Bitcoin is surging during a financial crisis – what’s going on?

In the wake of the blowup of high-profile Silicon Valley Bank, cryptocurrency is surging in price. After all, cryptocurrency is generally among the riskiest possible trading vehicles, typically backed by no hard assets or cash flow of an underlying company, unlike stocks.

So you might expect cryptocurrency to plummet when a crisis of confidence hits the markets. Instead, leading crypto Bitcoin rose following the announcement that the U.S. government was insuring virtually all deposits at the troubled California bank and depositors would be whole.

Here’s why Bitcoin is surging amid the crisis and why one asset-backed stablecoin is falling.

Bitcoin surges following bank blowup

As the bellwether for the sector, Bitcoin ran up about 18 percent following the news that regulators were insuring all depositors at Silicon Valley Bank and creating a fund to bolster others across the U.S. What’s going on with surging crypto prices? In a word: interest rates.

Cryptocurrency is a risky asset that trades on changes in the future direction of interest rates, similarly to how many growth stocks do. When rates rise, traders move away from risky assets, but when rates fall, they tend to move into riskier assets. Now they expect the torrid pace of the Fed’s rate increases over the past year will be slowing, if not stopping altogether.

“We believe this is actually a recognition of the underlying challenges we are seeing facing U.S. monetary policy,” says Gabriella Kusz, CEO, Global Digital Asset & Cryptocurrency Association.

The Federal Reserve has been pursuing a policy of rapidly raising short-term interest rates in order to tamp down inflation, which had been at multi-decade highs recently. Rising short-term rates have increased the funding costs of banks, hurt bond prices and put a lid on stock prices.

Crypto proponents see Bitcoin’s move as a sign of its stability and growing acceptance.

“As actors begin to understand the role which U.S. monetary policy, inflation and increases in interest rates have played in the current banking sector challenges, you are likely seeing a move towards Bitcoin and other forms of crypto as a reflection of their potential value as a hedge and alternative store of value during such times,” says Kusz.

But Bitcoin’s move may seem paradoxical, since investors seem more jittery and prone to run to “safe haven” assets such as U.S. government bonds in a crisis. After all, Bitcoin is a risky asset that’s not backed by hard assets or cash flow of an underlying entity, unlike stocks and bonds.

Crypto assets have been associated with a number of high-profile bankruptcies of late, including those of Celsius and BlockFi as well as the seeming fraud of crypto exchange FTX. Banks involved in fintech innovation such as Silvergate and Silicon Valley Bank have also been snared.

Key stablecoin USD Coin under pressure

Another cryptocurrency was under pressure over the weekend, a so-called stablecoin called USD Coin, whose goal is to peg its value to the U.S. dollar and to maintain a value of $1. Such stablecoins are not intended to fluctuate in price, unlike almost all other cryptocurrencies. Typically, stablecoins maintain some hard assets such as actual dollars to back their value.

Following the shutdown of Silicon Valley Bank, USD Coin declined in value to less than $0.88 over the weekend, a dangerous situation that could lead to a run on that cryptocurrency. Traders were speculating that, after an initial statement from regulators guaranteeing a full return only for depositors with less than $250,000, the stablecoin might come under further pressure.

“USD Coin dropped off its peg because less than 10 percent of the backing was held in Silicon Valley Bank, and it was unclear whether or not that money would be returned,” says Aaron Rafferty, co-founder of BattlePACs and CEO of StandardDAO.

“Since Friday, however, the federal government and President Joe Biden have confirmed that depositors will have 100 percent security in redeeming their funds, so crisis averted…for now,” he says.

Since its fall, USD Coin has nearly recovered its full value, and trades just shy of its $1 peg.

What should investors know about cryptocurrency?

It’s vital that those thinking about putting their money into cryptocurrency understand the risks of doing so, since it can be easy to gloss over the risks as well as how volatile crypto markets are.

The volatility of cryptocurrency markets can make even traditional stock markets look tame in comparison. Even so-called safe assets such as stablecoins can move significantly, as traders saw in 2022 with the spectacular blow-up of the UST stablecoin. When trading volatile assets, inexperienced traders can easily make mistakes and let their emotions get the best of them.

But volatility is only one part of the risk inherent in cryptocurrency. A more important risk is the lack of inherent value in most cryptocurrencies. They aren’t backed by the assets or cash flow of an underlying company, meaning that the only thing holding them up is the sentiment of other traders. In contrast, stocks are backed by the assets and cash flow of that specific company.

This lack of fundamental backing means that the only way to make money on crypto is to trade it to someone else who is even more optimistic about it. This is what’s known among investors as the “greater fool theory of investing,” and it’s why legendary investors such as Warren Buffett and Charlie Munger won’t touch it, and even have gone as far as saying it should be banned.

Bottom line

While the market for cryptocurrency ebbs and flows on short-term drivers such as the crisis at Silicon Valley Bank, investors should stay mindful of cryptocurrencies’ lack of underlying value. Wealth is built over time through prudent long-term investing, not by playing the lottery.