“Safe” assets can be risky – check your assumptions

Anyone moderately familiar with crypto assets is no doubt aware that the Terra stablecoin has been experiencing problems with its algorithmic smart contract controlled peg mechanism. There are lots of lessons here I am but I think Matt Levine flags one of the more interesting ones in his “Money Stuff” column (13 May 2022).

Safe assets are much riskier than risky ones.

Matt goes on to expand on why this is so …

This is I think the deep lesson of the 2008 financial crisis, and crypto loves re-learning the lessons of traditional finance. Systemic risks live in safe assets. Equity-like assets — tech stocks, Luna, Bitcoin — are risky, and everyone knows they’re risky, and everyone accepts the risk. If your stocks or Bitcoin go down by 20% you are sad, but you are not that surprised. And so most people arrange their lives in such a way that, if their stocks or Bitcoin go down by 20%, they are not ruined.

On the other hand safe assets — AAA mortgage securities, bank deposits, stablecoins — are not supposed to be risky, and people rely on them being worth what they say they’re worth, and when people lose even a little bit of confidence in them they crack completely. Bitcoin is valuable at $50,000 and somewhat less valuable at $40,000. A stablecoin is valuable at $1.00 and worthless at $0.98. If it hits $0.98 it might as well go to zero. And now it might!

The takeaway for me is to once again highlight the way in which supposedly safe, “no questions need be asked”, assets can sometimes be worse than assets we know are risky due to the potential for them to quickly flip into something for which there is no liquidity, just a path to increasingly large price falls. This is a theme that I regularly hammer (so apologies if you are tired of it) but still for me one of the more important principles in finance (right up there with “no free lunch”).

Tony – From the Outside

Author: From the Outside

After working in the Australian banking system for close to four decades, I am taking some time out to write and reflect on what I have learned. My primary area of expertise is bank capital management but this blog aims to offer a bank insider's outside perspective on banking, capital, economics, finance and risk.

2 thoughts on ““Safe” assets can be risky – check your assumptions”

  1. Of course Tony banking is a house of cards built 3 feet in the air with little visible means of support other than the fact it is convenient for everyone that it works. Hard to transfer that stakeholder wide self-fulfilling delusion to other entities.

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    1. Andrew. There is no question that Trust is the lifeblood of the system. That said, I think that the deposits (aka private money creation) part of the system is pretty well insulated from the risk part of the system. This is partly about increased equity and controls on the quality of assets but I think the extent to which the priority claim on assets is the real secret sauce to making bank deposits “information insensitive” in the sense that Gary Gorton argues for. This effective over-collateralisation means that shareholders and junior liability claims ranking behind the deposits bear the risk. The government provides the ultimate backstop via deposit insurance but this is mostly (if not entirely) about providing liquidity – the range of factors covered in the post below I think make the actual risk of loss relatively de minimis

      https://from-the-outside.com/2020/07/27/bank-deposits-turning-unsecured-loans-to-highly-leveraged-companies-into-mostly-risk-free-assets-an-australian-perspective/

      As always I may be missing something. A key concern/risk is whether bail-in instruments will actually work in the way they are intended to should the need arise

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