Cryptocurrencies have been falling since November 2021, in line with the stock market’s downturn on the back of the general risk-off mode. These declines were nothing new or alarming, as crypto is notoriously volatile; many have seen the declines as an easy entry point. However, the mood has changed after the crash of FTX and the still-ongoing harm it has induced. What’s even worse than billions of dollars disappearing overnight is that FTX’s demise, with its contagion across the digital currency markets, has shattered the general public’s confidence in all things crypto.
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Crypto’s “Lehman” Moment?
Investors in cryptocurrencies have lost billions of dollars since FTX started wobbling at the beginning of November. However, the crypto crisis is nowhere near being over; actually, it is in its early stages. The amount of collateral damage is still unknown but is likely to be enormous, as the crypto world operates in a closed loop with vast interconnectedness. The crypto ecosystem has grown into a parallel banking system, with firms investing in one another, buying each other’s tokens, and lending tokens and dollars to one another, which means the collapse of FTX will continue to topple others.
There are many similarities between what happened in 2008 and now that have led many to compare these developments with Lehman’s collapse in 2008. Just as it was with Lehman’s downfall, among the most prominent outcomes are the destruction of confidence and the recognition of a need for regulation and investor protection.
Lehman, Enron, and FTX
How does a company valued at $32 billion implode overnight? Simple: bad management, probable fraud, and lack of oversight – coupled with FOMO (“fear of missing out”) and hype that led investors to loosen their due diligence methods to the extent of virtually throwing money at anything with the right lingo.
Last year, as investors bought anything tech for any price, the craze, of course, included cryptos. Cryptocurrency exchange Coinbase Global (NASDAQ: COIN) went public at a market cap of $65 billion; its stock has lost about 90% since then. Australian Bitcoin (BTC-USD) miner Iris Energy (NASDAQ: IREN) IPOed at $25 per share; it’s now trading under $1.70. Another crypto miner, Stronghold Digital (NASDAQ: SDIG), had a hugely successful IPO with the price upsized by 40%; its share price has crashed now by 97%.
Basically, many publicly-traded miners have lost above 90% of their value since last year’s peak, with the biggest losses incurred before the FTX’s collapse.
Now, crypto lenders such as BlockFi, Galaxy Digital (TSE: GLXY), Digital Currency Group, and others are seeing defaults on their loans to miners. Many of these funders are expected to file Chapter 11 themselves or have already declared bankruptcy. All this just goes to show that the crypto space was in an enormous bubble, with the FOMO craze blinding investors and allowing mismanagement and fraud to fly under the radar.
Until it fell, FTX was one of the most trusted entities in the crypto space, believed to be “a gold standard” for crypto trading and backed by celebrities, financial influencers, and reputable institutions.
Among its investors are Sequoia Capital, SoftBank (OTC: STFBF), BlackRock (NYSE: BLK), Lightspeed Venture Partners, Ontario Teachers’ Pension Plan, Temasek Fund, and others, who channeled their shareholders’ money into the FTX black box without knowing the full nature and extent of the risk they are taking. This likens the FTX case – besides the parallels with Lehman – to that of a corporate fraud scandal at Enron in 2001.
No “Lender of Last Resort”
Interestingly, FTX investors could have continued to channel money to the exchange, increasing their future losses, if not for CoinDesk, a crypto information provider that published a report questioning FTX and Alameda’s solvency. One of the findings in the report was that FTX’s own token, FTT, was used to prop up Alameda’s balance sheet.
The report validated the uneasy feelings of many in the industry, causing the world’s largest crypto exchange, Binance, to unload its $500 million holdings of FTT, leading to a crash in its price. This started an old-fashioned “run on the bank” as FTX’s customers panicked and started pulling their money out. Still, the foul money-management practices meant that many customers will never see their money again, as they are long sunk into Alameda’s failed crypto trading and – probably – other stunts we still don’t know about.
In the unregulated world of crypto, there was no insurance for customers’ funds, but also no lender of last resort to back cash-strapped FTX. The beleaguered exchange tried to sell itself to Binance, who declined following a review of the company’s finances, apparently finding FTX unsavable.
