December 2, 2022
In the aftermath of the collapse of FTX, its sister hedge fund Alameda Research, and its hundreds of associated companies, much of the media discussion of the events has focused on the fraud that CEO Sam Bankman-Fried (SBF) may have committed by taking the money from depositors in FTX and using them to cover losses made by Alameda. This is a clear violation of FTX’s own terms of service  and seems likely to lead to many of FTX/Alameda’s senior officers facing considerable criminal liability, not to mention potential issues of wire fraud to be brought by US law enforcement. SBF can thus join a pantheon of fraudsters and con artists in North American history, standing alongside figures such as Elizabeth Holmes, Bernie Madoff, Gregor MacGregor, and John Law . While this is all good fodder for public amusement, and wry discussions about who should play SBF in the inevitable television series, it is important not to lose sight of the more systemic reasons why FTX/Alameda failed.
The proximate cause of the companies’ failure was not the criminality at play. It was in fact a report in CoinDesk (one of the crypto industry’s many trade publications, but one which does seem to take its journalistic duties relatively seriously) which purported to reveal a balance sheet that FTX had been sending around to potential investors as part of a capital raise. Much of the supposed balance sheet is not written using generally accepted accounting language, itself a troubling sign. But, more worryingly, the balance sheet revealed that the majority of Alameda’s assets were either illiquid positions in venture capital investments (mostly themselves crypto based) of dubious value, or a number of crypto tokens, most notably FTT and SRM. FTT is issued by FTX, and SRM is issued by Solana Labs, a company with which FTX had significant financial and personal ties.
Basing a company’s net worth on the assets it makes is not unusual in business – for example, Ford can add its unsold cars on its balance sheet as assets – but the nature of the crypto business swiftly reveals the precarity of both FTX specifically and crypto more generally. The real world equivalent of what FTX did is not Ford’s unsold cars but something akin to declaring that your apartment is now made up of 1 billion tokens, and you then give one token to a friend in return for $1. With each token now ‘worth’ $1, you can then notionally declare that you are ‘worth’ $1 billion because of your holding of 999,999,999 of those tokens (and the $1). Of course, that valuation is only worth the screen it’s typed on if the token you have in circulation either holds its value (or, indeed, increases). As with most things in the crypto world, everything will be alright as long as the lines continue to go up. But if your friend tries to sell their token but the buyer will only buy for 50 cents, your net worth will have halved. The problem becomes more serious when you try and actually put your vast net worth to use by transferring some of your tokens into US$. The sudden glut of your tokens on the market outpaces demand, driving down prices and your notional net worth with it. Crypto holdings are, therefore, a highly illiquid form of net worth. This, by itself, is a direct refutation of the promise that crypto will one day replace fiat: crypto holdings are still only valuable to the extent that they can be converted into fiat.
In only a slightly more rarefied sense, this is what happened to FTX. On November 6, Changpeng Zhao (CZ), the CEO of rival crypto exchange Binance, announced that his companies would sell off their holdings of FTT. Predictably, this caused widespread doubts about the value of FTT and numerous holders proceeded to sell their holdings of the token as quickly as possible. This led to the price of Alameda’s holdings of FTT (which amounted to an eye-watering 180% of all FTT ever issued) to collapse, leaving the hedge fund with a mere $900 million of assets to cover a total of $9 billion in liabilities. At the same time, users of FTX were trying to trade their crypto holdings for US$, US$ that the exchange did not have on hand. SBF thus found himself both illiquid and insolvent.
Nothing that has happened in the above paragraph was illegal. Such runs can, and have, happened in the past with respect to ‘real’ banks, until government interventions such as the development of federal deposit insurance helped to end that risk. But the risk of such a run is exacerbated in the crypto world by the volatility of the tokens used, and the lack of any kind of state protection.
There are a number of lessons to be learned from this, and they go beyond simply noting that SBF was a bad actor. Perhaps most critically for the industry, it is another demonstration that cryptocurrency valuations are based on nothing but smoke and mirrors. Some tokens may have more stable values over the long term (so-called ‘stablecoins’, which track the value of, usually, the US$) but there is no underlying asset value. In all cases, value is maintained by the efforts of issuers and/or current holders to make new buyers believe that the value is what they say it is.
Cynics will, no doubt, observe that much the same thing could be said about many fiat currencies. This is completely true, modern history is littered with collapsed currencies, such as the Argentine peso, the German papiermark and the Russian ruble. Even the comparatively mild issues suffered by the United Kingdom recently demonstrate the vulnerability of even relatively large economies to a run on their currencies. However, the dollar’s status as the largest reserve currency in the world means that there is a near limitless market for the currency. In short, if I am an Indian bank with dollar reserves, I know that I will be able to sell my dollar holdings in return for rupees or simply use the dollars directly to finance spending or lending. That, simply, is not the case with any cryptocurrency.
