Are there informal contagion channels?
Yes, several, and they are growing as leverage increases.
With government bonds offering miserly yields, as well as asymmetrical and unfavorable price prospects, some investors have seen cryptos as a better way to diversify assets for their much larger equity and equity-like exposures. Others have opted for investing in crypto platforms as part of their portfolio positioning.
Contagion risk increases as cross-holdings expand in more investor portfolios, especially when trades are levered, as quite a few are now, and the operational infrastructure supporting crypto trading comes under pressure, as it did last week. Remember, financial history is full of examples of how investors who are unable to sell what they want to sell—to protect their overall portfolios, raise cash or both — often end up selling other holdings with much different attributes. With that comes a higher risk of financial spillover.
How big is the contagion risk?
Not big on a stand-alone basis but more notable when judged with what else is going on in markets.
Bitcoin holdings are not sufficiently institutionalized, at least not yet, to constitute a stand-alone systemic risk. Many banks appear to have little to no balance sheet exposure. As such, any spike in volatility would have few direct spillover effects. That is the good news.
Less good news is that the rise in Bitcoin prices — which are still up more than 250% in the last 12 months despite the decline in the last five weeks from $63,000 to less than $40,000 — has been part of “an everything rally” powered by central banks’ continued provision of ample and predictable liquidity. With margin debt growing rapidly at the same time, the risk of a financial accident must be monitored closely by both market participants and financial authorities, especially when too many are driving so fast on the financial risk-taking highway.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management. His books include The Only Game in Town and When Markets Collide.