Tales from the Crypt(o)
“In other regulated exchanges, you would have segregation of customer assets. The notion you could use the deposits of customers of an exchange and lend them to a separate enterprise that you control to do leveraged, risky investments — that wouldn’t be something that’s allowed.” Secretary of the Treasury Janet Yellen, November 12, 2022.
Every financial system is based on trust. Aside from risks that you consciously take, you are only willing to invest with someone if you are confident that you will get your funds back. Someone making a deposit in a traditional bank expects to have access to all their funds at par on demand. Someone purchasing a speculative stock through a broker believes that they can sell it quickly at a price, obtaining the proceeds even if that represents a sizable loss.
With the collapse of FTX, we learned yet again that participants in much of the crypto world cannot do either of these things. Buying crypto instruments through exchanges that are beyond the regulatory perimeter is far less safe than trading speculative equities through a registered broker-dealer or regulated exchange. Crypto investors that hold their funds in such intermediaries cannot count on having access to the assets that they believe they own.
The run on FTX reflects a classic loss of trust. It is not extraordinary. Rather, it exemplifies the problems that plague a financial system in the absence of legal protections and public oversight. Importantly, these difficulties of establishing and maintaining trust have existed in the world of finance for centuries. As a result, virtually all traditional financial systems today address them through extensive legal rules and enforcement, as well as detailed regulation and supervision.
If we needed a reminder about the importance of trust in finance, FTX’s confluence of failures provides an excellent teaching moment. Ironically, the crypto movement arose from a desire to create a financial system that does not require legal rules or government intervention to establish trust. Leaving aside diehard believers, the story of FTX (as well as other crypto disasters earlier this year) should expose this for the fantasy that it is.
Before getting to the details, as we show in the following chart, market capitalization of the crypto world peaked in November 2021 at more than $2½ trillion and now stands at roughly $800 billion. (The exact numbers depend on the source.) If we remove the stablecoins (shaded in red), the decline is even more precipitous—a plunge of more than 75%. We take two messages from this. First, people are losing interest in crypto. Second, the crypto catastrophe is having virtually no impact on the traditional financial system, where the legal and regulatory framework continues to sustain trust.
Crypto market capitalization (trillions of U.S. dollars), 1 Jan 2017 to 13 Nov 2022
Source: Coinmetrics. Note that the levels here are somewhat lower than those from CoinMarketCap.
Returning to FTX, reports of the events of last week highlight the following fundamental failures (any one of which could have resulted in a run on FTX):
A lack of transparency. Based in the Bahamas, the parent firm FTX is not subject to U.S. generally accepted accounting principles (GAAP) and disclosure rules. According to its website, FTX underwent a U.S. GAAP audit for 2021 “and plans to continue undergoing regular audits,” but the results do not appear on its website. The auditor reportedly was Prager Metis, which lists 24 locations, including the Metaverse.
Organizational complexity. The FTX bankruptcy filing included 134 affiliates in numerous jurisdictions. Complexity often aids the concealment of risky activities.
Related-party dealings. Among its extremely risky activities, FTX made large, undisclosed loans to affiliates controlled by its executives. For example, Alameda, an affiliated trading firm, reportedly borrowed as much as $10 billion from FTX, some of which was customer funds. Such related lending has contributed to many episodes of bank failures across time and geographies (see, for example, La Porta, Lopez-de-Silanes and Zamarripa).
Weak corporate governance. The Wall Street Journal reports that “FTX’s board consisted of [its chief executive] Mr. Bankman-Fried, someone who works at FTX and a lawyer in Antigua whose website says he specializes in gaming.”
Using your own liabilities as collateral for loans. Some of FTX’s related lending reportedly was collateralized by another liability of FTX known as FTT. Accepting its own liability as collateral exposed FTX to “wrong-way risk” because a loss of confidence in the financial position of FTX or its affiliates would undermine the value of the collateral, further undermining FTX’s financial well-being.
Failure to segregate customer assets. In stark contrast with a U.S. licensed and regulated broker, FTX did not safeguard customer assets by holding separate accounts with a third party (see opening citation from Treasury Secretary Yellen). As a result, customers who deposited their funds with FTX now appear to be undifferentiated from other creditors of the bankrupt enterprise.
Allowing substantial customer leverage. FTX’s derivatives exchange had a leverage limit of 20 times, meaning that a customer could post $5 in margin to purchase a crypto derivative with notional value of $100. Given the volatility of crypto prices, this meant that FTX customer loans were extremely risky. Furthermore, when the value of the asset fell, it could trigger a margin call that might result in liquidation of the position, driving the value of the asset down even further.
In our view, each of these failures could have been individually sufficient to cause customers to lose trust in FTX. Why would anyone do business with a largely unmonitored financial intermediary that lacks transparency, has opaque structures, engages in extremely risky lending practices (including related lending and accepting its own liabilities as collateral), has weak governance, or fails to segregate accounts? These are all violations of basic safety and soundness practices that are the bedrock of financial regulation and supervision in most of the world.
In the aftermath of FTX, the question is what will happen next? The crypto system as it currently exists is unsustainable. Absent clear and easily enforceable property rights, a system that relies solely on private investors to monitor and discipline the behavior of opaque intermediaries has never been safe and effective. So, the big question is whether authorities ought to create a regulatory and supervisory framework that protects property rights and enforces the principles of safety and soundness.
Our hope is that governments will stand back and let the crypto world implode under the pressure of its unsafe business practices. Of course, officials should insist that traditional financial intermediaries avoid crypto exposure. They also must enforce applicable laws against fraud and theft. However, most FTX activity is taking place beyond the legal and regulatory purview of those nations with the largest financial systems. By offering a government seal of approval, a new, widely accepted crypto framework would create undeserved legitimacy for a system that does little to support real economic activity and poses virtually no threat to financial stability.
Better to let it go, ensuring that the horror tales of the crypt(o) are clear to everyone and will not be soon forgotten.