The Crypto Collapse Could Have Been Much Worse

The cryptocurrency world is collapsing, and so was the subprime mortgage market in 2007. Back then, barely understood and in-demand financial products plunged the world into crisis. Is it about to happen again?

This is one of the questions raised by the dramatic fall of FTX, a huge crypto exchange launched by Sam Bankman-Fried, a press-loving (well, for two weeks) billionaire, generous Democratic Party financier. The politicians and effective-altruism causes (two weeks ago), and a young man known as a good guy in the crypto scam world (you get the idea). What exactly happened at FTX remains unclear, and how the sudden death of a $32 billion company could affect the financial markets and the real economy remains unknown.

However, for the moment, the situation demonstrates two things. The first is that despite all the hype around bitcoin and all the speculative money pouring into companies such as FTX, the crypto world remains a marginal niche within the larger financial system. And the second is that precisely because regulators in the United States and other countries have understood the risks of crypto, traditional financial institutions – the creators of the subprime mess – are insulated from the current meltdown.

The central problem is that cryptocurrencies remain little more than speculative assets and crypto markets are little more than a casino, plagued by fraud. For years, however, Wall Street has been desperate to pump money into crypto. And for years, crypto has been desperate to take money from Wall Street. To facilitate this, crypto entrepreneurs and investors have pushed for laws and regulations this would allow them to operate without the scrutiny normally applied to US investment banks, commercial banks, stock exchanges and trading firms. Regulators have slowed some of these exclusions, while Congress has not passed yet legislation opening financial markets to crypto, and so Washington might have averted disaster.

The FTX debacle began earlier this month, when Ian Allison at CoinDesk published a story showing that the main asset on the books of Bankman-Fried’s crypto-trading firm, Alameda Research, was a digital token issued by FTX; market watchers took this as evidence that Alameda could use FTX assets to hedge its trades. A drop in the value of the token would jeopardize both companies, and this drop quickly materialized. The general director of Binance, one of FTX’s main rivals, has announced that Binance is liquidating its holdings of the FTX token. Others have followed suit. FTX investors started withdrawing their money from the exchange, causing a sort of bank run. Binance considered stepping in to support FTX, but pulled out after doing due diligence on the beleaguered company. After that, the exchange giant did not so much crumble as evaporated into thin air.

The fallout has been nuclear among cryptocurrency-related businesses, leading to write-offs, asset freeze, and concern about the viability of the entire sector. The price of bitcoin, ether, and a number of other digital currencies and tokens have fallen, as have the shares of many crypto companies. “Today is a bad day,” Edward Moya, market analyst at OANDA, wrote in a research note. “Many crypto businesses will likely be vulnerable.”

The vulnerability is widespread due to numerous incestuous entanglements between cryptographic entities. Alameda and FTX appear to have been dangerously bound: Bankman-Fried may have used what FTX clients believed to be secure deposits in custodial accounts to fund transactions involving Alameda. FTX was pay money in the same venture capitalists that were putting money into it. Problems with crypto companies lead to massive cryptocurrency sales; sales in a cryptocurrency are causing sales in other cryptocurrencies. The market is “extremely interconnected” concludes Filippo Ferroni, an economist at the Federal Reserve Bank of Chicago, and therefore extremely volatile. Price movements amplify on their own and ripple through the entire industry.

Still, the FTX debacle has so far had no obvious impact on the stock Exchangeand had no effect on publicly traded shares financial companies. Wall Street’s “fear index”, a measure of financial volatility, went down a touch when FTX went down in flames. A number of companies writing where are should write the value of their investments in FTX. But there is little concern about systemic risk, at least for now. “There could be pension funds directly exposed to FTX,” Mark Hays of Americans for Financial Reform told me. “They are starting to reduce their valuations to zero, and that could further extend the circle of damage. But if you are not an institutional investor investing directly in crypto assets or companies like FTX, then you are not exposed.

Why is contagion so limited? I posed this question to Dennis Kelleher, co-founder of Better Markets, a nonprofit that advocates for financial regulation in the public interest. “The only reason we don’t have a financial crisis right now, with a crash and bailouts, is because regulators have resisted tremendous pressure to allow interconnection and linkages between crypto businesses. and the heart of the financial and banking system,” he said. Due to the position of their regulators, American banks are not loan guarantee with cryptocurrencies, for example. They do not freely trade crypto derivatives.

Meanwhile, an aversion to US regulation has prevented crypto firms, many of which are based overseas, from becoming more involved in US finance. “If you’re SEC-registered and SEC-regulated, you’re required to have client account segregation,” Kelleher explained. “You are required to have books and records. You are required to have codes of conduct that include prohibitions or identification of conflicts of interest. You are prohibited from mixing funds. You must have margin capital and you have cash requirements. Crypto companies “didn’t want that,” Kelleher said. He added: “It’s a Ponzi scheme. When there was tulip mania, at least when you lost all your money, you still had a tulip.

Hays told me that members of Congress should keep the FTX debacle in mind — and its so far limited impact — when considering how to regulate crypto in the future. “The debate has centered around this idea that we need to foster special regulations for this new and growing industry,” he said. “Policymakers on both sides of the aisle should really think about getting it right.”

An absence of financial contagion does not mean an absence of financial harm. The collapse of FTX has caused billions of dollars in losses, and the crypto sell-off is crushing the many small investors who have invested a little money in this volatile, lunar asset over the past few years. At least these kitchen investors aren’t being asked to bail out companies caught making risky bets and embezzling their clients’ funds.

Comments are closed.