When on Monday FTX CEO Sam Bankman-Fried (hereafter referred to as SBF) took to Twitter to reassure depositors that the third-largest cryptocurrency firm’s liquidity was fine, one could be forgiven for hearing echoes of Bear and Lehman’s c-suiters talking to CNBC to reassure their respective sources of funding, their short-term lenders, that their liquidity was also fine, when in fact their own firms were in their death throes. That sense of foreboding was temporarily eased when on Wednesday it was announced that Binance, the market’s largest crypto firm, would rescue FTX by absorbing it in a takeover reminiscent of the one that saw J.P. Morgan gobble up the smaller Bear Stearns during the onset of the Great Financial Crisis.
However, after just a few hours of Binance’s due diligence team looking over its rival’s books it was announced Thursday that the deal was off. As a CoinDesk report the week prior had noted uneasily, FTX had put much of its depositors’ money into “hard to sell” positions. These included large equity stakes taken over the summer in troubled crypto-players BlockFi and Voyager, as well as large loans to one of SBF’s other business ventures, the Hong Kong based crypto trading firm Alameda. Facing a $4 billion dollar shortfall, the firm announced Friday FTX and all its related companies were filing for bankruptcy.
It marks the largest collapse of a crypto player to date and sparked a sell off in crypto markets already badly beaten down by rising interest rates.
The irony that it was Binance that had first dangled salvation before taking it away was not lost on informed observers of the crypto space. Following a series of public spats over SBF’s perceived friendliness toward financial regulators having gone too far, Binance’s announcement that it would begin closing its large position in FTX helped spark the run that eventually killed the firm.
The problem, apart from Binance’s impending withdrawal, was the signal it sent to the market. Selling its FTT holdings, the digital token underlying the FTX network, worth billions of dollars at the time, would tank the price. If you know a whale is selling, it’s best to be out first, and that logic prompted huge withdrawals. For its part, meeting these calls for customer cash became increasingly difficult for FTX. Even if it had been able to access the FTT it had lent to Alameda, which was being used as collateral to trading counterparties, selling it for cash at distressed prices would have likely blown up both firms. On the one hand, selling so much FTT would have tanked the price, putting FTX in dire financial straits; while on the other, the fall in the asset’s value would have triggered a cascade of margin calls on Alameda’s outstanding positions.
Just like Bear and Lehman, whose houses of mortgage-backed collateral collapsed when a sudden panic over their quality meant the positions were effectively unsaleable and would not be taken as collateral, FTX and its related companies had no assets they could sell quickly to raise cash and no collateral any counterparty wanted to take.
From being worth billions to being bankrupt in less than a week, given the similarities between the implosion of FTX and the financial crises faced by other firms in the past, several recurring lessons seem worth pointing out:
First, hold a diverse balance sheet. Much of the panic that results in the variations between asset classes going to one is caused by firms realizing the instability large un-diversified counterparties pose to the system. From Long Term Capital Management’s short equity volatility position to the investment banks that bet it all on their subprime securitization businesses, a lack of high-grade liquid assets will always leave a firm on knife’s edge.
Second, when credit conditions begin to tighten firms need to either deleverage or else carefully manage their liquidity. Neither of those things happened.
Third, when depositing money at an institution, one is in effect making a loan. The interest rate, therefore, should be seen as an indicator of the level of risk a depositor is taking on. In the case of crypto lenders, operating without the Federal Reserve’s safety net, the interest rate offered to attract lenders is generally several times higher than one could get at a legacy deposit taking institution. The reason, as just evidenced, is that these firms are paying buyers for taking on the risk of a complete loss of capital.
Fourth, beware obvious conflicts of interest. Just as it should have been a red flag that the ratings agencies were being paid by the banks for their ratings and had to compete with one another to retain the lucrative business of the big banks, SBF’s role as unencumbered head of both FTX and Alameda deserved much more scrutiny than it got.
Finally, it isn’t just “dumb” retail investors that are on the hook for huge losses. Several large institutional investors face a combined billion dollars in potential write downs. Such “smart” money made all the classic mistakes that have seen banks from UBS and Credit Suisse to Merrill Lynch get themselves into loads of trouble before. Related hedge funds or special investment vehicles that could potentially expose a lender to losses need to be carefully supervised, and by at least two different people.
Taken in by a story told by a charismatic young entrepreneur, these investors all chased yield at their peril, whether they knew it or not.
One can only hope the inevitable calls for more regulation of the crypto space and an expansion of the powers of the Consumer Protection Bureau will be deterred by cooler heads, who recognize there was nothing so special in the death of FTX at all.
