Is This Crypto’s Lehman Moment?

In the very first transactions in the bitcoin blockchain, Satoshi Nakamoto included a message, a headline from the Times of London on January 3, 2009: “Chancellor on brink of second bailout of banks.” Indeed, the financial crisis was one of the motivators of the crypto revolution. Why not design a financial system that is transparent, operates without middle people, reduces transactions costs, and promotes financial democracy? These are all noble goals, but have we come full circle? Billions of dollars of FTX customer money is locked and very likely lost.

The failures of FTX and Lehman are very different. Lehman Brothers was an investment bank that employed extreme leverage—over 30 times its capital. This leverage is equivalent to someone with a net worth of $200,000 convincing their bank to lend them $6 million for a luxury house. Lehman invested in risky mortgages such as the so-called Alt-A mortgages (which required minimal documentation). When the housing market turned down, the value of Lehman’s assets plummeted, eventually falling below the value of their liabilities. Lehman filed for bankruptcy on September 15, 2008. Many other banks were in a similar situation and most of those were bailed out with taxpayer funds.

A different mechanism

The FTX mechanism was much different. FTX was an offshore broker/exchange, once the third largest crypto exchange in the world. In traditional finance, customers trade stocks and bonds and their brokers provide custodial services. That is, the customer does not hold their stock certificates, they let a broker such as Robinhood hold them. The centralized crypto exchanges operate similarly: the exchange—not the customer—holds keys that define the cryptocurrency. The way it is supposed to work is that the exchange holds the customer’s assets one for one. That is, if I buy one bitcoin via a centralized exchange, the exchange is expected to hold one bitcoin for me. At any time, I can request the private key or keys that define my bitcoin ownership.

Details are still emerging, but it appears FTX did not follow that practice and loaned up to $10 billion in customer money to a related trading firm, Alameda. This is known as co-mingling and is not allowed in regulated exchanges. Further, it looks as if Alameda was already insolvent at the time some of the loans were made.

So, FTX was using customer funds to bail out a related entity. In regulated jurisdictions, this is straight up securities fraud, but FTX operates outside the U.S. to avoid regulatory scrutiny. ?

The Lehman mess was very different. In both situations, the prices of key assets, mortgages for Lehman and crypto currencies for FTX, were decreasing, but the Lehman saga did not involve fraud. While one can argue Lehman was guilty of a gross failure of risk management, that is far different than potentially illegally using customer capital to prop up an insolvent hedge fund.

Similar implications: bank runs and contagion

Although the mechanism causing the Lehman and FTX blow-ups is not the same, there are two important commonalities.

For both Lehman and FTX, customers fled at the first hint of trouble. As soon as the former FTX CEO tweeted “All is fine” it was evident to many the jig was up, which helped trigger the exodus. If the CEO needs to send that message to investors, it usually means the opposite. As an investor, even if you believe the chance of bankruptcy is small, best to withdraw your capital while you can. This is a classic Diamond-Dybvig bank run.

The second similarity is the possibility of contagion. In Lehman’s case, the failure sparked a fear that all other banks might be vulnerable. This instigated a flight to quality assets, driving the prices of risky assets even lower as they were dumped, which put additional strain on the banks. Eventually, all large banks were recipients of taxpayer-based rescue funds.

Crypto investors were (and are) likely thinking the same way. As crypto prices slide, margin calls could stress the system. Investors rightfully should have second thoughts about parking their capital at opaque, unregulated offshore exchanges. More shoes are likely to drop.

The decentralized alternative

What about Satoshi’s dream of a financial system created with peer-to-peer transactions in which trusting central institutions or even participants is unnecessary? Indeed, I heard from numerous people suggesting I should revise my book because FTX’s failure meant the end of decentralized finance, or DeFi.

Exchanges, such as FTX and Binance, are centralized. Investors trust them to custody their tokens. Whereas these exchanges provide a trading venue for many decentralized tokens, the exchanges are not part of DeFi. In DeFi, trust is not necessary.

Consider an example of a decentralized exchange, often called a DEX, such as the Uniswap protocol. A DEX uses an algorithm designed to allow for the trading of asset A and asset B. It is open source, owned by no one, and lives on the Ethereum blockchain. Certain individuals who already own asset A and asset B may choose to provide liquidity. Their motivation is straightforward. When trading occurs, they get a fee. They are putting their money to work. They can withdraw their liquidity at any time.

Suppose I own asset A and I want to buy asset B. I send my asset A to the decentralized exchange and in return I get asset B. I see the liquidity and I see the price. I can do this 24/7. A DEX has no central counterparty. I interact directly with the algorithm. This is DeFi.

Consider the key differences. In a decentralized exchange, I can see the liquidity in real time, essentially an instantaneous audit. There is no leverage. The liquidity is not lent to hedge funds. No broker/dealer is involved, just an open-source algorithm. When I trade, the execution and settlement are simultaneous. Most importantly, I do not delegate custody of my tokens. The result is no waiting in line as an unsecured creditor in a bankruptcy. ?

Of course, nothing is risk free and this new technology of decentralized exchange has certain risks. Nevertheless, it does present an intriguing new model. Indeed, it is not that farfetched to believe we will be interacting with algorithms for many applications—not just in finance—in the future.

The demise of FTX provides a chance to reflect on Satoshi’s original vision. Customers trusted FTX and we know now that trust was misplaced. Decentralized finance offers a sharply different model: no banker, customer, retail investor, qualified investor, or institutional investor. Every participant is a peer with equal standing.

A path forward for centralized exchanges

The current regulatory environment and uncertainty about future regulation in the U.S. has led many exchanges to operate outside the country. Today, more than 90% of trading has moved offshore into an unregulated setting, increasing investor risk. That risk was realized with FTX.

Regulatory clarity would potentially allow for onshoring some of this foreign trading and greatly reduce investor risk. Closely regulated U.S. exchanges, such as Coinbase, will likely be winners as a result of FTX’s demise. ?

Aside from regulatory innovation, offshore centralized entities need to be much less opaque. Tools exist to provide cryptographic proof of reserves and/or solvency, allowing any investor to do an instantaneous audit before allocating their funds. While proof of reserves does not eliminate all risk, it would be a big improvement from the opaque system we have today.

Decentralized vs. centralized

We can learn much from the FTX implosion. One immediate insight is that FTX was a centralized company that traded crypto tokens. Customers trusted FTX with their wealth and, ex post, that turned out to be ill-advised. Decentralized finance, however, has no commercial institution that investors are required to trust. You, the investor, holds your wealth in your wallet.

Any new technology faces bumps in the road. We can choose whether to go down that road—or not. We should weigh the costs against the benefits, and the potential benefits of decentralized finance are vast. I place my bet on the model of financial inclusion and financial democracy, DeFi. The FTX fiasco will hopefully encourage more people to consider decentralized alternatives.

#FTX #ftxcrash #defi #dex #SBF