FTX is concurrently the largest scam and the culmination of the largest banking crisis within the history of the crypto industry. But the FTX debacle has little or no to do with crypto itself: it’s just one other episode within the long history of such disasters in global finance.
Despite extensive regulation and central bank activity, traditional finance is riddled with shocks, panics, bank runs and other disasters, of which FTX is just the most recent episode. But unlike traditional finance, crypto offers a path to a more robust economic system. If crypto is to realize this, the principles of decentralization, immutability and verifiability should be adopted by more centralized institutions.
Financial crises are symptoms of the opaque fractional reserve banking system
Fraud is as old as humanity, and banking crises are as old as banking itself. However, the ubiquity of such excesses has increased as banks have evolved from depository institutions that held customer deposits on reserve to fractional reserve banks.
Fractional reserve banks only hold a small portion of customer deposits in stock. Because they’re hungry for returns, they prioritize profits over the protection of their customers and increase their balance sheets by investing customer capital in longer-term, less liquid and fewer creditworthy assets. This significantly increases the sector’s profitability, but leaves banks vulnerable to runs and bankruptcies.* As customers try and withdraw their deposits en masse, banks wouldn’t have the capital obligatory to fulfill demand.
The collapse of FTX is a results of this method. FTX CEO Sam Bankman-Fried allegedly bailed out his own trading firm Alameda Research using FTX client capital, effectively turning FTX right into a fractional reserve bank and committing typical financial fraud.
Regulation and monetary policy don’t suit crypto
Traditional finance attempts to counteract the inevitable excesses of fractional reserve banking through regulation and monetary policy. None of those are more likely to work effectively within the crypto space. Let me explain.
The FTX scandal highlights the continued regulatory arbitrage potential of cryptocurrencies. Bitcoin, Ethereum and other crypto assets are decentralized, internet-based financial technologies. They facilitate the movement of capital between different parties around the globe, no matter their jurisdiction. In more distant jurisdictions, exchanges may be easily set as much as bypass restrictions and gain market share without facing the aggressive eyes of developed market regulators. In fact, FTX took exactly this route and selected to conduct its operations within the Bahamas. Paradoxically, the stricter regulators in developed markets turn into within the wake of the FTX collapse, the greater the motivation for crypto operators to migrate to more permissive jurisdictions.
Enron, Barings Bank and Theranos all show that complex banking regulations don’t solve banking crises or fraud. In fact, FTX’s Bankman-Fried has maintained close relationships with US regulators in Congress and the SEC over the past few years. He hid in plain sight and regulators didn’t notice.
Thoughtful crypto regulations could help curb crypto intermediaries in the longer term, but history shows that regulation is just not a panacea.
Central banks actually reduce the chance of bank runs in traditional financial markets. A central bank’s status as lender of last resort reduces the motivation to flee insolvent institutions. But with cryptocurrencies, monetary policy is each undesirable and never particularly applicable.
Effective monetary policy requires elasticity of supply. The Federal Reserve can manipulate the US money supply, but nobody can easily print Bitcoin.** An inelastic supply of primary assets represents a significant constraint on any lender of last resort. Furthermore, recent events show why central bank bailouts are each damaging in addition to undesirable.
FTX itself effectively acted as a lender of last resort within the crypto space in May and June: it bailed out troubled centralized lenders BlockFi and Voyager, in addition to its trading arm Alameda. But these measures only obscured the underlying risk of those institutions and led to a bigger crisis later. Binance, the most important crypto exchange, looked like it will step in as FTX teetered on the sidelines, but correctly stayed on the sidelines.
Healthy economies reveal failures. They don’t hide them.
Poor business practices, low risk appetite, excessively indebted firms and outright fraud should be exposed and put out of business. This is how a healthy, functioning economy works. Central banks can assist obscure these challenges within the short term and delay the ultimate settlement, but in the long run this creates economic inefficiency and hurts productivity.
So what’s next for crypto?
Apply the principles of auditability and transparency to centralized finance
Like any recent technology, Bitcoin is volatile but resilient. Bitcoin and Ethereum proceed to process transactions and smart contracts, enabling financial freedom for disadvantaged people around the globe. They offer these services without the necessity for regulators and central banks.
Centralized institutions like FTX have didn’t live as much as the principles that make Bitcoin, Ethereum, and other cryptoassets useful: transparency, openness, decentralization, etc. To take this industry to the following level, crypto advocates must impose these principles on centralized financial institutions Institutions. Crypto intermediaries like FTX must not succumb to the age-old shenanigans of traditional finance.
Asset self-custody and decentralized exchanges are two great solutions as they don’t expose users to the whims of centralized custodians and their penchant for fractional reserve banking.
Proof of reserves may also make centralized institutions more transparent. Finally, centralized intermediaries will not be going away. Not everyone has the obligatory funds to completely enter the decentralized crypto universe. Traditional financial institutions have to integrate the essential principles of cryptocurrency into their operations. A straightforward on-chain proof of reserves that permits the general public to view company assets and liabilities can be a very good first step. While it will not prevent all wrongdoing, it will dramatically reduce the risks by promoting accountability, openness and transparency. Regulators wouldn’t be required to look at stock market balance sheets. Instead, crypto can automate audits through code and on-chain transparency. This information may very well be distributed in real time and available to everyone.
Crypto isn’t going anywhere
Bitcoin has fallen 78% since its peak in October 2021. It also fell by 92% in 2010 and 2011, by 85% in 2014 and 2015 and by 83% in 2018. None of those crashes affected the functionality or rapid adoption of the relevant technology. In fact, crypto has continued to evolve with each successive cycle and its adoption rate is among the many fastest of all technologies.
Bitcoin bear markets
Bitcoin market cap
While the FTX fiasco has rocked the industry, the return to basic principles will see cryptocurrencies re-emerge as a viable alternative to increasing global monetary disruption. The query is: Can the principles of decentralization, resistance to censorship, immutability, transparency and auditability be prolonged beyond protocols to centralized intermediaries around the globe?
*An earlier version of this post contained the sentence: “After all, fractional reserve banks are, by definition, insolvent.” In the interests of full accuracy, it has been removed.
** An earlier version of this text stated that Ethereum’s supply can’t be manipulated like fiat currency. However, since Ethereum’s supply is just not fixed like Bitcoins, we’ve removed the reference to Ethereum.
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Photo credit: ©Getty Images/Stas-Bejsov
