The Crypto Financial Crisis

And Why It Basically Hasn't Mattered

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A commercial bank has two primary functions—to manage consumer deposits and to create credit. The first function is at its core just the simple management and accounting stuff—getting cash from ATMs, managing payments, settling cash transfers, and the like. The second function is the more macroeconomically interesting—you lend to businesses and individuals, in the process creating bank deposits, and profit from a combination of risk and interest margins.

You can imagine (and many people already have) a system where these two functions are separated. Companies and/or public sector entities manage bank deposits as functionally equivalent to digital cash, and a completely separate set of companies and/or public sector entities do the job of borrowing money at risk-free interest rates and lending to companies and individuals at risk-adjuted rates. This way you avoid the risk of a bank run that simultaneously wipes out a large number of consumer deposits and creates a credit crunch that wrecks the real economy.

In practice, the vast majority of bank deposits are fully insured by the US government and therefore functionally equivalent to digital cash. Financial institutions that facilitate credit creation without taking bank deposits also already exist—in fact, they basically compose large chunks of the massive shadow-banking system, but these institutions remain vulnerable to “runs” and can still pose systemic risks to the global economy.

However, the idea of a financial system built of the wedding between digital cash and non-bank financial intermediaries is appealing to many people—and forms the basis for much of the modern cryptocurrency ecosystem. You own digital coins in a digital wallet, those coins represent a series of financial assets (usually cash, equity, bonds, or some Frankenstein’s monster of the three), and you use those coins to interact with centralized or decentralized financial institutions to borrow, lend, exchange, and so on.

Right now, cryptocurrencies are in a massive bear market. Bitcoin and Ether, the two largest coins, are both down 70% or more over the last year—but the bigger deal is the collapse of several billion-dollar crypto credit institutions, lending protocols, and yield projects. The entire crypto ecosystem is currently experiencing the worst financial crisis in its short history, with a series of token, bank, hedge fund, and exchange bankruptcies culminating with the recent collapse of the industry’s second-largest exchange FTX just this week.

The massive crypto financial crisis, however, has not had any big effects on the broader macroeconomy. The crypto credit ecosystem remains so isolated that the vast majority of crypto institutions just use crypto loans for crypto assets and crypto investments—there is so little real credit and investment generated by the crypto economy that the crypto financial crisis functionally hasn’t mattered outside crypto.

Goodbye JPeg Morgan

Sam Bankman-Fried has been crypto’s savior throughout most of this year. As the billionaire head of a massive exchange FTX and associated market-maker Alameda Research, he was the man in crypto who had capital, patience, and balance sheet capacity when nobody else did. When algorithmic “stablecoin” UST—a coin designed to hold its value at $1 based on pseudo-arbitrage systems and community faith in the Terra ecosystem it inhabited—collapsed and broke the associated LUNA token, massive crypto hedge fund Three Arrows Capital collapsed, and through contagion helped cause the downfall of crypto banks Voyager, Celsius, and BlockFi. Sam Bankman-Fried helped bail out Voyager and BlockFi while considering relief for Celsius—and comparisons to the ruthless acquisitions, centralized control, and authoritarian enforcement of financial stability from American banker JP Morgan led to SBF gaining the title “JPeg Morgan”.

Now it is SBF who needs a bailout—though details are scant and the story is shifting quickly, it looks as though lots of Alameda’s assets were FTT tokens (a very illiquid coin that represented a sort of stock in FTX), Alameda had borrowed against FTT heavily, and a lot of FTX’s assets were loaned to Alameda. CoinDesk got a hold of Alameda’s balance sheet and spots the large amount of FTT, rumors started floating that Alameda is illiquid/insolvent, the CEO of Binance (the world’s largest crypto exchange) says they’re selling all their FTT based on the news, suddenly everyone starts running for the exit, and now you’ve got a classic bank run doom-loop except the bank seemingly borrowed against their own equity too. Binance swoops back in to buyout FTX for functionally nothing but backs out the next day after seeing the absolutely gaping hole in FTX’s balance sheet, and rumors start flying that the Department of Justice and SEC are involved. JPeg Morgan’s empire is gone overnight.

It’s impossible to understate how big a collapse this is within the crypto ecosystem. It’d be like if Citadel Securities went insolvent, Bank of America announced they had therefore lost hundreds of billions in loans to Citadel, a bank run toppled Bank of America, and then JP Morgan Chase said the hole was too big to be worth plugging. Anything remotely equivalent in the traditional finance ecosystem would likely be a generational disaster that threatened the entire global economy. In crypto it’s Tuesday.

