Crypto contagion? What Terra’s ‘Lehman Brothers’ moment means for markets

Taken as a whole, cryptocurrencies’ market cap is down roughly 45% year-to-date, and in just a week’s time, the world’s leading digital assets, Bitcoin and Ether, have plummeted 23% and 31%, respectively.

Even worse, since November 2021’s highs, cryptocurrencies have given back around $1.6 trillion in value, and some of the most respected names in the industry are arguing this week’s blow-up of the algorithmic stable coin TerraUSD (UST) is a “Lehman Bros event.”

But unlike the events leading to the subprime mortgage crisis of 2008, the financial community is divided on whether a crypto blowup could lead to systemic risk for financial markets. 

“It will probably be a ‘Lehman Bros’ event for the Terra ecosystem,” the billionaire founder of FTX, Sam Bankman-Fried, told Fortune on Thursday. “But the contagion to the rest of the crypto industry is going to be more limited.” 

While Bankman-Fried isn’t worried about the fallout from UST’s collapse, risks from a serious downturn in crypto are definitely something U.S. Treasury Secretary Janet Yellen has on her mind.

In front of the Senate Banking Committee on Tuesday, Yellen argued that “digital assets may present risks to the financial system and increased and coordinated regulatory attention is necessary,” specifically citing turmoil in the crypto markets and the collapse of the TerraUSD stablecoin.

On the whole, most experts agree that, as of now, the risk of a domino effect trampling through financial markets akin to what was seen in the Great Financial Crisis is limited.

“The realm of crypto has been dominated by a handful of larger investors and small retail players. The odds that this meltdown becomes a source of contagion to the financial system is thus remote,” Danielle DiMartino Booth, CEO and chief strategist of Quill Intelligence, told Fortune.

But that doesn’t mean another type of contagion risk isn’t possible.

A different kind of contagion risk

Cryptocurrencies’ recent downturn could hurt retail investor sentiment and further the ongoing, partly Fed-induced, risk asset sell-off,  DiMartino Booth told Fortune. 

“The overarching and justified concern is that this first major confidence crisis sends a shiver through smaller investor sentiment as margin calls of any ilk tend to do,” DiMartino Booth said. “Retail investors have traditionally played the role of the canary in market selloffs. Because crypto is where so many smaller investors have placed their bets, the losses sustained could become a driver of a broader risk-off move in the stock market.” 

She’s not the only one sounding the alarm.

“Contagion here is not via linkages between the crypto ecosystem and the traditional financial system, but via retail investors’ sentiment,” Nikolaos Panigirtzoglou, a global market strategist at JPMorgan Chase, told Bloomberg on Thursday. “If the $1 trillion capital loss in crypto markets causes broad-based retrenchment by retail investors in other risk assets such as equities, then that’s where the spillover is.”

Retail investors pumped $114 billion into stocks through March even as the S&P 500 dropped into a correction, the Wall Street Journal reported on Tuesday. If those flows slow, it could mean more pain ahead for a market that is already reeling. The area that’s likely to be most affected? Highly-correlated tech stocks. 

The once-high flying tech space has already experienced one of its worst starts in history, with the tech-heavy Nasdaq Composite sinking more than 28% year-to-date, but if cryptocurrencies continue to drop, worsening retail investors’ attitude toward investing, things could get even worse.

“Cryptocurrencies are increasingly moving in sync with tech stocks with investors treating both as risk assets and often retreating to safer corners of the market during bouts of market volatility,” Michael Kamerman, CEO of trading platform Skilling, told CNN on Monday.

A slowdown in crypto adoption 

The other potential contagion effect from crypto’s recent collapse could be a slowdown in the adoption of digital assets. 

“The value of cryptocurrencies depends crucially on the perceived likelihood of their becoming more widely used in the payment system. Now, with Terra’s collapse, this perception is low,” Chiente Hsu, the co-founder of the DeFi platform ALEX and the former global head of quantitative investment strategy at Morgan Stanley, told Fortune. 

“Down the road, maybe six months, the perception should increase again, but I think events like the Terra collapse puts the likelihood of wide adoption further into the future, that’s for sure,” she added.

But Hsu said she isn’t worried about contagion spreading to the financial system, because the government won’t be riding to the rescue of crypto companies. And other stablecoins, including the two industry leaders Circle’s USDC and Tether’s USDT, are backed by “hard dollar reserves” instead of algorithms.

Hsu noted that while Tether was tested on Thursday, briefly falling to 95 cents, that was largely a result of the stable coin not being 100% backed by cash or cash equivalents. Only roughly 85% of Tether’s assets are in cash, cash equivalents, short-term deposits, and commercial paper, she said.

So while the crypto meltdown will undoubtedly have a cooling effect on investor sentiment, barring an outright collapse in the total ecosystem, contagion effects should remain limited.