JPMorgan Chase’s recent decision to allow trading and wealth management clients to use crypto Exchange Traded Funds (ETFs) as collateral for loans is a concerning development that introduces multiple layers of risk. This move, starting with BlackRock’s iShares Bitcoin Trust, integrates a volatile and complex asset class into traditional lending practices, which will have significant negative consequences.
Custody and Ownership Concerns: “Not Your Keys, Not Your Crypto”
A primary concern with crypto ETFs is the nature of ownership and custody.
Lack of Direct Ownership: When investing in a crypto ETF, individuals do not own the underlying cryptocurrency directly (Investopedia). Instead, they own shares of a fund that holds the crypto. This means investors cannot take custody of their share of the crypto assets; they can only trade the ETF shares.
Reliance on Custodians: Crypto ETFs depend on custodians to safeguard the underlying digital assets. This reliance introduces significant risks:
Single Point of Failure: Crypto ETFs rely on custodians, such as Coinbase, which holds a significant percentage of Bitcoin for these ETFs. This concentration is concerning, as any major operational issue, security breach, or insolvency at the custodians will have disastrous consequences for the ETFs and their investors.
Security Breaches and Mismanagement: Custodians must protect cryptographic private keys against theft, loss, and corruption. However, the security of these assets held by third-party custodians remains a crucial concern, with potential vulnerabilities to hacking or mismanagement (Ulam Labs). The failure of a custodian due to poor financial risk management or regulatory action is a known risk, leading to investors being unable to recover their assets or receiving compensation in dollars at a lower value.
“Not Your Keys, Not Your Crypto”: The crypto adage “not your keys, not your coins” highlights that if you don’t control the private keys, you don’t truly own the crypto. In the ETF structure, the fund (and its custodian) controls the keys, not the investor. If the collateral (the crypto ETF shares) is based on assets where the ultimate control lies with a third-party custodian, there’s an inherent risk of loss if that custodian fails or is compromised.
Inherent Risks of Cryptocurrencies and their ETFs
Beyond custody, the underlying assets and the ETF structure present further dangers:
Extreme Volatility: Cryptocurrencies are notorious for extreme price fluctuations. This volatility makes crypto ETFs inherently high-risk investments and, consequently, risky collateral. The Depository Trust Company (DTC), a key clearinghouse, applies a 100% haircut to Bitcoin ETFs for settlement purposes, effectively not accepting them as collateral due to this volatility and lack of ratings. “There are at least two sound reasons why crypto gets a 100% haircut. The first is its inherent volatility and lack of ratings, characteristics that makes it a risky asset for collateral. The second reason is the Basel Committee rules for bank exposure to cryptocurrencies.” (https://www.ledgerinsights.com/why-the-dtc-wont-accept-bitcoin-etfs-as-collateral)
Regulatory Uncertainty: The regulatory environment for cryptocurrencies is still evolving and varies across jurisdictions. Changes in regulations could significantly impact the operation, availability, and viability of crypto ETFs.
Quantum Computing Threat: Quantum computing poses a threat to current cryptographic standards that secure cryptocurrencies. Quantum computers can break the encryption used to protect private keys, compromising the security of the underlying crypto assets in an ETF. Bitcoin is particularly vulnerable.
Risks for Banks Accepting Crypto ETFs as Collateral
JPMorgan’s decision to accept these assets as collateral introduces specific risks to the bank and the broader financial system:
Questionable Collateral Quality: The Basel Committee on Banking Supervision, which sets global banking standards, does not consider cryptocurrencies or stablecoins as eligible collateral. This means any loan using crypto as collateral would likely be considered unsecured for risk-weighting purposes, forcing the bank to hold more capital against it, making it an expensive endeavor.
Increased Financial Instability: The introduction of spot crypto ETFs can magnify existing risks inherent in the underlying crypto assets and pose additional risks, such as creating new channels for transmitting financial instability. If financial institutions become insolvent due to cryptocurrency crises, it could necessitate policy support at high social costs.
Systemic Risk: Increased interconnectedness between crypto-assets and the traditional financial sector, especially through lending activity, heightens systemic risk.
JPMorgan’s Own History of Risk Management Failures
JPMorgan’s past actions do not inspire confidence that it can manage these new risks flawlessly.
- The “London Whale” Scandal (2012): The bank suffered over $6 billion in losses due to failures in its credit model and inadequate monitoring of risky trades in its Chief Investment Office (CIO). Risk metrics were not granular enough, VaR limits were breached repeatedly without consequence, and a new, untested VaR model failed.
- Role in the 2008 Financial Crisis: JPMorgan was significantly involved in the subprime mortgage crisis, including its acquisition of Bear Stearns, which had made large, risky investments in subprime mortgage securities. The bank was later fined $13 billion for engaging in bad practices related to these activities. These incidents demonstrate that even large, sophisticated institutions can suffer from critical breakdowns in risk management.
Pervasive Fraud in the Crypto Ecosystem
The crypto space is rife with fraud and scams, which should give pause to any institution looking to integrate it more deeply into traditional finance. Common types of crypto fraud include:
- Investment Scams: Often promising high returns with little risk.
- Impersonation Scams: Scammers impersonating businesses, government agencies, or even new crypto projects (fake Initial Coin Offerings – ICOs)
- Rug Pulls: Where developers promote a new crypto project, attract investment, and then disappear with the funds.
- Phishing Scams: Targeting crypto wallet private keys.
- Fake Exchanges and Apps: Tricking users into depositing funds or revealing sensitive information.
Conclusion: A House of Cards Getting Taller?
JPMorgan’s decision to accept crypto ETFs as collateral is reckless. It leans into an asset class characterized by questionable custody arrangements where investors don’t hold their own assets, extreme volatility, evolving (and often lacking) regulation, and a high prevalence of fraud. Given the inherent risks of crypto ETFs, from custodian vulnerabilities and market manipulation to the current threat of quantum computing, and JPMorgan’s own past missteps in managing complex financial risks, this move seems to be piling on to an already fragile house of cards. The approval of crypto ETFs in the first place has been criticized for legitimizing an unstable asset class; using these ETFs as collateral for loans only amplifies these concerns and introduces new avenues for financial instability.
IN RESPONSE TO:
And specifically @floridanow1 saying “Why not, these ETF’s are just like stocks and used for loan collateral.”
I responded and said “Theyโre really not at all.”
He responded and said “All ETF’s are bought and sold like stocks….in a second.”
I responded and said “Do you really want me to write an article and pwn your Kindergarten brain? Cuz I will” .
He said “Yes…then copy JP Morgan and educate them genius.”
Then he blocked me, understandably for flaming, but he really is stupid at a kindergarten level of understanding.
@jpmorgan (Why isn’t Jamie Dimon on @X anyway? Is he hiding from New Media 4th Branch Q & A, Yes Man?)
SOURCES:
investopedia.com, ledger.com, youtube.com, sec.gov, ftc.gov, moneysmart.gov.au
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