Xavier Vives | Cryptos well-worn path to crisis | Company

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Rapidly rising interest rates have burst the cryptocurrency bubble, exposing fragility, poor governance, and even fraud in many corners. And the dramatic collapse of crypto exchange FTX follows other recent failures in the cryptosphere, such as Terra-Luna, Three Arrows Capital, and Voyager Digital.

No one should be surprised – not even how many people were surprised.

“There is nothing new under the sun,” Ecclesiastes reminds us. At FTX headquarters in the sunny Bahamas, the company’s publicity urged customers not to “miss” “the next big thing” – blockchain-based currencies, financial products and non-fungible tokens. But only the assets were new. The narrative of the crypto crisis was established a long time ago.

The collapse began, as financial meltdowns often do, with a bubble. Investor demand has exceeded reasonable short-term expectations of what cryptocurrencies might achieve.

Impractical as a medium of exchange, the uses of bitcoin, ethereum and the rest seemed limited to financial speculation and illegal activities. But historically low interest rates have fueled mania for what crypto could become. Due diligence has taken precedence over soaring asset prices.

Cheap money made it easier for companies to take on excessive leverage. Investors needed bigger and bigger returns to outpace the market and beat their competitors. This meant more leverage and more risk taking.

When bubbles inevitably burst or shrink, profits flounder. Less favorable circumstances reveal the fragility of the system – inappropriate regulations, bad governance and bad actors that were once easily hidden. At the extreme, companies hide their losses through fraud. When a company falls, the contagion spreads to exposed entities.

Flamboyant FTX founder Sam Bankman-Fried wanted to get into crypto, and big funds like Sequoia Capital and Singapore’s sovereign wealth fund Temasek invested in the project. Celebrities like Tom Brady and Larry David promoted the swap in Super Bowl commercials. Former heads of state like Bill Clinton and Tony Blair have coasted with Bankman-Fried. A new financial era was beginning and the only thing investors feared was missing out.

Euphoria, however, surrounded a house of cards. The crypto rout began with the collapse of the Terra-Luna “stablecoin” ecosystem, a collection of digital currencies that lost its peg to the dollar just as the United States Federal Reserve began raising interest rates. interest in early 2022.

The contagion spread to Three Arrows Capital, a now-defunct crypto hedge fund that had extensive exposure to Terra-Luna. FTX tried to stop the contagion by bailing out companies like Voyager and BlockFi. Some have even compared Bankman-Fried to the legendary JP Morgan, whose private financial intervention successfully curbed the Panic of 1907.

While the details are still hazy, FTX’s sister hedge fund, Alameda Research, ran into trouble over the summer as uncertainty swept through the cryptosphere. In violation of FTX rules, Bankman-Fried used US$8 billion in client funds to try to save Alameda, run by his former romantic partner. Alameda’s loans, however, were reportedly backed by FTT, FTX’s now worthless internal crypto token.

The dominoes were placed. The fateful boost began with a public feud between Bankman-Fried and Changpeng Zhao, founder of rival exchange Binance. Zhao said Binance plans to sell US$529 million in FTT tokens, prompting FTX customers to start withdrawing funds from the platform. FTX faced a massive liquidity crunch and quickly became insolvent.

After saying Binance would buy the crippled exchange, Zhao reneged when he saw FTX’s books. Bankman-Fried resigned as CEO soon after, and the company went bankrupt. Allegations of FTX fraud, waste, and abuse have flooded the cryptosphere.

Investors were caught off guard by the sudden collapse. Nearly 40% of crypto hedge funds had invested in FTX. Many had probably assumed that big funds like Sequoia had done their due diligence. Instead, the excitement over FTX and its founder had substituted for a good assessment of fundamentals, covering a deep rot.

Current FTX director John Ray III, who oversaw Enron’s liquidation, said “such a complete failure of corporate controls and such a complete absence of reliable financial information” was “unprecedented.” “.

The FTX implosion has severely damaged the cryptosphere’s vision of a decentralized and unregulated financial system, but that doesn’t mean technology is to blame for the chaos. Other forms of digital finance and blockchain technology – like smart contracts – can further improve payment systems and expand financial inclusion. Many central banks are also getting into the game and launching their own digital currencies to bolster monetary sovereignty and financial stability.

Regulators face a conundrum. Overreacting to the ongoing crypto crisis could turn potentially beneficial applications of the technology into collateral damage. And while they may welcome crypto markets into the regulatory fold, they risk moral hazard as investors seek public protection from private loss.

On the other hand, if regulators ignore crypto markets, instability could grow – although crypto markets are still too small to pose systemic risks.

The lessons of the crypto crash are neither new nor controversial. Entities that operate like banks should be regulated as such or closed. Speculative casinos should be monitored for any signs of fraud. Auditors and regulators must ensure that gambling is not rigged, and investors must be warned that gambling losses are not insured.

Even James Bond’s Casino Royale, which was filmed near FTX’s island headquarters, had to follow certain rules. It is reasonable to expect neighbors to do the same.

Xavier Vives is a professor of economics and finance at IESE Business School.

© Syndicate Project 2022

www.project-syndicate.org

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