Whereas people bought homes with bank loans before the housing crisis and dot-com stocks on margin during the 1990s tech bubble, most people aren't using borrowed money to buy bitcoin. At least, that's what we think.
Truthfully, there's little way to know how billions of dollars in daily bitcoin transactions are financed, because cryptocurrencies are largely bought and sold on unregulated markets. But it seems evident, at least to me, that a small portion of the bitcoin market thrives on other people's money, and lenders may be left holding the bag on bitcoin's plunge.
Buying bitcoin on credit
A recent LendEDU poll of bitcoin investors found that 18% of buyers used a credit card to make their investment. Of those, 22% could not afford to fully pay off their balance after buying the digital currency, suggesting that speculators were risking more than they could truly afford to lose.
The findings corroborate with other data that suggest credit cards may have helped fuel bitcoin's boom in 2017. As the price of bitcoin soared, the number of Google searchers looking for a way to use credit cards to buy the cryptocurrency jumped, too, reaching a peak in the week of Dec. 3 to Dec. 9, 2017.
Credit card balances increased markedly at the same time bitcoin was soaring. Revolving consumer credit balances increased at an annual rate of 9.9% year over year in October 2017. In November, balances jumped by 13.3%, according to the Federal Reserve. To put the increases in perspective, consider that revolving balances increased at a 7.3% annual clip in the fourth quarter of 2016.
Banks are backing away
Some banks are turning off their customers' ability to buy bitcoin and other cryptocurrencies on credit. Based on numerous reports, Capital One Financial (NYSE:COF) began blocking credit card transactions at known cryptocurrency exchanges on Jan. 12, 2018, when bitcoin had already lost a third of its value from its all-time high set one month earlier.
In a statement to Brietbart, Capital One said that it is "currently declining credit card transactions to purchase cryptocurrency because of the limited mainstream acceptance and the elevated risks of fraud, loss, and volatility inherent in the cryptocurrency market." It also said it would continue to evaluate allowing its customers to use their cards to buy digital currencies.
That a major credit card company is actively standing in the way of bitcoin purchases suggests, at least to me, that it found something it didn't like in the cohort of customers who had used their cards at online currency exchanges.
Little room for error
In light of declining prices of digital currencies, credit card lenders may have to set aside more cash for increased defaults, weighing on their profits. Capital One's domestic card business earned pre-tax income of $748 million on average balances of $93.7 billion in the third quarter of 2017. What it set aside for losses was roughly double what it earned in pre-tax profits that quarter.
When margins are razor thin, any loan loss can be a significant loan loss. That goes double for credit card issuers, who often see their non-interest expenses increase with their loan loss provisions, as they spend more money trying to collect on bad debts.
To be clear, I'm not saying that the plunge in digital currency prices is likely to result in an economic catastrophe quite like the 2008 financial crisis. Far from it. But I suspect that bank earnings may take a bitcoin-related hit as bad debts emerge from the rubble of depressed cryptocurrency prices.
Jordan Wathen has no position in any of the stocks or cryptocurrencies mentioned. The Motley Fool has no position in any of the stocks or cryptocurrencies mentioned. The Motley Fool has a disclosure policy.