered with supply chains. Energy exploration and takeaway were hampered worldwide by conditions and aggressive ESG policies. Then energy prices were driven higher by economic and physical war in Eurasia. The labor market was structurally changed due to mandated medical countermeasures creating a mixed picture of the labor market strength. And trillions of dollars were manufactured through multiple packages to provide liquidity.
All of which turned into inflation.
After a period of denial, the central banks responded with the most aggressive rate increases in history. This came after a long period of low and declining interest rates and the expectations that these would continue.
And on the books of banks, including the central banks, now sits lots of debt-based paper, trading at significant discounts from where they bought them.
The losses are unrealized because they are booked as hold to maturity. But that doesn’t help if you need liquidity today. Selling these now means steep losses.
This is what happened to SVB.
Now, there is an argument to be made for lousy risk management on rates or the securities they chose to buy. This is a valid point.
But the real story here is about easy money and how the financial system relies on confidence.
And this isn’t unique to traditional finance. It can apply equally to crypto.
We’ll return to that in a second.
But first, let’s look at what happened.
The currency of banking is confidence
SVB was caught in a difficult position. Their loan growth slowed due to changes in rates. The startup funding, which formed a base of deposits, was dormant. And there were outflows to meet obligations without much new money coming in.
It wasn’t until forty billion exited the bank in a single day that the bank was in trouble.
Why did that money leave?
Someone got a whiff that something might be wrong, and money was pulled, which hit the wires and added more withdrawals.
As the bank was closed, the books were combed over. The belief was that regional banks all had exposure similar to SVB with similar challenges due to rapid and unexpected rate hikes.
Now, remember, everyone knows about these rate hikes. They all know these institutions have this exposure. They knew about it a week ago. Months ago. But it wasn’t until confidence changed that things started to change rapidly.
And when the package was announced on Sunday, there was talk of moral hazard. Now, these banks had permission to invest aggressively, some said. But that’s not the reason they were down on Monday.
The bond and stockholders of SVB were wiped out. And nobody was thinking about how stock and bondholders might react when markets reopened.
The deal was great for depositors but a potential signal to sell for stock and bondholders.
Crypto performance in the latest turmoil
Crypto got tagged as Silvergate (SI) went under and bitcoin and the crypto market followed by dropping and basing. SVB had little impact on that part of the market.
But SVB did impact USDC, which broke the peg as SVB, holder of some of their collateral, was closed.
Some traders bought USDC at a discount for the return of the peg to par when their deposits were guaranteed. And I’m not suggesting you should do this, but it’s a way that some traders approached the event.
And USDC returned to par on Monday.
But in the meantime, Jeremy Allaire made a comment about having USDC reserves at the Fed in the future. And this is not inconsistent with what he’s said before. But it sounds a lot like a CBDC if that were to occur. Just food for thought.
Bitcoin rallied as the deal was announced, and it continued to rally into a weak Monday close for the overall market.
And the next day, it ripped higher, giving the appearance of some good old-fashioned short squeezing. Why are people short? Because they think the shutdown of Silvergate and Signature Bank cut crypto off from banking in the US.
But the market sees it differently.
The close for regionals on Monday demonstrated a lack of confidence, whereas the close of bitcoin shows an abundance of it.
George Gilder’s financial entropy
Thinking back to George Gilder’s Knowledge and Power, we are witnessing the power of entropy in finance.
Low entropy means low information. Low risk. Instant. Fast.
High entropy means new information, high risk, high return potential, and more scrutiny.
The banking sector, by way of its regulatory environment, has relatively low entropy. Or at least it could be argued that it is perceived that way.
But when something goes wrong, everyone shines a light on where the problem is, and suddenly, that low entropy entity becomes high entropy. That’s when things get interesting.
That’s where we are now with these smaller banks.
And this looks like it may be spreading to weak institutions elsewhere. Credit Suisse just got a guarantee from the Swiss National Bank. And the big banks are being flooded with new deposits.
Crypto, by contrast, is high entropy. It’s information-rich, volatile, and speculative as an asset.
But it’s also low entropy as a decentralized, censorship-proof payment system, value storage, and transfer service.
When you’re looking at the situation that’s unfolding before us, what you see is our financial world is evolving. And the role for bitcoin is now being revealed.
Do we now have a financial safety valve?
Among some crypto diehards, there is some glee at the damage we are seeing. This view is myopic and short-sighted. Banking upheavals can cause a lot of damage, and crypto isn’t capable of replacing a system that has been centuries in development.
The traditional system is what most people know and understand. This is not the kind of disruption you want to see.
However, crypto can have a meaningful role to play here.
What has to be recognized is that we are in the process of transition. The financial system has a problem. It relies on a constant stream of credit creation to function.
And we are in the process of a credit contraction and demand destruction.
We have seen that the central banks are ready and willing to step in. But what should also be recognized is that it continues to consolidate its power and influence. And given their role in creating the financial situation we are now in, that’s not ideal.
Certain existing crypto-banking relationships in the US are changing. The Feds are gathering control over how and where crypto can be used in the US. But crypto continues unabated elsewhere in the world regardless.
The lesson here is about confidence.
The banking system is a byproduct of confidence. The securities market is a byproduct of confidence, and this confidence is shaped by the belief in the underpinning regulatory environment. It was also shaped by more than a dozen years of cheap money.
And regulations have been a large part of the financial system for a long time. But these regulations would not have allowed the development of crypto had it started in traditional finance.
And having said that, crypto also relies on confidence. That confidence comes from the communities built around various projects. It’s expressed by hodling, and participation.
I don’t know about you, but this question crosses my mind a lot these days.
And there are lessons we can take from the last three years to give us insight going forward.
Over the next several days and weeks, the negative news will be fast and furious. Remember, the naives in the news make their money selling death, destruction, and fear. They’ve done this bigly over the last three years.
When you absorb too much of their message, you can become fearful. And when you’re consumed with FUD, you won’t be able to think straight.
And thinking straight is what you want to be able to do here.
Nobody knows what will happen next. And as we described in our piece on trading during uncertainty, you can expect wild and crazy.
And it requires asking good questions and thinking clearly because the panic button isn’t a solution.
In a recent interview, renowned quant strategist Martin Armstrong said that gold wasn’t a hedge.
He said that you buy gold when you lose confidence in the government.
So what about crypto?
It could be argued that crypto is being revealed as a financial safety valve. And this may become the role it will play through this.
Time will tell, of course.
But it’s fortuitous that so much of the trash in the space has now been taken out. It makes the case for bitcoin, ether, and other crypto assets more, not less, compelling than before.
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