However, even if Binance had saved FTX – who would save Binance if it ran into trouble? When JPMorgan (NYSE: JPM), one of the largest, oldest, and most stable financial institutions in the world, bailed out Bear Stearns in 2008, it had to rely on the Federal Reserve’s backing – otherwise, it wouldn’t risk the mess, just like Binance. Decentralized Finance was built on the basis of being free from government regulation and meddling, so there’s no Fed in the crypto world to save the sinking ship.
FTX, BlockFi, and All That Jazz
The public is now just starting to discover the level of interconnectedness, as well as the prevalence of malfeasance among crypto platforms. We now know that FTX owner and CEO Sam Bankman-Fried has secretly forwarded FTX customers’ funds to his trading firm, Alameda Research, to cover its funding gap that was caused by falling crypto prices.
A striking example of malpractice in the crypto world is the unhealthy relationship between BlockFi and FTX. After BlockFi filed for Chapter 11, documents revealed it was a creditor to FTX that lent money to Alameda, which, in turn, used the money to buy shares through one of Bankman-Fried’s shell companies. These shares were then used as collateral for FTX’s loans from BlockFi. BlockFi is now blaming its demise (besides the sharp declines in cryptocurrency prices) on Alameda’s default on $680 million owed to BlockFi.
U.S. state securities regulators are now conducting an inquiry into the interconnectedness of crypto firms. Already, about 100 companies affiliated with FTX are filing for bankruptcy, and many more will follow. The wipeout of a large number of crypto firms will put even more pressure on liquidity and volume throughout the crypto ecosystem.
The Gold Standard of Trust
The crisis in the crypto space began in May when stablecoin TerraUSD collapsed because investors lost confidence in the asset that backed it, Luna token. The crash of the “stablecoin” underscored the fact that the only thing really supporting crypto’s value is investor trust.
In a way, it’s not much different from any other types of currencies – from shells through cattle to dollars. Money is a means of exchange; if people believe that a shell buys you a knife, then a shell is worth a knife. A dollar bill is just a piece of paper, but it is backed by a common belief in its value – as well as by the law and the Federal Reserve.
The Federal Reserve was established to bring stability to the financial system, which suffered from banking panics and failures. These were the times of the financial “Wild West” when confidence was the scarcest commodity of all. The Fed became the issuer and the supporter of a single national currency and the lender of last resort. With it came deposit insurance and comprehensive regulation, which allowed the public to trust the institutions holding their capital.
Cryptos were made to be like dollars but better – without the oppressive control of the governments. They were based on a notion that “every person is their own bank,” beyond the reach of the central authorities. However, if anyone can make a token in a stroke of a key without backing it up with any real asset or trusted authority, how do you convince people it’s worth the price you’ve attached to it? As that question is still unanswered, it looks like, at least for now, cryptocurrencies failed as an alternative to central bank money.
Regulation is Coming
So maybe effective regulation will solve the trust issues like it did for the U.S. dollar? Perhaps, but that would eliminate most of the efficiency and anonymity that drive cryptocurrencies’ appeal. However, regulation and oversight are certainly coming to the industry after the FTX debacle, whether the crypto bugs (perpetual crypto bulls, similar to “gold bugs”) want it or not.
Certainly, the regulation will apply to crypto exchanges and brokerages, not to the tokens themselves, as they are built to be virtually uncontrollable (leaving aside the issue of controllable mining businesses). For crypto bugs, the exchanges represent a sellout of the pure idea of freedom money. However, without the exchanges, cryptos would still be shadow means of payments used only by criminals and a small number of geeks. The emergence of exchanges was a major factor fueling cryptocurrencies’ price growth as they opened the crypto world to millions of average Joes who have no idea what blockchain is.
Regulation and oversight might be positive for the survivors of the crypto purge, as it could restore confidence and even lead to higher investor interest and an increase in the prices of tokens. Ultimately, it would turn cryptos into another OTC asset, like equities, but with a bit more digital style and higher risk. The industry may have little choice if it wants to survive.
On the other hand, Vitalik Buterin – the inventor of Ethereum (ETH-USD) – said recently that to avoid the corruption of anything centralized, the crypto world should abandon exchanges altogether, returning to its initial decentralized state, even if it means much less efficiency and much lower prices. However, most digital currency investors do it for profit, not for the idea, so the return to the pure roots seems unlikely.
One way or another, the crypto space will not be the same in a post-FTX world, but cryptocurrencies will probably survive.
