The collapse of FTX shows how immature crypto is and how immature it's leading figures are. More troublingly though, it shows how that impacts everyone else in the crypto space.
The founder of FTX has been in the news a lot recently, and never for good reasons. While the list of articles about FTX is long and filled with horrifyingly poor corporate governance, my favourite is the rather petty article from gaming website Kotaku where it’s described how bad FTX’s founder is at popular video game League of Legends despite allegedly having played League while on a pitch meeting with Sequoia Capital, a large American venture capital firm. The reason why Kotaku ran a story about the rank Sam Bankman-Fried, FTX’s CEO, achieved in League’s ranked mode (bronze III) is that his crypto currency exchange has recently gone bankrupt.
In an admittedly quite provocatively titled blog post in May I made the case on the blog that the crypto currency sphere has a structural problem of crypto finance being overly exposed to crypto currencies. The idea I was trying to present was that by having a financial system where everyone is through a complex system of ownership and derivatives reliant on a single or small group of assets there is a great risk of contagion. Contagion is when a single financial institution having problems spreads to other financial institutions because both have ownership stakes in each other, or because both own a lot of the same asset. To explain consider this example: bank A and bank B both own a lot of share 1 so when bank A is on the verge of bankruptcy it will sell a lot of share 1 to cover its debt which lowers the price of share 1 which could in turn create problems for bank B given that bank B owns a lot of share 1. Most crypto currencies end up having a reliance on Bitcoin or Ethereum given how much the crypto finance space relies on those two crypto currencies and, as events at FTX has shown recently, any industry which is built on shaky foundations will inevitably transfer trouble from one institution to the next.
FTX for those who haven’t heard of it was a crypto currency exchange. The idea was to have a central exchange where customers could trade a variety of crypto currencies conveniently by paying a fee on each transaction to FTX. FTX had a very close relationship with a crypto hedge fund called Alameda Research which was founded and owned by FTX’s CEO Sam Bankman-Fried. Too close in fact as Alameda Research was trading with clients’ deposits in FTX despite that being against FTX’s terms of service. Why did Alameda need FTX’s clients’ crypto? As it turns out, it seems likely that it was due to the Terra/Luna debacle in May 2022. I wrote the previously mentioned blog post called ‘Crypto’s 2008?’ about the Terra/Luna collapse where I made the point that crypto is often ultimately backed by other crypto rather than conventional assets which makes the risk of the sort of contagion described above very likely should something go wrong. It appears that the Terra/Luna collapse made things difficult for Alameda Research and that the leadership at Alameda and FTX decided to try to use FTX’s clients’ funds to make up for Alameda’s losses in Terra/Luna.
Obviously breaking your own terms of service and using your clients’ capital to speculate on crypto currencies to make up for losses incurred due to speculating on cryptocurrencies is unethical, and a rather poor strategy given what landed them in a situation where they had to use FTX’s clients’ funds to speculate on crypto to make up for their losses. But it also once again highlights not only that everything in the crypto sphere is interconnected, but also that everything in the crypto sphere is underpinned by Bitcoin and Ethereum. If Ethereum or Bitcoin were ever to suffer the fate of Terra then I suspect every single crypto currency would suffer catastrophic contagion due to some “hedge fund” which doesn’t even bother trying to hedge against a fall in the value of Bitcoin or due to some exchange which issues its own token backed by Ethereum.
My point with titling the previous post “Crypto’s 2008?” wasn’t to imply that crypto was about to have a once in a lifetime downturn, it was to make the comparison between American investment banks being overly exposed to the American housing market in 2007 to how the entire crypto finance sphere is overly exposed to Bitcoin and Ethereum now. When Lehman Brothers collapsed it impacted firms which had no real stake in the mortgage derivatives which bankrupted Lehman and similarly today lots of crypto “hedge funds” and currencies have been impacted by Terra/Luna’s implosion six months ago through FTX and Alameda Research.
Despite having been around for 13 years the crypto sphere is awash with scams, fraud, terrible risk management, and laughable corporate governance. I’ve been saying for years that I think any given crypto “currency” is practically digital monopoly money, but even if I’m wrong on that point the failure of FTX shows how immature the crypto finance system is. Almost as immature as someone who thinks his ranked game of League of Legends is too important to interrupt to do an investor pitch for Sequoia when his rank is bronze III.
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I've always been interested in politics, economics, and the interplay between. The blog is a place for me to explore different ideas and concepts relating to economics or politics, be that national or international. The goal for the blog is to make you think; to provide new perspectives.
Written by Karl Johansson
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Cover photo by RODNAE Productions from Pexels, edited by Karl Johansson
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