OKEx Weekly Update: Mar 28 – Apr 3
Jay Hao: On Crypto Market – Rate Cut, Quantitative Easing, Circuit Breaker & Future
This week, the Federal Reserve lowered the federal benchmark interest rate target range to 0-0.25% and launched a massive $700 billion quantitative easing program. However, the market took this negatively, constituting to a plummet of the US stock futures index. The same happened in the Bitcoin market too, where BTC price gave up all gains after a brief rise. What is the reason for the Fed to launch QE again 10 years later? What impact will this have on cryptocurrencies, the blockchain industry, and the digital economy as a whole? Is it feasible for the crypto market to develop a circuit breaker to safeguard against panic selling?
The necessity of quantitative easing
While many were surprised that the Fed suddenly decided to launch QE, but I’m not surprised at all. It is inevitable for the Fed to do so. Why? Because the US government has basically run out of conventional monetary policy tools to deal with liquidity crisis – they have already slashed interest rate.
The Fed would usually lower the Federal Reserve Fund rate to inject liquidity into the market when faced with a financial or economic crisis. Last week, they directly slashed the target interest rate by 50 basis points and maintained it at a low level of 1.25%, but still it couldn’t solve the liquidity crisis and the plunge continued in the US market.
The federal benchmark interest rate could only be lowered to zero, and there was barely room for further reductions for its current low interest rate of 1.25%. If extremely low interest rates (zero interest rates) still cannot help to mitigate the market liquidity, the Fed would have no choice but to seek unconventional monetary policy by launching quantitative easing.
What’s the difference between a rate cut and quantitative easing? A rate cut means to reduce the cost of funds and inject liquidity into the market by regulating the market’s borrowing costs; while quantitative easing increases the market’s fund amount to inject liquidity into banks through continuously purchasing a large number of government bonds, forcing banks to loan out money despite zero interest rates, and therefore enhancing market liquidity. As such, quantitative easing is considered an unconventional solution to maintain market liquidity when interest rates fall.
Why did QE lead to market plunge?
Since zero interest rate and quantitative easing policy both aim to inject liquidity into the market, then why did the US stock futures market plunge? What are their impacts on cryptocurrencies in the future?
Milton Friedman once said that it is difficult for discretionary policies to achieve desired effects, and sometimes they might backfire too. The scale of the monetary easing this time has far exceeded market expectations, not only did they lowered the interest rate range to nearly zero, but they also directly launched quantitative easing. The Fed really went all out this time in terms of conventional monetary policies. If there were another financial crisis in the future, the Fed is left with only the QE card up their sleeve.
More importantly, such move also gave a negative signal to the market – if it was not a serious financial crisis, why did the Fed implement such a large scale of solution? What the Fed did indeed signaled that they are pessimistic on the economic prospects, which sparked market concerns and led to the plunge.
How will QE affect crypto market?
So, how does this affect the crypto market? In theory, the Fed’s loose monetary policy will drive Bitcoin price up in the mid-to-long term. Currently, we can expect it might affect cryptos in two ways:
1. Loose monetary policy → increase in bank credit → increase in liquidity → part of the increased fund would flow into the crypto market and drive up crypto prices
2. Loose monetary policy → market interest rates drop → returns on dollar-denominated assets drop → funds flow out of the dollar market and the dollar depreciate → some of the funds flow into the crypto market and drive up crypto prices
Note that the above two expectations are mostly theoretical. It is uncertain that whether the interest rate and Bitcoin price are correlated. As cryptocurrencies, such as Bitcoin, have not been included in the asset allocation pool of most global investment institutions, it might take a longer time for the rate cut to take effect. Therefore, the crypto market, especially Bitcoin price, is hardly affected by the Fed’s loose monetary policy in the short term, but we might expect it to happen in the mid to long term.
Circuit breaker for crypto market is unfeasible
On the other hand, the U.S. stock market tripped the circuit breakers four times amid the recent market shock. It has stirred up debates among the crypto community about the possibility of setting up a circuit breaker (trading curb) system for crypto exchanges.
The circuit breaker is a protective mechanism that can safeguard the interests of small and medium investors and prevent them from suffering dramatic losses. However, when it comes to the cryptocurrency market, it would be hard to be put in place. Here’s a look at why.
First, the volatility in the crypto market is high. It would be hard to set thresholds for circuit breakers. Looking at the traditional markets, the circuit breaker system has undergone multiple revamps over the years in the hope that it will not be triggered. Because when it does, it will not only halt trading, but inevitably disrupt the market. In the US stock market, a circuit breaker will come into effect if the S&P 500 index is down by 7%, 13%, or 20% respectively. In the past two decades, the circuit breaker was triggered twice following two 7% drops. Let’s take a look back at the cryptocurrency market. According to the data in 2019, the median of daily bitcoin price change is 12%, which means that if we set a circuit breaker at 7%, the bitcoin trading market could have experienced multiple curbs, which is demaging to the whole crypto market.