At The Bottom, There is a House

At no point did any of this require any sort of like economic case, it’s just like “other people put money in the box, and so I'm going to too, and then it's more valuable.” So they're gonna put more money in, and at no point in the cycle did it seem to like, describe any sort of like economic purpose?

Joe Weisenthal, in an interview with Sam Bankman-Fried on yield farming

When the global financial system collapsed in 2008, many people were understandably confused and frustrated with the financial services industry. Why had bankers gambled so much with our money? Why had they been allowed to take these risks in the first place? And why on Earth was the government bailing them out when these gambles went south?

It was difficult to explain to voters why AIG’s credit default swaps on collateralized loan obligations posed a systemic risk to the financial system and necessitated a government bailout. Plenty of people were surprised to learn that mortgages could be securitized in the first place, believing that banks had to hold onto the mortgage themselves. But the pitch to voters was that this massive network of extremely complicated financial products was essential for enabling residential construction and basic economic functioning.

“At the bottom, there is a house—and all of this complicated financial engineering is in the interest of letting you build that house. If we don’t bail these companies out right now, the bank run and ensuing credit crunch will wreck the economy and nobody will be able to build that house. So we need to bail them out, and we’re going to make them pay, and we’re going to put rules in place to ensure that this never happens again.”

The primary point of finance is to generate information and direct credit/investment towards the productive/profitable sectors of the real economy. This is why a credit crunch is so devastating—solid, worthwhile investments and enterprises go unfunded and credit-worthy consumers are now unable to get money. AIG going under means you won’t be able to get a mortgage which means less homebuilding which means construction workers lose their jobs which means they can’t afford rent—and soon you’re headed towards Global Great Depression, population 6.5 billion, unemployment rate 34%. FTX goes under and it’s absolutely devastating to the crypto economy but barely registers on traditional markets. At the bottom, all that’s there is more crypto.

Mr. Crypto Gets Out of Washington

The last thing I will say is that if you look at what precipitated some of the 2008 financial crisis you saw a number of bilateral, bespoke, non-reported transactions happening between financial counterparties which then got repackaged and releveraged again and again and again such that no one knew how much risk was in that system until it all fell apart.

If you compare that to what happens on FTX or other major cryptocurrency venues today there’s complete transparency about the full open interest, there’s complete transparency about the positions that are held, there’s a robust, consistent risk framework applied, and we’re excited to work with the CFTC on our US licensed and regulated venue to bring a lot of this to US customers as well.

Sam Bankman-Fried, Testimony before the House Financial Services Committee, December 2021.

Crypto is still very, very small compared to the total US economy—the total crypto market cap dipped below $1 Trillion dollars in the aftermath of FTX’s collapse—so even in a situation where a large share of crypto was going toward real economic investment its collapse would have fairly limited effects. Even FTX couldn’t fully operate within the US—a segregated, much smaller, significantly less risky FTX.us was the only part legally allowed to operate, and that part is supposedly unaffected by the collapse (though as I write this they are publicly warning of possible trading halts). But Sam-Bankman Fried’s vision was for crypto to be much, much bigger—institutional investors and normal people were going to up their financial exposure to crypto, and crypto was going to become a much, much larger source of credit in the real economy.

He was instrumental in the push for more acceptance of crypto in Washington DC. He argued that the industry needed to accept more regulation to gain mass-adoption, personally donated enormous sums of money to political campaigns and think-tanks, and helped kickstart a large crypto lobbying push. He was a respectable, serious, responsible ambassador for an industry that Washington long viewed as some combination of criminal money laundering and unregulated gambling. His face was plastered over Union Station in the same way ads for Lockheed Martin fighter jets are put up outside the Pentagon metro stop—he wanted lawmakers to trust and remember him, and his fall will significantly damage crypto’s already-bad reputation.

Crypto itself likely retreats a bit away from its centralized financial intermediaries in the wake of this week—more emphasis on wallets, less emphasis on banks—and the traditional-finance world gets a bit more vindication for having little exposure to crypto assets. In any sort of mass-adoption scenario, the failure of FTX could have been a global catastrophe—and bankers, regulators, and lawmakers will likely remember FTX’s fall when thinking about crypto for the foreseeable future. Possible sources of contagion between the crypto and traditional financial systems—notably, the under-regulated centralized stablecoins like Tether that create a dollar bridge between the two systems—will likely get much more scrutiny. Right now contagion risks are low because crypto enables relatively little real-world investment—and the collapse of FTX makes it less likely it will in the future.

In the end, Sam Bankman-Fried’s dream of a cryptocurrency financial system integrated into the global economy might go down with him.