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  • Writer's pictureInvestment Synergy Team

Does... somebody needs to pop the cryptocurrency bubble now while there’s still time?

This is the moment, say the more breathless cryptocurrency fans, that digital currencies go mainstream. It’s the moment that the bitcoin price “goes parabolic”, they claim. It’s the moment the Luddite crypto-sceptics have to stare at their shoes in embarrassment.

Unless there is last-minute hiccup or change of heart by the regulator, the US Securities and Exchange Commission, the first exchange traded fund linked to bitcoin futures is set to start trading within hours.

Suddenly, investors will as easily be able to put their money into something approximating to bitcoin as they can into any other listed share or fund. The new ProShares Bitcoin Strategy ETF will sit in their retirement accounts and look no different to any other listed, traded and liquid security.

The new securities (stock market code: BITO) will be lapped up as easily as, say, another fund devised by ProShares, its popular investment product specialising in companies making pet products, which goes by the cuddly ticker PAWZ.

While consumers can already buy digital currencies through specialist platforms, some are nervous about holding digital assets directly and grappling with digital wallets. Institutional investors are often legally prevented from doing so.

The new fund, by contrast, will be priced in familiar, reassuring US dollars. It will buy and sell futures contracts, via a regulated US exchange, also priced in familiar, reassuring US dollars. It could, in theory, come close to replicating the returns or losses from holding bitcoin.

It won’t exactly, of course. The frictional costs of buying exposure through derivatives will act as a drag on returns and could amplify any losses. The fund has to constantly sell bitcoin futures as they approach expiry date and buy new ones in a perpetual process known as “rolling”. There are major liquidity issues too.

A handful of other US asset managers are lining up to follow so long as the SEC doesn’t veto the ProShares product. In the weird world of financial regulation, the SEC doesn’t actively approve products; it just doesn’t explicitly block them.

News from Bloomberg last week that the product was unlikely to be blocked was enough to push the price of bitcoin past the $60,000 mark and within touching distance of the $64,895 peak of April this year.

With this milestone, crypto becomes a little bit more normalised, institutionalised and embedded in the mainstream financial system. Which is precisely what gives some sensible regulators the jitters.

Many of the downsides of crypto have been well rehearsed: its use to finance gangsters, money launderers, tax cheats and hackers. Its consumption of mind-boggling amounts of electricity. Its spawning of hucksters and fraudsters who prey on the credulous and greedy.

We all know the investor protection worries. Most digital currencies including bitcoin are backed by nothing and have no intrinsic value. Their appeal is entirely based on the hope that someone else may be prepared to pay even more for them in future. Regulators cannot say too often that buyers risk losing 100 per cent of their money.

There is just about a plausible case that one cryptocurrency could evolve to become a lasting and credible store of value in dicey times — digital gold, in fact. But what about the other 7,999 cryptocurrencies out there? Gold is valued precisely because it isn’t tin or iron. Even this “digital gold” theory is doubtful.

At the heart of the appeal of gold is that it is not just rare, but physical and portable and still desirable in even the most violent and anarchic of times. In the event of a complete breakdown in civil society, it’s not at all clear that a string of non-replicable computer code would buy bread or sweeten a border guard. By any conventional measure, therefore, unbacked crypto looks like a bubble. So what about its ability to destabilise the entire financial system? The deputy governor of the Bank of England Sir Jon Cunliffe in an important speech last week concluded that crypto didn’t yet pose this kind of threat, but soon could.

For now the entire $2.3 trillion value of crypto was too small, set in the context of the $250 trillion financial system, and too disconnected from the conventional banking system. For comparison, the dotcom smash in 2000-2003 wiped out $5 trillion of value without seriously discombobulating the financial system.

However, unbacked crypto’s tentacles are pushing deeper into the mainstream space. Twenty one per cent of hedge funds invest in crypto, according to one PwC study. Pension funds in America and Australia are starting to dabble.

Banks may not be directly exposed but could still be seriously hit if their leveraged clients are wiped out by margin calls in the event of a crypto price collapse. The Archegos Capital implosion in March was a warning in microcosm of how banks can be far more exposed to levered clients than their risk committees like to think.

“A massive collapse in cryptoasset prices, similar to what we have seen in tech stocks and sub-prime, is certainly a plausible scenario,” according to Cunliffe. The “current trajectory” of crypto means it could soon pose financial stability risks.

If that is the case, a crackdown will be needed, as China has already decided. Distributed ledger technology is a useful innovation, with many potential benefits. But unbacked crypto (as opposed to stablecoins, which are backed by fiat currencies) is not one of them.

No one wants to be the pooper ending this party. But to pop a bubble now when its deflation would not destabilise the entire financial system is surely better than allowing it to inflate further — to a time when it would. Cunliffe doesn’t quite say that. Someone needs to.

Patrick Hosking is Financial Editor of The Times

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