Just when it seemed that cryptoland could not get any crazier — it has. Last week, Sam Bankman-Fried, the 30-year old wunderkind, oversaw an empire worth more than $32bn, composed of the FTX crypto brokerage and Alameda fund. He was a sports sponsor, philanthropist and backed by mainstream financiers such as BlackRock. Indeed, when I recently met “SBF” (as he is known) at a conference, he was thronged by Wall Street and Washington players.
No longer. This week SBF revealed that FTX has seen $6bn in customer withdrawals, and tried (and failed) to sell itself to his arch-rival Binance, the biggest crypto exchange. Unless he can plug a reported $8bn liquidity hole, bankruptcy looms.
This is the crypto version of the 2008 Lehman Brothers shock. Not because it could cause the implosion of mainstream finance; the entire crypto universe is a mere $1tn in size today (a third of last year) and its tokens mostly operate like chips in a casino (ie they can only be used there). But what the FTX saga has done is unleash crypto contagion, further deflating a bubble previously pumped up by cheap fiat currency.
Indeed, the sector is a key example of how investor risk appetite has been hurt by central bank tightening (which, as I have noted before, is ironic given that crypto was billed as a hedge against central bank excess). And just as the Lehman collapse sparked a subprime rethink, FTX will cause a re-evaluation of crypto. Recriminations loom.
So does this mean that crypto will now die? Not necessarily. But in the short term, many mainstream investors and institutions will probably run away, unless there is sweeping regulatory reform. For the FTX implosion has revealed that the sector has at least two big Achilles heels.
One is that it is fiendishly difficult to know what assets underpin digital tokens (other than blind faith), since balance sheets are often opaque. FTX and Alameda used to be considered well capitalised. But last week a report suggested that their balance sheets were padded by massive holdings of a digital token called FTT, which none other than FTX itself had issued.
FTX has not confirmed this. But what is clear is that Binance’s head Changpeng “CZ” Zhao subsequently tweeted out plans to dump his holdings of FTT, causing the token’s price to collapse — and sparking a downward spiral for SBF. Opacity is costly.
The second issue is custody, where practices have long been a dangerous mess (as I also recently warned). The SBF empire was simultaneously a broker, proprietary trader, lender and custodian for the crypto world, reportedly rehypothecating assets on a large scale. This created concentrations of power (which, in another irony, make a mockery of crypto’s decentralised mantra). It also means customers may not recoup their funds. Hence the panic, given the lack of any investor safety net — or lender of last resort — in crypto land.
In theory, these problems could be fixed if crypto were forced to adopt the same regulatory tenets around custody and transparency as fuddy-duddy fiat-based finance. If so, mainstream investors might stay involved. bipartisan congressional bills are already floating that try to do just that. But these have not been implemented yet, amid political gridlock. And, in practice, crypto players’ attitudes towards regulation is — at best — mixed.
Take Binance. This week CZ announced a flurry of transparency initiatives, and criticised FTX for using its own token as collateral and lending without proper reserves. But Binance mostly operates offshore, and CZ says he dumped FTT tokens because “we won’t support people who lobby against other industry players” — presumably with regulators. Welcome to another crazy plot twist that will (rightly) scare institutional investors.
Yet it would be a mistake to assume that this means all crypto is dead. One reason is that there is still a large pool of players who use digital assets to evade government controls — whether due to libertarian ideologies, or to engage in nefarious activities, or to move money out of jurisdictions such as China.
The FTX implosion is unlikely to change this; after all tether remains the biggest stablecoin today, even though US regulators have repeatedly censured it for misleading balance sheet statements.
Second, even as private sector crypto assets shrivel in value, governments are copying some of the underlying technologies themselves. Most notably, central bank digital currency, or CBDC, experiments are heating up, not least because, as I was told last month, the government of China (and, to a lesser extent, Europe) want CBDCs to displace private digital assets.
The retail version of CBDCs seems unlikely to fly any time soon. But many European and Asian central bankers think wholesale CBDCs could be useful. And while the Federal Reserve is less enthusiastic, Jerome Powell, its chair, recently suggested he could accept private-sector dollar stablecoins if (and only if) they were Fed-regulated.
Thus the crypto future could be bifurcated: one sphere of shady, offshore activity and another of sober, tightly controlled central bank experiments. This is certainly not what the libertarians who first launched the crypto dream ever expected. But it seems the most likely bet — unless there is badly needed regulatory reform. Either way, prepare for more twists.