Is Bitcoin Too Big to Fail?

Every few months or so, when Bitcoin inevitably swoons, there’s another bumper crop of doomsday stories about whether the cryptocurrency is going straight to zero. This autumn, that question was entertained by The Economist, Bloomberg, and, JPMorgan Chase & Co. CEO Jamie Dimon, who called it “worthless,” again. 

It is unclear what is gained from the near-obsessive warnings about Bitcoin. But this has not stopped Dimon, billionaire Warren Buffett, and others of their ilk from taking swipes whenever they get in front of a microphone. After deriding the cryptocurrency last month, Dimon hastened to add, “I don’t want to be a spokesperson; I don’t care. It makes no difference to me.” 

But if it makes no difference, why keep banging on about it? Somewhere beneath all the crypto-pageantry and peculiar moralizing about what makes other investments legitimate — while Bitcoin, according to economist Nouriel Roubini, remains merely a “pseudo-asset” — seems to be a deep-seated and very real fear that, one day, the world will wake up and Bitcoin, along with the entire $2.6 trillion cryptoverse, will have vaporized. 

Although Dimon himself appears to think that is unlikely, worries about Bitcoin’s long-term future are not just idle catastrophizing. Many traders, hedge fund managers, and institutional investors across Wall Street are genuinely struggling to size up crypto’s systemic risks — and finding that it’s no simple network-mapping exercise. “It’s the question on everybody’s lips,” says a director at Coinbase, a cryptocurrency platform with partners in more than 100 countries. “Could this all go horribly wrong?”

With institutional acceptance on the rise and ever larger amounts of capital at stake, there is indeed a hunt for crypto’s Damoclean sword. Specifically, market participants don’t want to finally invest in Bitcoin only to witness the long-feared “cryptocalypse” (as The Economist delicately puts it). For naysayers, there’s clearly something about crypto that gives them an unshakable sense of impending doom. Perhaps it is the vestigial effects of the global financial crisis. They lived through it and remember it well. Why shouldn’t they ask if Bitcoin is another house of cards?

In the eyes of Bitcoin evangelists, however, there’s no greater risk than not hoovering up the cryptocurrency whenever the price dips. Over the past month, Bitcoin struck a fresh record high above $67,000, climbing nearly 20-fold from the pandemic’s lows. So much for heading to zero. This time, the cryptocurrency’s rally followed the late-October launch of the first Bitcoin exchange-traded fund on the New York Stock Exchange.

“The fact is, Bitcoin’s been one of the greatest investments that human beings have ever been able to get their hands on,” says Daniel Masters, chairman of CoinShares, a digital asset investment firm based in New York, London, and the Channel Islands. “Not just at the institutional level, but at the retail and disenfranchised level. If you have an internet connection, you can participate in crypto. It’s made a lot of people a lot of money.” 

It’s those foamy gains that have lured slews of institutional investors into the crypto space this year. According to a recent study by Fidelity Digital Assets, seven in ten institutional investors globally plan to diversify into digital assets in the near future, with current adoption rates among institutions in Asia at 71 percent, Europe at 56 percent, and the U.S. at 33 percent. Though those rates are expected to continue to accelerate over the next several years, this year’s influx of capital has led to renewed calls for an in-depth examination of the potential market risks that could deliver a crippling, if not fatal, blow to crypto.

The hand-wringing has been at its fiercest over Bitcoin’s possible exposure to systemic risk, both existential and otherwise. Chief among those concerns is whether a crypto crash, taking place in what is effectively a parallel, decentralized financial universe, might spill over into the traditional financial system. The fact that so many exchanges and crypto intermediaries remain offshore and unregulated continues to fan fears.

Lack of regulation also makes it nearly impossible to accurately measure the crypto market’s overall leverage. In the meantime, surveys of who owns the largest Bitcoin fortunes often are reduced to guesswork. As a result, crypto’s economic linkages and possible path to contagion have been hotly debated. But new research released in October by the National Bureau of Economic Research, a nonprofit, nonpartisan organization in Cambridge, Massachusetts, may shed some light. 

