Memo: Stockholm FTX Banco

This past weekend in Sao Paulo, the Grand Prix’s top drivers had a sudden change of plan. George Russell and Lewis Hamilton’s Formula One racers were without FTX branding, within hours of the bank run on Samuel Bankman-Fried’s cornerstone of the cryptocurrency exchange industry. Mercedes AMG reacted in kind.

The Bitcoin currency has seen a 77% decline from its trading peak in November 2021. The dot com bubble was a 76% decline from its peak in March 2000, according to a study administered by Bank of America. The only two steeper declines on record were the 83% decline in the stocks of US homebuilders between 2005-2008 and the preceding months of the Great Depression. A recent report by Fortune explains:

The economic events of 100 years ago also share similarities with today. Following the first world war, the U.S. government was spending more than it was earning back in tax revenue, and high inflation ensued. American industrial power, though, created a flood of jobs as the country emerged as a major international player.

According to an NBC poll in May 2022, one in five Americans have invested in cryptocurrency. Nearly half of men between the ages of 18 and 49 have traded cryptocurrencies and around 40% of African Americans polled as traders of the digital currencies. These are staggering figures that may help to explain why the failure of the second largest crypto exchange has shaken many users and enthusiasts. But there was a striking paragraph just a few beneath this demographic rundown:

But without a major legislative effort, the crypto market still looks like the “Wild West,” according to Securities and Exchange Commission Chair Gary Gensler. That may be why only 19% of those polled by NBC News said they view crypto positively and 25% indicated they view it in a negative light.

A quarter of those polled indicated a negative view of “crypto.” This report, just six months removed, will be remembered as one of the many prescient ones. In a number of ways, the “crypto collapse” mirrors the first of many bank runs: the Stockholms Banco run of 1660. Within three years of the bank’s founding, the first to ever issue banknotes, its illiquidity issue became the first of many examples throughout history. A greater irony is that just 1,213 kilometers away from the Stockholms Banco, the first speculative bubble in history came and went: Tulipomania. Both events occurred within 25 years.

Written just 30 days prior to the bank run on FTX, a found essay by Bank Underground highlights the fact of the matter. That there remains a number of old problems for the new assets:

New assets don’t always mean new problems or new solutions. Ironically, despite being promoted as alternatives to traditional finance, the crypto ecosystem faces many of the same problems. Some challenges relate to the underlying currencies – ideally you want a currency with stable value whose quantity can be changed to supply liquidity. But unbacked cryptocurrencies like bitcoin or ethereum which are the cornerstones of the system have the opposite properties: unstable value and a quantity that can’t be easily changed.

FTX has contrasts and similarities to the forefathers of modern banking. Due to the SEC’s mismanagement of regulatory clarity, it was not uncommon for exchanges to move offshore (FTX is currently based in the Bahamas). Aaron Klein, a senior fellow in economic studies at the Brookings Institution:

The US regulatory system is not well-designed to handle crypto. But part of the appeal of crypto was that it’s not well-regulated and that it disrupts the existing financial system.

The implosion of FTX means a financial reckoning is certain; there are lessons to gather from the past. Risks can come with reward, but to ignore history in pursuit of high-stakes gambling is historically ill-fated. Web3 and crypto have largely been distractions from the real-world infrastructure that is worth the same investment.

The fallout has been swift. Many FTX holders are still in the lurch, unsure if they’ll regain any of their investments following the company’s bankruptcy filing and the stepping down of CEO Sam Bankman-Fried, once considered a genius entrepreneur, unchecked by the common oversights typical of companies that size. Bankman-Fried was once worth $24 billion. In the course of the week, his former company began bankruptcy consideration and awaited potential investigation by the US Department of Justice. FTX’s undoing has been explained thoroughly elsewhere but here is the debrief. Last week, competitor Binance’s CEO Changpeng Zhao announced that his company was withdrawing its FTT holdings from FTX based on the belief that the company may not be stable. The bank run ensued as spooked customers rushed to cash out. FTX didn’t have the funds for the payouts – about $8 billion were owed. Binance nearly stepped in to buy FTX and bail it out, but further review of the company and its business practices led to it pulling out of the deal.

People who had money tied up in FTX’s exchange, or held its coin FTT, are now at risk of losing their investments and savings. WIRED magazine detailed the crises that people are now facing, including a person whose $25,000 nest egg may never be reimbursed and one who was locked out of their account for 24 hours, unable to cash out funds before it was too late. Why the black hole in the balance sheet? FTX shifted customer deposits around into external investment vehicles – against the terms of services of the FTX platform. From WIRED:

Aaron Kaplan, a securities attorney and co-CEO of trading platform Prometheum, says that although the final outcome for FTX and its customers is not yet crystal clear, there is precedent in scenarios such as this for people never to recover their funds. Unfortunately, those caught up in the collapse are left with little in the way of legal recourse, says Kaplan. “The facts will come out in time. What is clear at this present moment is that FTX was taking advantage of a gray area at the heart of which was the expectation of profit, irrespective of the best interest of customers.”

The founder and CEO of Binance (FTX’s chief competitor), Zhao recently tweeted a reflection meant to serve as, both, a rebuke and an assurance.

Two big lessons:

1: Never use a token you created as collateral.

2: Don’t borrow if you run a crypto business. Don’t use capital “efficiently”. Have a large reserve.

FTX’s ripple effect means that the entire crypto community is being viewed through a skeptical lens. Bankman-Fried’s firm had links to multiple crypto exchanges, including BlockFi, which had been bailed out by FTX earlier this year. Also, Solana sold 50 million units of its currency to FTX.

Many have been wiped out and the way forward is unknown. Crypto is largely unregulated, and investments were essentially bids on digital-first infrastructure and the idea that it could replace more traditional (and to some archaic) ways of building and transferring wealth. At the same time, the parallels between this crypto crash and the 2008 crash are strikingly similar. Bank Underground drew the points clearly:

But crypto lenders such as Celsius allowed collateral to be rehypothecated – ie the lender could then use the collateral itself and re-pledge that asset to another lender. The collateral then gets passed along with multiple claims on it. If any party in the chain gets into trouble, there can be a domino effect. Rehypothecation by shadow banks and others was identified as a problem after the 2008 crisis by Singh and Aitken and others.

Other key tentpoles of Web3 and the crypto space have broken down. Meta’s bet on the metaverse is not materializing. Layoffs are expected to continue across the entirety of the tech sector. And it’s hard to overemphasize how much money and trust has already been lost. Consumer trust in crypto has been fractured since the products’ year-long collapse sustained and this will only make it far worse.

If it wasn’t for the 2008 economic crash, it’s like that Bernard Madoff’s ponzi scheme would have survived much longer. If it wasn’t for the 2022 crypto crash, FTX would be in good standing. Has crypto been a distraction, all along? Existing infrastructure, real world problems, and improvements are all in need of investment, sweat equity, and proper management. Web3 will be there waiting when we’re ready for it. But for now, we’re not – and there’s historical precedent that suggests that stability is far more valuable the speculation.

By Web Smith | Edited by Hilary Milnes with art by Alex Remy and Christina Williams

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