Falling Meteorite FTX Scorches Crypto Landscape

by | Nov 12, 2022 | Blog Articles, crypto, finance, USA, Why America Matters Book

Cover art/illustration via Financial Times

After several months of calm in the crypto industry, characterized by a role reversal in which equities were highly volatile and cryptocurrencies flat and boring, a familiar if tragic drama reminiscent of Icarus is now playing out.

This week saw the dramatic failure of FTX, one of the world’s largest cryptocurrency exchanges, and the ignoble demise of its celebrated founder and CEO Sam Bankman-Fried. Bankman-Fried, commonly referred to as SBF, was estimated to have been worth $17.2 billion before the collapse, and likely somewhere in the neighborhood of zero following it. All this occurred over the course of 48 hours.

Making matters worse, billions of dollars of client funds may have been lost, and as of today, FTX depositors are unable to make withdrawals.

The collapse of FTX was sparked by a liquidity crisis akin to an old fashioned bank run. FTX depositors became nervous when rumors of a too-intimate relationship with Alameda Research, a company founded and controlled by SBF, began to swirl. Insinuations of co-mingling of client funds followed. According to reports, about a third ($5.8 billion) of Alameda’s $14.6 billion of assets were in the form of FTX’s exchange token (FTT), which lost nearly 85 percent of its value in less than 24 hours on Monday. The FTT token was being used as collateral for credit lines by Alameda and other entities, which suddenly found themselves facing margin calls and the need to post fresh collateral. As the rumors spread, FTX depositors feared the worst, and withdrew $6 billion of liquidity from FTX within hours.

SFB scrambled desperately over the course of Monday and Tuesday to find rescue financing, reaching a tentative agreement to sell FTX to exchange competitor Binance. This deal fizzled less than a day later during due diligence when Binance discovered an $8 billion hole in FTX’s balance sheet. A bankruptcy filing may now be the only way out for FTX.

The collapse of FTX led to contagion across the industry, with share prices of Coinbase, the largest crypto exchange, falling 25%. The values of underlying assets (i.e., the digital tokens themselves) were also clobbered, with prices for Bitcoin (BTC) and Ether (ETH), falling by more than 25% and 31% respectively. Bitcoin and Ether represent the two largest coins by market capitalization, with a combined value of over half a trillion dollars even after this crash, and as such the pain was felt broadly.

One of the ironies of this tragedy is that the now disgraced SBF was one of the key figures leading the crypto community’s effort to help shape the future of crypto regulation, including the Digital Commodities Consumer Protection Act, which if enacted will give the Commodity Futures Trading Commission (CFTC) authority to regulate the industry. The CTFC has been in a turf battle with the Securities and Exchange Commission (SEC) and the U.S. Treasury’s Office of Foreign Assets Control (OFAC) over who gets to oversee crypto. In the absence of clear legislation, these entities have chosen to regulate by enforcement rather than by law or rules-setting. Following the collapse of FTX, as well as several other crypto industry failures in 2022 whose explosions blew shrapnel across the industry and its customers, including Luna/Terra,  Three Arrows Capital, and Celsius, these regulators now have plenty of sensational ammunition to back their argument for greater regulation.

What can investors learn from all of this?

The common links among all these failures include excessive leverage, using coins (including of customers) as collateral, co-mingling funds, and potentially outright fraud.

The collapse of FTX, like those before it, all sprung from the same issue: liquidity, or lack thereof. The violent downturn in crypto asset prices over the past three days reflects this liquidity squeeze, and specifically the glut of seized collateral being dumped onto the market.

The failure of these firms resulted from bad business models, not from flawed crypto fundamentals. They each sought to make something that is intended to be decentralized, i.e., where only the owner of the asset has control over it, and recentralize it, like a bank or brokerage, where the exchange or asset manager take custody of the coins.  They used this power to leverage assets to boost returns. And customers, in their ignorance, let them.

This entirely defeats one of the main purposes of crypto, which is control by the owner of the token. Those new to crypto should take away from this that crypto exchanges are there to facilitate buying and selling, not as a place to store coins beyond the short-term. Investors should store their digital assets in wallets with private keys that only they control. They should learn and apply the crypto mantra, “not your keys, not your crypto.”

These failures do not reflect the underlying intrinsic value or potential use cases of digital tokens. Nor are they an inditement of the potential role of crypto to transform the concept of money, though regulators and some commentators will try to make these arguments.

What has gone unnoticed outside of the crypto community is the fact that Ether is now anti-inflationary “hard money,” in that more ETH are being burned than minted and its supply is shrinking. Bitcoin supply is growing less than 2 percent per year, and will fall to near zero in the years to come. Compare this to the nearly 40 percent increase in the U.S. dollar money supply (M2) since the beginning of the pandemic and it becomes clear which asset should hold its value better over time. That is, assuming crypto isn’t strangled by onerous regulation along the way.

FTX and similar failures are flushing out the frauds, the bad business models, and fools who rush in seeking too-good-to-be-true yields. By way of example of what not to do, they are purging, reforming and strengthening the industry, which is necessary for crypto to thrive over the long-run.

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