Plumbing Bitcoin addresses with the highest-value holdings, better known as the “Rich List” — one of the most widely followed databases in all of crypto — the group found that “despite the significant attention that Bitcoin has received over the last few years, the Bitcoin ecosystem is still dominated by large and concentrated players, be it large miners, Bitcoin holders or exchanges.” According to the organization’s findings, exchanges do play a central role in the cryptoverse, generating roughly 75 percent of real Bitcoin volume, whereas other types of activities, such as illegal transactions and mining rewards, account for a small part of the total volume. A deeper dive into Bitcoin holdings, however, showed that, collectively, it is individuals who boast the largest stockpiles. 

Using algorithms developed to analyze Bitcoin addresses and wallets, NBER was able to separate addresses belonging to individuals from those linked to exchanges, investor pools, and other intermediaries. What it found was that Bitcoin balances held by intermediaries grew steadily from 2014, reaching about 5.5 million bitcoins by the end of 2020. That’s approximately one-third of the Bitcoin in circulation. Yet it was the individual Bitcoin holdings that were the most highly concentrated, tallying at about 8.5 million bitcoins by the end of 2020.

“The top 1,000 investors control about 3 million bitcoins and the top 10,000 investors own around 5 million bitcoins,” NBER wrote in its report last month, noting, “This inherent concentration makes Bitcoin susceptible to systemic risk and also implies that the majority of the gains from further adoption are likely to fall disproportionately to a small set of participants.”

These findings suggest that though newcomers to crypto would be subject to all the usual risks, they would not benefit from the same outsize gains as first movers, whose smaller, earlier initial investments — likely at lower Bitcoin prices — would have already had the chance to reap massive gains. Indeed, according to Chainanalysis, institutional investors who first entered the market less than a year ago, at an average price of $37,000 per Bitcoin, would bear the brunt of any heavy losses.  

With more than $2 trillion at stake, a crypto cataclysm would certainly obliterate many fortunes, but it likely wouldn’t raze key pillars of the financial system. “I don’t think there’s a chance in hell that crypto is the source of any systemic financial collapse,” says CoinShares’ Masters. “Basically, all of crypto amounts to the price of Apple stock. Would the world open tomorrow if Apple was erased from the planet? Of course it would.” 

That doesn’t mean contagion isn’t possible in the future, but at the moment, the intrigue surrounding Bitcoin with its larger-than-life profile makes it seem bigger than it actually is, Masters reckons, adding, “It’s always punched above its weight.”

Other factors dogging crypto have been, not surprisingly, worries about both over-regulation and under-regulation, each of which poses its own set of unique hazards. The same murky governance that makes it so hard to measure leverage in the crypto ecosystem has made it possible for major offshore players to sow the seeds of not just existential, but very concrete systemic risk. For much of this year, those perils coalesced around so-called “stablecoins.”

Investors inhabiting the worlds of crypto and traditional finance — trading in both the dollar and Bitcoin, for example — often rely on stablecoins, a cryptocurrency that lives on the blockchain, can be exchanged for a range of crypto assets, and is pegged to the dollar or the euro. Stablecoins are the lifeblood of crypto trading, because they grease billions of dollars of transactions that would be slower and more costly if subjected to the laborious process of converting dollars to Bitcoin. This is why concerns spread rapidly when troubles arose in the dominant stablecoin, Tether. The company had claimed its tens of billions of dollars in digital coins were fully backed by U.S. dollars — but they weren’t.

In October, the U.S. futures market watchdog, the Commodity Futures Trading Commission, ordered Tether to cough up $41 million “for making untrue or misleading statements and omissions of material fact” about its U.S. dollar Tether token, which, the agency said, it had misrepresented as a stablecoin that was “100 percent backed by corresponding fiat assets.” In truth, Tether had failed to disclose that reserves backing its stablecoins included “unsecured receivables and non-fiat assets.” The British Virgin Islands–based company had also falsely represented that it was undertaking routine, professional audits to demonstrate it held sufficient fiat reserves at all times — but it wasn’t.

