More than one million direct creditors are estimated to suffer from FTX’s demise, but the cumulative pain from yet another crypto collapse is raising the spectre of something much more pernicious: financial contagion.
FTX is the third crypto exchange to formally file for bankruptcy protection in the past six months, following Celsius Network and Voyager Digital, and a growing number of crypto firms have either wound up or lost their relevance this year, including Three Arrows Capital, a hedge fund, and Terraform Labs.
The cumulative effect conjures nightmares from the 2008-09 global financial crisis. Because FTX is such a central player in the crypto ecosystem, the fear is that containing the fallout will be impossible. Like a forest fire that has jumped a highway, FTX’s collapse has the potential to amplify contagion across the sector.
“I see a lot of similarities between what’s happening in crypto and what was happening in traditional finance in the run-up to the 2008 crisis,” Saule Omarova, a Cornell law professor and an expert on financial derivatives who was U.S. President Joe Biden’s initial pick to run the Office of the Comptroller of the Currency, a key banking regulator, said in an interview. (She withdrew her nomination after Republicans torpedoed her chances.) “It’s the same formula.”
To be clear, what has transpired in cryptoland to date is nothing close to Lehman Brothers’ collapse in September, 2008. The investment bank’s demise was a category 5 hurricane for the global financial system because Lehman was deeply intertwined with core lenders. Crypto, meanwhile, has largely operated outside the traditional financial network so far.
But one thing has become clear watching crypto companies fall: These institutions are interconnected in ways few people realized, and the extent of their exposures to one another, usually through loans, is eerily similar to 2008. While reckless mortgage lending was the root of that crisis, what nearly tipped the banking system into freefall was an opaque web of derivatives and counterparty exposures between financial institutions, making it nearly impossible to determine who owed what to whom.
The fact that so many crypto CEOs have scoffed at the suggestion of tougher regulation amplifies the analogy, because that is exactly what transpired in the early days of derivatives in the 1990s. “This is a complete replay,” said Dennis Kelleher, a former corporate lawyer who is now CEO of Better Markets, a non-profit organization in Washington, D.C., that advocates for consumer protection.
Left to fester, derivatives spawned a shadow banking system that eventually had the force to sink the world’s most powerful banks. That may seem far-fetched for crypto right now, but without fixes, the potential for widespread financial pain one day can’t dismissed.
As stand-alone products, financial derivatives and crypto assets aren’t inherently good or bad. How they are used dictates their impact.
Early on, derivatives helped banks and the global economy because they could be used to transfer a loan’s risk off of a bank balance sheet and to a third party, perhaps an asset manager, by layering an insurance contact on top. The asset manager may not be a great risk manager, but the insurance contract ensured it would be reimbursed if the borrower defaulted. These products help get money moving through the economy because they free up bank up capital, allowing the institution to lend to someone else.
The problem is that derivatives became more exotic. Banks and hedge funds started hiring math PhDs, often with the goal of engineering more ways to transfer risk.
Derivatives could also be used for nefarious reasons. Energy company Enron Corp. famously tried to transcend its sleepy roots and become a cutting-edge trading giant in everything from natural gas to weather derivatives, but its paper profits proved to be a sham. Management hid billions of dollars in debt by transferring it to entities that were kept off the company’s balance sheet.
In 2002, the year after Enron collapsed, Warren Buffett and his partner at Berkshire Hathaway, Charlie Munger, warned investors and regulators in the duo’s annual letter to shareholders. “Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.”
Yet the popularity of these instruments only grew, because Wall Street started tying them to one of the hottest assets around: residential real estate. Banks transferred mortgages off of their balance sheets by packaging and selling the loans in tranches, and these tranches were often then split and repackaged into even more tranches, with insurance contacts layered on top of each.
Everything started falling apart when the U.S. housing market began wobbling in 2006. Technically, each derivative was unique, but they were all rooted in the same asset: houses. And because there were so many derivatives flying around, it was next to impossible to track how they all interacted.
The crypto sector is a far way off from that, but even in its infancy, such interconnectedness is already present, and it started causing problems in April when the prices of two cryptocurrencies, luna and terraUSD, plummeted in a matter of weeks.
