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Interest in cryptocurrencies like Bitcoin and Ethereum has been spreading. Now some experts are worried the next time these volatile assets crash, it could become a financial wildfire.

While cryptocurrencies have been around for more than a decade, they’ve so far been regarded as a niche asset, meaning investors who weren’t interested in the digital currencies' potential could safely ignore their price fluctuations. But, with values above $1 trillion and money managers on and off Wall Street snapping up coins, that may be about to change, according to regulators and financial pros. Earlier this week, Treasury Secretary Janet Yellen convened a study group on just this issue, looking in particular at the dangers of a subset of cryptocurrencies known as “stablecoins," which are backed by traditional currencies or other assets.

The last time cryptocurrency prices plummeted, in 2018, Bitcoin fell by as much as 80%. But the event happened in a financial vacuum. Bitcoin transactions were isolated on then-obscure venues such as Coinbase that had little or no links to public markets or the broader economy. Bitcoin was an upstart that bucked the financial system, from the outside. This time, Bitcoin -- whose price has declined 50% since April -- is inside the system.

Think of the global financial system as an orchard composed of a wide variety of trees and plants, interconnected below the surface in endlessly complex entanglements. Weeds and plants on the margins can easily be pruned before they damage adjoining areas, as happened with Bitcoin in 2018. But if a certain type of weed is allowed to grow out of control, or a new tree allowed to take root and entangle itself, rot from these new organisms can quickly threaten the entire system. This threat is called “systemic risk,” and some people fear it’s a threat that cryptocurrencies now pose.

“It’s similar to the dot-com bubble in the 90s,” said John Quiggin, an economist at the University of Queensland in Australia. “While you have just a small number of people speculating in stuff -- if they lose their money, they lose their money. Once you get embedded in the financial system there are bigger problems.”

There are three main ways that cryptocurrencies have become tethered to the broader financial system since 2018.

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Crypto has gotten huge

The market value of cryptocurrencies -- roughly $1 trillion, down from more than $2 trillion earlier this year -– is suddenly far more than a drop in the financial ocean. When the sums at stake are that large, implosions typically cause ripple effects. As CNN Money reported at the time, an index of 170 Internet stocks lost $1.8 trillion in value during the dot-com crash, an event which sparked a recession across the economy.

The debate over whether cryptocurrencies are large enough to constitute a systemic risk is now happening in the highest echelons of central banks and governments. Federal Reserve Bank of Atlanta President Raphael Bostic recently said the digital currencies lack the “scale and reach” to pose a systemic risk. But ahead of the 2008 financial crash, many smart regulators and market participants said the same thing about “subprime” mortgage securities. Federal Reserve Chairman Alan Greenspan and others argued that the popularity of high-risk home loans was not on a systemic scale.

And so it appeared, on the surface. Due to a lack of regulation and sleight of hand by the banks trading the securities, a vast root system of derivatives had grown beneath the visible subprime-security market. It was this derivatives market that hopelessly entangled great oaks of Wall Street like Bear Stearns and Lehman Brothers -- eventually pulling them down.

Derivatives markets are now appearing below cryptocurrencies, and their scale is once more unclear. On one exchange alone, Binance, derivatives with a “notional” value of $2.46 trillion, changed hands in April alone, according to Coindesk.

Crypto has deep ties to the stock market

Bitcoin has also developed significant links to the broader stock market. Coinbase Global, the Bitcoin exchange, is vying with Intercontinental Exchange to be the largest publicly traded financial exchange by market value, with a current worth of $46 billion. In April, the Grayscale Investments’ Bitcoin Trust, a de facto exchange-traded fund currently only available over-the-counter, had roughly $50 billion in assets under management, comparable to ETF giants such as the SPDR Gold Trust. Suppliers of the specialist chips used in Bitcoin-mining equipment, such as Nvidia, also have exposure to the cryptocurrency.

Another way Bitcoin losses could ripple through the stock market is through “common ownership.” In the months leading up to the 2008 financial crash, a debate raged on Wall Street and in the Fed as to whether a rout in the riskiest corners of the mortgage-security market was safely “contained.” Banks promised that they were “ring fenced” Unfortunately, the banks that owned the devalued mortgage securities were forced to sell other assets, from stocks to junk bonds to commodities, in order to keep themselves afloat.

“Many of the same participants who own cryptocurrencies are also long speculative stocks and growth, like Nasdaq [stocks],” said Lorenzo Di Mattia, manager of hedge fund Sibilla Global Fund, who was one of the first people to sound the alarm on the scale and reach of the 2008 market shock. Intensified selling of either asset class could spill into the other, he warned.

Some institutional investors, such as insurance firm Massachusetts Mutual, have voluntarily disclosed purchases, but there are not formal requirements to do so.

In written testimony to a congressional committee exploring crypto risks to the economy, Alexis Goldstein, a spokeswoman for the Open Markets Institute, a think tank funded by billionaire George Soros, cited an Intervest survey showing that a group of mid-sized hedge funds had allocated an average of 11% of their assets to crypto. “Extreme volatility in cryptocurrency markets could spread to other financial markets,” she wrote.

Stablecoins link crypto to the U.S. economy

Perhaps the most dangerous way that cryptocurrency markets are tied to the U.S. economy is through a multibillion dollar hybrid currency that’s literally called Tether. Tether is a “stablecoin,” specifically designed as a bridge between the world of crypto and the world of the U.S. dollar. These stablecoins have multiplied tenfold to roughly $100 billion in the space of a year. By backing coins with conventional financial assets and using a little financial engineering, these coins have maintained a stable value, often trading 1:1 with the U.S. dollar.

But the conduit Tether uses to tie itself to mainstream financial markets is one that would cause anyone who traded through the 2008 financial crisis to shudder. Tether, according to reports in The Financial Times and elsewhere, has become one of the largest institutional owners of “commercial paper.” Commercial paper is a short-term corporate debt market that’s used to meet payroll and keep the lights on by companies of all sizes. If investors suddenly bailed out of the Tether cryptocurrency en masse, it could be forced to dump commercial-paper holdings. That, in turn could rattle confidence in the broader commercial-paper market. It was a crunch in the commercial-paper market that transmitted the great financial crisis into the heart of the real U.S. economy in 2008.

Among other things, Treasury Secretary Yellen’s working group will study the “risks [stablecoins] pose to users, markets, or the financial system.”

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How to protect yourself from the next crypto crash

What can you do to protect yourself from systemic risk posed by cryptocurrencies? Don’t assume that your portfolio is completely “ring-fenced” off from the crypto crash. That’s the assumption many banks made in 2008, and many retail investors made in 2000.

Instead, prepare the same way you would for a regular bear market in the stock market -- by owning a sensible mix of stocks and safe-haven assets like bonds, which tend to rise when stocks and crypto fall.

If you do invest directly in cryptocurrency (or other similarly risky assets) most financial planners recommend making these no more than 5% of your portfolio.

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