The CFTC simultaneously filed and settled the charges, following a closed-door meeting over stablecoins held by U.S. Treasury Secretary Janet Yellen this summer. The action against Tether marked the first time the CFTC had applied its rules to a stablecoin as a “commodity,” but it seems the U.S. Securities and Exchange Commission, as well as Congress, may soon move to regulate stablecoins much like U.S. bank deposits. At any rate, Tether is a cautionary tale of how easily crypto’s internal plumbing can be potentially destabilized from offshore.

Just as under-regulation is seen as a risk, too much regulation — or even bans on all crypto transactions and mining, as seen in China this autumn — could prove calamitous. But given the decentralized, mobile, and global characteristics of crypto, any crackdown usually leads to Bitcoin activities simply shifting to a different jurisdiction. “Regulation that is obstructionist or damaging, particularly in the U.S., could be stifling,” says crypto enthusiast and hedge fund manager Roy Niederhoffer, founder of R.G. Niederhoffer Capital Management in New York. “Or a major, concerted, global central bank effort to ban it. But ultimately, that would probably make cryptocurrencies like Bitcoin more valuable.” This would especially hold true, he says, if restrictions on crypto took place alongside fears of hyperinflation. 

Masters says another concern is how global banks might react to decentralized finance as its hegemony grows. “The banking lobby is very strong,” he notes. “There is a chance crypto could be regulated out of existence. But the U.S. just approved the first crypto ETF; the U.S. is not anti-crypto. If it was, this would not be happening.” 

Another danger, which has lingered since the inception of Bitcoin, would be a mutiny by crypto miners. Because Bitcoin’s blockchain requires that decentralized miners be honest brokers for the system to function, if a single miner or a set of colluding miners gained control of 51 percent or more of the mining power in the network, it could upend Bitcoin’s ledger of transactions, allowing miners to alter the previously verified records. “The possibility of such attacks creates systemic risks for financial stability and potentially even for national security, if a large fraction of citizens uses Bitcoin as a store of value,” says NBER. “It is, therefore, important to understand how concentrated the mining capacity is.” 

According to NBER data, the top 10 percent of miners control 90 percent of mining capacity, with just 0.1 percent, or about 50 miners, controlling close to 50 percent. It should also be noted that the network is most susceptible to a “51 percent attack” when Bitcoin prices drop, as miners are then less incentivized to participate. For the past five years, NBER reports, Bitcoin’s mining capacity has been highly concentrated, with 60 to 80 percent of it based in China. This finding confirms anecdotal evidence.

Not all threats to Bitcoin need be dramatic or complex, though. Sometimes it just comes down to sentiment. In March 2020, when Bitcoin fell below $6,000 as the Covid-19 pandemic hammered the U.S., fomenting fears of an economic collapse and compelling many to convert their investments to cash, the cryptocurrency remained under $10,000 for months. “That may be the greatest risk of all,” asserts Niederhoffer. “A long and growing loss of enthusiasm for crypto. People were just giving up on it.” 

Of course, he says, these kinds of pullbacks were also seen nearly a century ago, during the Great Depression. “My grandfather was wiped out in the stock market crash of 1929,” he recalls. “Emotionally, he could never bring himself to buy a stock again. When the market falls apart like that, it can take a long time to recover.”   

Crypto has so far evaded such prolonged doldrums. Even with the pandemic, there are now more than 11,000 cryptocurrencies in existence, up from about 6,000 in 2020, according to the website CoinMarketCap. “Nothing is too big to fail,” says Niederhoffer, a former neuroscientist, “but I suspect Bitcoin’s biggest critics have never used it to perform a transaction. Having that experience makes a huge difference in your comfort level and understanding Bitcoin’s importance.”