Luna attracted a huge following early in the year because some major crypto traders had started hyping it, and the resulting demand boosted the fortunes of terraUSD, because the two assets were inextricably linked. TerraUSD is what is known as a stablecoin, used as an intermediary for transferring in and out of cryptocurrencies without having to convert into U.S. dollars.
The problem, though, was that unlike normal stablecoins that hold U.S. dollar reserves in a bank account as a backstop, TerraUSD was backed by luna and a fund of other cryptocurrencies, including bitcoin. When the prices of these cryptocurrencies dropped, the bottom fell out.
In only a few weeks, US$40-billion in value was wiped out and the collateral damage spread to Three Arrows Capital, a hedge fund linked to multiple other crypto companies. Voyager Digital, a TSX-listed crypto trading and lending platform with $2-billion worth of loans, filed for bankruptcy this summer after disclosing it lent $US655-million Three Arrows, and the money wasn’t repaid.
As well, BlockFi, which acts like a crypto bank and lends to other crypto companies, had to sell itself in order to survive after lending US$80-million to Three Arrows, while Galaxy Digital Holdings, another TSX-listed crypto company, disclosed it would lose US$300-million in a single quarter because of its bets on luna.
Galaxy’s shares have lost 89 per cent of their value over the past year, but the company is still trudging along. Voyageur and BlockFI, though, were rescued by FTX – which is problematic now that FTX itself has filed for bankruptcy protection.
When FTX rescued other companies, the consensus was it had one of the best balance sheets in the business. What’s clear now is that FTX has been in financial disarray. After founder and CEO Sam Bankman-Fried resigned at 4:30 a.m. on Nov. 11, the company installed John Ray III as its new CEO, and he has been stunned by what he’s already seen.
“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here,” he wrote in an affidavit filed in court.
This week, Mr. Bankman-Fried acknowledged in interviews that FTX quietly lent money to Alameda Research, the sister crypto trading firm he owned. FTX’s exchange token, FTT, is also garnering attention.
Crypto exchanges often create their own tokens, or coins, which they market like points for loyalty rewards programs. Clients who trade using these exchange tokens, rather than transacting with cash each time, often pay lower trading fees.
But it appears that money clients put into FTT coins wasn’t safeguarded in any way. Instead, Mr. Bankman-Fried may have lent it to plug financial holes at Alameda. It is possible this happened for a while, but no one noticed because FTT was doing well.
It was only when the price of FTT plummeted early this month that the whole operation started to shake – in the same way derivative values started to crumble when housing prices slumped before the financial crisis. None of the allegations have been proven in court.
The trauma is already ricocheting through the crypto sector. Genesis, a crypto lender with US$2.8-billion in active loans as of September, has halted investor redemptions because it has US$175-million in funds stuck on FTX. BlockFi, meanwhile, has disclosed “significant exposure” to FTX and Alameda, including loans to Alameda.
Gary Gensler, chair of the U.S. Securities and Exchange Commission, has warned about such schemes, saying in August, 2021, the crypto sector is “rife with fraud, scams and abuse.” But he hasn’t been able to do much about it because lawmakers haven’t decided how to govern crypto. In order for a regulator to have any jurisdiction, a traded asset needs to fit into a box –whether it’s a currency, a security or something else entirely.
This year’s crypto collapse will likely force lawmakers to act, because so much money has been lost and the contagion is worrisome. Last November, the total value of crypto assets globally amounted to US$3.2-trillion, according to the FT Wilshire Digital Asset Index. Today, it is US$861-billion.
Some experts hope new rules will help conventional banks enter the sector – something many banks have been desperate to do because crypto trading fees are so high. If they do, their participation could help clean up the industry.
But Ms. Omarova, the derivatives expert who nearly became chief U.S. banking regulator, isn’t so sure. “That was exactly the logic of allowing banks to get into the derivative business: They know how to manage risk.”
Derivatives regulation was signed into law in 2000 in the United States, and eight years later, Lehman Brothers went bankrupt. “There is still a danger,” she said.