To beat the market and their rivals, investors wanted returns that were getting greater and bigger. More risk-taking and leverage were therefore necessary.
The bitcoin bubble has been burst by rapidly rising interest rates, revealing fragility, poor leadership, and even fraud in several places, most notably at the cryptocurrency exchange FTX. Additionally, FTX’s stunning fall follows other recent crypto industry disasters like Terra-Luna, Three Arrows Capital, or Voyager Digital. Even at how many people were astonished, no one should be shocked.
Ecclesiastes informs us that nothing new has ever appeared beneath the sun. Customers were warned not to “lose out” on “the next big thing”—blockchain-based currencies, financial goods, and non-fungible tokens—with advertisements at FTX’s offices in the Bahamian sun. Only the assets were new, though. The story of the cryptocurrency issue has developed over time.
Like many financial disasters, this one started with a bubble. Investor demand exceeded realistic expectations for what cryptocurrencies may do in the near future. The applications of Bitcoin, Ethereum, and others looked to be restricted to financial speculating and illicit behavior because they were impractical as a medium of exchange. However, historically low-interest rates fostered the craze for what cryptocurrency may develop into. Due diligence was put on hold since asset prices were rising so quickly. It was simpler for businesses to take on excessive leverage while money was cheap. To beat the market and their rivals, investors wanted returns that were getting greater and bigger. More risk-taking and leverage were therefore necessary.
Profits inevitably decline as bubbles pop or contract. Less favorable conditions reveal the system’s weakness, including inappropriate rules, faulty administration, and bad actors who were previously simple to conceal. In the extreme, businesses use fraud to cover up losses. When one company fails, the problem spreads to exposed businesses.
Sam Bankman-Fried, the flamboyant creator of FTX who is currently in custody, sought to make cryptocurrencies more widely accepted, and major funds including Sequoia Capital and Singapore’s Temasek participated in the initiative. In Super Bowl commercials, stars like Tom Brady and Larry David pushed the conversation. Bill Clinton and Tony Blair, two former leaders of state, partied with Bankman-Fried. Investors’ primary concern as a new financial age ushered in was missing out.
However, the joy enveloped a house of cards. The Terra-Luna “stablecoin” ecosystem, a collection of digital currencies that lost its dollar peg just as the Federal Reserve started rising interest rates in early 2022, is credited with sparking the crypto crash. Three Arrows Capital, a now-defunct cryptocurrency hedge firm that had substantial exposure to Terra-Luna, caught the infection. In an effort to stop the spread of the problem, FTX bailed out companies like BlockFi and Voyager. Some individuals even likened Bankman-Fried to the illustrious JP Morgan, whose private financial intervention is renowned for putting a stop to the Panic of 1907.
While specifics are still sketchy, Alameda Research, FTX’s sibling hedge fund, ran into issues during the summer as unease spread throughout the cryptosphere. Bankman-Fried attempted to save Alameda, which was run by his former love partner, using $8 billion in client cash in contravention of FTX regulations. But FTT, the now worthless internal cryptocurrency token of FTX, was said to have been the backing for Alameda’s loans.
The dominoes had been placed. A public dispute between Bankman-Fried and Changpeng Zhao, the creator of the competing exchange Binance, signalled the beginning of the fatal push. Zhao said that Binance intended to sell $529 million worth of FTT tokens, which caused FTX users to start withdrawing money from the marketplace. Due to a severe lack of money, FTX quickly went bankrupt. Zhao backtracked on his promise that Binance would buy the struggling exchange after learning about FTX’s books. Soon after, Bankman-Fried left his position as CEO, and the company filed for bankruptcy. The cryptosphere was inundated with claims of fraud, waste, and abuse involving FTX.
Investors were taken aback by the abrupt decline. In FTX, about 40% of cryptocurrency hedge funds have put money. Many probably believed that large funders like Sequoia had performed the necessary due diligence. Instead, enthusiasm for FTX and its creator had taken the place of a rational analysis of the facts, masking a serious flaw. “Such a comprehensive breakdown of corporate controls and such a complete absence of trustworthy financial information,” according to the current FTX administrator John Ray III, who oversaw the liquidation of Enron, was “unprecedented.”
The cryptosphere’s ideal of an uncontrolled, decentralized financial system has been severely harmed by the collapse of FTX, but it doesn’t imply that technology is to blame for the anarchy. Smart contracts, among other blockchain-based digital finance tools, have the potential to enhance payment systems and increase financial inclusion. To support monetary sovereignty and financial stability, several central banks are also getting involved and developing their own digital currencies.
Regulators are now faced with a dilemma. Overreacting to the developing crypto crisis might result in uses of the technology that could be useful becoming collateral damage. Additionally, they run the potential of moral hazard as investors look to the government for help in preventing personal losses even while they may applaud the regulated framework for crypto markets. On the other side, instability may develop if regulators disregard the crypto markets (though crypto markets are still too small to pose systemic risks).
The lessons learned from the cryptocurrency meltdown are neither novel nor debatable. Organizations that function like banks have to be regulated as such or shut down. Speculative casinos need to be kept an eye out for fraud. Investors should be informed that gambling losses are not covered, and auditors and regulators should make sure the game is not manipulated. There were regulations that even James Bond’s Casino Royale, which was filmed close to FTX’s island headquarters, had to follow. It is fair to anticipate the neighbors will act similarly.
