From Trust Fall to Trustful
When we started college, textbooks always said: "Banks have the highest credit rating, and the central bank will affect and control the bank's operations and risks, so savings is one of the safest investment methods."
However, the real market is completely different from what is written in textbooks. The content in textbooks is usually composed of various 100% probability assumptions, such as the efficient market hypothesis and the "rational person" hypothesis. In the real world, banks may collapse, national bonds may default, and the central bank may cause a financial market earthquake due to various irrational operations. In short, there is no 100% "safe boundary" - in the crypto market, various risk events have left a deep impression on us, and the banking crisis in 2023 once again refreshed investors' perceptions.
Compared with the East Coast, people on the West Coast seem to be naturally inclined to be enterprising and adventurous. Modern venture capital flourished on the West Coast, giving birth to Silicon Valley, the Internet, and Bitcoin. Various VCs provide complete services from incubation to listing for many startups, and regional banks also provide necessary loans for various startups to maintain their operations and research and development needs.
From a risk control perspective, providing loans to startups is undoubtedly one of the "highest risk behaviours". Startups may go bankrupt for various reasons (even just a team discord), adding bad debts to the bank and even affecting the bank's operating cash flow. However, once certain companies become unicorns, the income brought by the expansion of their valuations may be "hundreds or even thousands of times" of the initial valuation, and banks can also obtain considerable profits from their investment and loans to startups.
Under the expectation of substantial returns, the "gambling" behaviour is tacitly approved by banks. The gambling mentality begins to spread in every department of the bank: risk control reduces the requirements for internal risk control of the bank, bankers are encouraged to "explore new directions", and the trading department begins to break through the risk control margin to find ways to obtain higher returns. Similar things are not the first time: in 2007-2008, Societe Generale Bank lost 4.9 billion euros due to "trading incidents". Now, similar things are happening on a series of banks represented by Silicon Valley Bank on the West Coast.
In traditional cognition, investing in bonds, especially investing in national bonds, is considered to be one of the "extremely low risk" investment methods. National bonds are guaranteed by national credit; the income obtained by holding national bonds is "risk-free" - the 10-year US T-notes yield has become a synonym for "risk-free rate". In the low-interest-rate era, banks pay interest on the purchase of national bonds, obtain additional income, and there is nothing wrong with it. "US bonds are safe" - this seems to have become common sense.
However, no asset can be risk-free. The buyer and seller of bonds are not necessarily "held to maturity"; they usually buy when the bond price is relatively low and sell when the price is relatively high. The price fluctuation of bonds is usually relatively stable, and the price cycle is usually 1-2 years. Therefore, buying bonds at a relatively low level, waiting for 1-2 years, can obtain a certain income; and if the bond price drops too quickly, the Federal Reserve will intervene in a timely manner - at least since the 1990s.
However, in the financial market, historical data can only serve as a reference, and traders, funds, and banks who have lost their entire wealth due to "following the old tracks" have long been countless. Silicon Valley Bank is just one of them.
Strict risk control does not seem to conform to the West Coast people's "enterprising and adventurous spirit"; according to the relevant US banking laws after 2018, "regional banks" like Silicon Valley Bank are classified as "Category IV banks", which do not require stress tests (a bank risk control method) and do not need to report stress test results to the public regularly. That is to say, the managers of regional banks can use this money for any investment within the "legal framework."
Starting in 2020, affected by the Covid-19 epidemic, the yield of 10-year US Treasury notes began to rise continuously; the rise in bond yields means a decline in prices. At this time, buying "cheap" risk-free bonds seems to be a profitable business that is not lossmaking. Buy low-priced bonds, wait for the expiration to get income, and after deducting the interest paid to depositors every year, the net profit is still considerable. And as the US bond prices continue to fall, the expected returns brought by the expansion of bond yields are becoming more and more "generous." Therefore, Silicon Valley Bank bought a large number of 10-year US Treasury notes, buying more as they fell, and hoped to make a big profit in the future until they realised a problem: US bonds seemed a bit wrong.