What’s more, cryptocurrency market runs 24/7 and cryptocurrencies are traded on many exchanges. Imagine if a trading platform implemented and tripped a circuit breaker, there will be price difference of a crypto asset across exchanges, driving investors to go for arbitrage. Eventually, the circuit breaker will fail on its purpose.
For example, Exchange A has implemented a circuit breaker for Bitcoin. One day, the Bitcoin price plunges massively. Exchange A triggers a circuit breaker, and its Bitcoin price remains at $9,000. At the same time, the Bitcoin market price has fallen to $8,000 on other exchanges. There, the gap creates arbitrage opportunities for traders. When Exchange A resumes trading following the halt, the Bitcoin price on its platform will inescapably to fall to $8,000 for the effect of arbitrage. From this case, we can see that the circuit breaker is not effective for the open crypto market at all.
What if all the exchanges or major exchanges in the industry reach a consensus to implement a uniform circuit breaker system? Will it work?
The answer is NO. Because such an alliance is in fact a cartel (The Organization of the Petroleum Exporting Countries, aka the OPEC, is an example of a cartel), which is unstable by nature because its members tend to have a deceptive motive. Such situation is a prisoner’s dilemma. That implies, when a circuit breaker is triggered, if some exchanges in the alliance trade secretly, it will bring substantial benefits to them in terms of market share and revenue, which will then encourage other members to follow suit. Then, a Nash equilibrium will be formed – exchanges will trade under the table or abandon the circuit breaker system completely. Eventually, the system will be paralyzed. The recent oil plunge is also an example of a prisoner’s dilemma – Saudi Arabia demanded Russia to reduce its oil production, but the latter refused for its market share and income. The breakdown of negotiations led to an increase in Saudi Arabia’s oil supply, which further crushed crude oil prices to even cheaper bottled water. If both parties comply with the production reduction agreement in the first place, the situation would be different now.
Monetary policies are failing
In fact, we should not just focus on the volatility of cryptocurrencies, but also think forward about the future of the crypto economy post Fed’s cut. It is noteworthy that the Fed’s aggressive QE policy not only failed to revive the traditional financial market, but resulted in a sharp plunge.
It is no secret that the so-called quantitative easing policy is just same as printing money. By increasing money supply to implement QE, the Fed in fact collects seigniorage from the world to ease US’s debt repayment pressure due to the sustained dollar depreciation. Therefore, some countries believe that it is a harmful act to their interests. Also, the effectiveness of this discretionary approach is in doubt. Milton Friedman, the American Nobel Prize-winning economist, noted that since the discretionary policy has time lag on the currency market, either excessive stimulation or over-contraction could result in adverse impacts on economic activities.
For the above reason, Friedman proposed the “single rules”, which suggests that the Fed should carry out a monetary policy based on US’s expected economic growth to ensure the growth rate in dollar supply stays keeps pace with the country’s economic growth. In addition, the government should not carry out any forms of currency intervention and hold an open attitude towards market’s invisible hand to maintain economic equilibrium. Afterwards, some economists, such as Robert Mundell, further developed the theory to suggest shifting the sole direction of the Fed’s monetary policy from “money supply” to “inflation”.
Back in 1970s when the US economy faced stagflation and Keynesian policies failed, Fed’s then-Chairman Paul Volcker implemented a series of monetary policies based on the single rules principle, which successfully saved the US from stagflation and cemented the status of the dollar as the world’s leading currency. He was also known as the greatest Fed’s Chairman.
However, after Alan Greenspan took over as the Fed’s Chairman, the single rules system existed in name only. Since then, the Fed kept rates low and released much money to drive the growth in the real estate and capital markets, which indirectly led to the subprime mortgage crisis in 2008. Moreover, the Fed’s monetary policy is often subject to political interference catering to politicians. For instance, after Trump assumed office in 2017, he has always been regarding the stock market boom as one of his achievements and urging the Fed for rate cuts. It casts a shadow over the independence of the Fed’s monetary policies.
Bitcoin is a good reference to real-world economy
How to ensure a country’s monetary policies maintaining continuity between administrations and free from interference by political parties? I think Bitcoin gives us a good example. Although I disagree that the token supply limit on Bitcoin should be applied to the modern monetary system as it will cause deflation and economic depression, the concept of “code is law” is a valuable reference for us. Central banks can create their own digital currencies to prevent politicians’ intervention and abuse of monetary policies. If the single rules principle is adopted in the digital currency issuance system, this can avoid the devaluation of a credit currency and maintain normal economic growth.
Blockchain technology and cryptocurrencies will play vital roles in the above assumption. Of course, this is only my dream so far. There is a long way to go in achieving the success of blockchain technology and cryptocurrencies. All parties in the blockchain and crypto community should work together to make the dream come true.
Disclaimer: This material should not be taken as the basis for making investment decisions, nor be construed as a recommendation to engage in investment transactions. Trading digital assets involves significant risk and can result in the loss of your invested capital. You should ensure that you fully understand the risk involved and take into consideration your level of experience, investment objectives and seek independent financial advice if necessary.
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