Crypto issuers have been able to take advantage of public interest in the sector to raise enormous sums of money. Unlike with securities, they have no reciprocal agreement between the issuer and the buyer. (Some coins may provide for this, but most do not.) This has enabled a bunch of insurgents to raise billions of dollars of capital, promising the world based on their capacity to provide poorly-defined “innovation.” In a now-famous episode of Bloomberg’s ‘Odd Lots’ podcast , SBF agreed that there was a “depressing amount of truth” in host Matt Levine’s comment that FTX sounded like a ponzi scheme . Now interpreted as something of an early ‘gotcha’ moment, at the time SBF’s admission was not interpreted as a blunder. Rather, it was seen as good news. The crypto industry is awash with wide-eyed true believers whose lyrical invocations of extreme libertarianism and financial disintermediation actually serve to put off traditional financiers – in much the same way that no-one wants to be stuck next to their conspiracy theory-obsessed uncle at Thanksgiving dinner. Instead, SBF was signaling to his hoped-for allies in the media and Wall Street that he was, like them, in on the joke in some way. He knew that this whole industry wasn’t going to replace fiat money; he knew that it was just airy financial engineering. But he was also asserting that, through that cynicism, he had discovered a way to ride the tiger of the crypto industry successfully.
He had not. Like everyone else in his industry, SBF was traveling on nothing but hot air.
FTX, and the figure of SBF more particularly, had been a major player in the industry’s ongoing move to make itself more well-known and more reputable to the general public. This has not only included large partnerships with people like Tom Brady, buying the naming rights to the Miami Heat’s home stadium, and shooting glossy Super Bowl commercials with Larry David, but also large donations to a range of politicians. Most of these were Democrats but the targets of his donations included prominent Republicans, including senators John Hoeven and John Boozman. SBF’s investment in Boozman’s career was rewarded when the Arkansas senator introduced a crypto regulation bill in the last Congressional session which would have largely exempted the industry from regulation.
However, his downfall is illustrative of his failure in this arena. When SBF was desperately trying to raise cash in the first two weeks of November, he found that institutional investors would not touch him. In the end, he turned to his former enemy CZ for a bailout. Notwithstanding that this proposed bailout collapsed within hours, this move is revealing of the fact that most people outside crypto will not touch crypto. The same is true for the investments: crypto investors invest in other crypto businesses. This is one reason why it is proving so hard to say what, exactly, happened to all the money Alameda took from FTX’s customers’ wallets: in all probability it was other crypto projects, most of which will have probably gone bankrupt too.
In the world of contemporary financial engineering, it is often forgotten that the role of finance is to provide capital to productive businesses. Our current world of derivatives, hedge funds, and private equity is merely epiphenomena built on top of this basic fact. Even the subprime fiasco of 2008 had, at its core, money loaned to individuals to buy houses. But the entire crypto industry is just a superstructure built on nothing – an alternative financial universe in which nothing is actually being financed.
This aspect of crypto – the superstructure without the structure – is one which will have to be borne in mind as the political tide seems to have turned in favor of a regulatory crackdown. In particular, much of the mainstream media has coalesced around the narrative that Gary Gensler, chair of the Securities Exchange Commission (SEC), has been proven right in his hawkish attitude towards the industry and that regulation of it should now be handed over to his agency . This view, that there should be some form of regulation for the industry, is now being embraced by some of the more crypto-credulous press as well, presumably as a perceived lifeboat for their embattled industry .
Although a rational response to the recent fiascos, encouraging finance regulators to try and apply their rules to crypto is wrong-headed. What kind of securities prospectus could be written for the issuance of a crypto token? What kind of rules could have possibly ensured that the value of FTT wouldn’t have gone down if Alameda had tried to liquidate all their holdings of the token? It’s hard to imagine answers to those questions which don’t just require something like FTX/Alameda to register as a bank. This may not be a bad thing, all things considered, but it would rather ruin what it was that made FTX unique in the first place.
Crypto sits poorly when compared to other forms of financial product precisely because of this lack of structure and the quantum of pure chance that is required to successfully ‘invest’. Much of the thrill of investing in crypto derives not from any serious attempt to engage in high finance but to take the risk of losing everything for the potential reward of getting rich quickly. Regulation of financial services is important because financial services can (in theory) fund important societal goods and it is appropriate for risk to be minimized so those societal goods can be funded. But in cryptocurrency, the risk is the whole point. In this sense, it is not unlike gambling.
Despite its varied promises, the crypto industry has failed to either become a viable replacement for fiat, or integrate itself into the existing financial system. It has instead created a series of digital tokens which are highly volatile speculative products with no fundamental value attached, while the wider industry is a complicated superstructure which looks a lot like traditional high finance but is, in truth, home to little more than financial engineering, at best, or ponzi schemes and criminal money laundering, at worst. SBF’s promise to the world was that he represented something ‘more’ to come from the industry, and his downfall represents the hollowness of that promise. If the industry is to be regulated – which seems both likely and just – then we shouldn’t give it the respectability of being regulated like other financial instruments. Instead, regulation closer to that currently seen for gambling is more in order.
: In what would, no doubt, also be a fascinating dinner party guest list.
: It is one of the more brutal demonstrations of America’s racial history that this kind of con is named after the poor immigrant Charles Ponzi and not the Gilded Age titans of industry such as Jay Gould and Thomas Durant, who made use of much the same sort of schemes.