Due to record-breaking inflation, the Federal Reserve began the fastest rate hike since the turn of the century in 2022. The impact on the financial markets was within expectations, and the market capitalisation of the crypto market evaporated by nearly 70% during the rate hike. However, the impact on banks cannot be ignored either: as interest rates rise, they need to pay higher interest rates to depositors. For banks with adequate reserves, this still seems acceptable, but for banks that invest too much in long-term bonds, their liquidity is "locked" in risk-free bonds, and the price of 10-year T-notes continues to decline.
For Silicon Valley Bank, the situation may be worse. They hold a large amount of 10-year US Treasury notes, and as the Federal Reserve continues to raise interest rates, with the rise of recession expectations, the US bond market has a yield inversion - that is, short-term bond yields are higher than long-term bond yields, with a negative spread. This means that regional banks need to pay higher interest rates to depositors, and it is difficult to recover costs in the future. In similar situations in history, the Federal Reserve usually chooses to stop raising interest rates and restart providing liquidity to the market, just as they did in 2018.
But this time is different. Powell has not expressed an attitude of stopping the rate hike; due to the ups and downs of inflation, the Federal Reserve is walking further and further on the road of raising interest rates. Eventually, in February 2023, the yield inversion of US Treasuries reached the level of the Volcker era, setting a record since 1982; the price of US Treasuries also continued to fall, and the yield of 2-year US Treasuries reached a high of 5.09%.
For depositors, it is now a "worth considering" issue whether to put money in the bank. Inflation is still high, and bank interest rates are not ideal. Faced with an annualised return of more than 5%, depositors seem more willing to buy US Treasuries through money market funds. Withdrawals have begun, marking the advent of a local banking industry disaster.
At this time, Silicon Valley Bank has two choices:
- Sell US Treasuries and regain liquidity. However, as the Federal Reserve continues to raise interest rates, the price of US Treasuries continues to fall, and selling will only confirm the paper loss. Considering that a large amount of user deposits have actually been used to buy US Treasury notes, the resulting losses are difficult to count.
- Try to appease depositors as much as possible, hoping that they will not withdraw their money, and pray that the Federal Reserve will cut interest rates soon, the US bond market will return to normal, they can sell US Treasuries to regain liquidity and make a profit, "as if nothing happened".
They did both in the face of depositor withdrawal requests. This further brought catastrophic consequences: some depositors realised that the liquidity of Silicon Valley Bank seemed to have "some problems", and Silicon Valley Bank subsequently disclosed losses and sought refinancing, resulting in investors' "doubts" about liquidity turning into "firm belief". Depositors began to withdraw their money in a rush, and the outcome of Silicon Valley Bank can be imagined in the face of a run on the bank.
Of course, it is not just Silicon Valley Bank that has problems. As a "Category IV bank", regional banks that lack risk control have exploded various problems that may far exceed imagination. Depositors no longer trust banks; under the wave of bank bankruptcies, only national credit and gold are worth relying on. Investors' purchase of US Treasuries has made the liquidity of US Treasuries once dried up, and bond prices fluctuated beyond the impact of the 2020 epidemic; while the price of gold has broken through $2,000, reaching a historical high.
Large banks have also been hit hard: Credit Suisse suffered billions of dollars in losses due to risk management issues for several years, and its stock price approached zero under the impact of the banking crisis, ultimately being acquired by Swiss Bank. The Swiss authorities' decision to write off part of Credit Suisse's debt led to further losses for investors. As the Credit Suisse crisis has temporarily eased, problems at another major European bank, Deutsche Bank, have begun to emerge.
As a practitioner in the crypto industry, we cannot help but start to consider a question in the current dilemma: ordinary investors are bearing unprecedented risks: even banks that were once considered "safest" cannot be trusted anymore. So, can the crypto market take on some of the liquidity from the banks at this time and be incorporated into investment portfolios in the long term?
Liquidity Is Coming, but It May Only Be for Hedging
In the current spread of the traditional market's banking crisis, the crypto market is also difficult to "act alone." The collapse of Silicon Valley Bank impacted USDC, causing its price to drop by 12% due to panic selling and decoupling from the US dollar. Even though Circle was eventually successful in withdrawing all deposits from Silicon Valley Bank, investors' cautious attitude towards USDC has not diminished, and the price of USDC has not yet stabilized.
However, the influx of hedging flows has significantly pushed up the prices for mainstream cryptos such as BTC and ETH. BTC's price hit a six-month high, up over 40%; interestingly, ETH's performance has been much weaker. At the same time, the futures market's weak response to the rise indicates that this rise is mainly driven by spot buying driven by hedging sentiment rather than bullish buying behavior based on reasonable expectations.
It must be acknowledged that these hedging funds have injected some vitality into the crypto market. Trading volume has increased, and liquidity has also improved. But does this mean that the bull market in the crypto market has restarted? It seems not necessarily.
First of all, although the threat posed by the banking crisis has led the Federal Reserve to release some liquidity to alleviate the problems of some banks, it is far from what investors believe to be a "Fed surrender." Inflation remains high, and it is unknown whether the high inflation cycle will end in 2023, which means that the Fed's policies may not be more dovish.
At the same time, although the Federal Reserve may suspend rate hikes, the high-interest rate environment will continue. It isn't easy to reproduce the low-interest rate era similar to 2020-2021 in the next few years. Although traders expect the Federal Reserve to gradually lower interest rates in 2023, interest rates will remain at a high level of more than 3.5% and may last longer. The Fed's liquidity pressure may continue until inflation is completely relieved; the European Central Bank, facing a similar situation, may take similar actions.
In addition, according to the current relief plan, the emergency liquidity released by the Federal Reserve is mainly provided to banks. Considering the liquidity end position of the crypto market and the fact that "crypto-friendly banks" were almost wiped out in the banking crisis, the time for the crypto market to obtain liquidity may be relatively lagging, and the proportion may be lower.
Therefore, the arrival of hedging liquidity does not mean the recovery of the crypto market. Investors' confidence has not yet recovered after experiencing a series of crypto market risk events in 2022; once the traditional market returns to stability, the outflow of hedging liquidity may cause a reverse impact on the crypto market.
From Trust Fall to Trustful
The recent success of the crypto market is largely due to investors’ trust in Bitcoin. Unlike traditional banks, the Bitcoin network is designed on the principle of “trustlessness” and will not go bankrupt. As long as the private key is kept secure, the liquidity stored in Bitcoin in the form of Bitcoin is “absolutely safe.” Despite the huge fluctuations in Bitcoin prices, for investors with a relatively high risk tolerance, crypto assets are still a viable option, especially when government bonds and large bank bonds are no longer safe.
However, for investors to buy cryptos, hold cryptos, invest using cryptos, and obtain returns, they need to interact with multiple parties, including wallets, exchanges, and project parties. In 2022, these links all experienced a series of problems, causing many investors to lose trust in the crypto market and choose to leave. Therefore, compliance, professionalism, transparent operation, and stricter risk control systems must be put on the agenda.
Crypto institutions must provide transparent information, including their business model, risk management, and security measures. This can help users understand how the crypto market operates and build trust. At the same time, crypto institutions need to strengthen security measures, including but not limited to Merkle Trees, multi-factor authentication, and third-party custody measures, to ensure the safety of users’ assets. In addition, crypto institutions need to further comply with regulations and user requirements, re-establish funding channels between the crypto market and traditional markets, and rebuild trust between institutions and users.
Improving risk control systems is also essential: asset misappropriation and loss are unacceptable. Therefore, crypto institutions need to reduce wrongdoing through transparent operation methods such as asset proof and ensure that investors’ funds will not be lost due to internal investment errors through stricter risk control systems.
Blofin is working towards these goals. We have introduced the Merkle Tree system to ensure the transparency and reliability of asset structures, which our customers can verify at any time. At the same time, Blofin’s assets are custodied by Fireblocks, and Fireblocks provides insurance services to deal with various situations, such as asset theft, maximizing the safety of users’ assets. Of course, based on our experience in responding to a series of crises in the crypto market, we have also iteratively upgraded Blofin’s risk control system to respond effectively to possible future risks.
For the crypto market, the banking crisis is undoubtedly a valuable opportunity. The arrival of hedge liquidity is rare, and turning “hedge liquidity” into “permanent liquidity” requires internal iteration and improvement of the crypto market to regain investors’ trust — “From Trust Fall to Trustful.”