THE cryptocurrency dominoes have started to fall, and it is unclear how many more will go down before Bitcoin itself collapses. The issues that take Bitcoin down might be the same issues that it was created to prevent.
“The market has gone from a pessimistic view about entering the space to: ‘Do not touch anything crypto-related’,” said Edward Moya, senior market analyst at foreign exchange brokerage Oanda Group.
There is a good chance that Bitcoin will stabilise after the recent slump and remain an asset class, albeit a fringe one. But there is also a chance that the kind of apocalypse narrowly averted for the global financial system in 2008 cannot be prevented for cryptocurrencies. In this scenario, the cornerstone financial institutions of the “cryptoverse” would be wiped out by contagion – and Bitcoin and its brethren would perish with them.
Franklin D Roosevelt (FDR), the US president during the Great Depression, called contagion the greatest threat to the banking system. When confidence in the viability of a bank or broker evaporates, there is a mad rush of clients desperate to get their money out.
In 2007, British bank Northern Rock had queues of nervous depositors stretching down the streets. In 2008, brokers in the United States such as Merrill Lynch and Wachovia were inundated with withdrawal phone calls.
The only thing that could stop the contagion was the US government and central bank pledging to use every resource at their disposal to backstop the financial system. The Federal Reserve bought tens of billions of dollars of mortgage bonds, the US Treasury bought large chunks of Wall Street banks and the contagion was stemmed – although some would say it was fumigated after US taxpayers’ money went up in smoke.
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Cryptocurrency evangelists – the ones who flood Twitter with commands to HODL (hold on for dear life) rather than sell during downdrafts – rejoice in crypto’s unregulated status. Unfortunately, this also means there will be no regulator to act as a backstop. Crypto is running out of saviours.
The crisis of confidence in crypto markets began in the summer with a so-called stablecoin, Terra USD. Without the backing of the conventional reserves necessary to achieve its goal of mirroring the US dollar, Terra USD crashed. Contagion spread to crypto lender Celsius and others.
At that time, an unlikely 20-something saviour emerged – wearing a five-o-clock shadow, and what appeared to be always the same baggy T-shirt. Sam Bankman-Fried (SBF), the chief executive of FTX, played the role that then Treasury secretary Tim Geithner had played during the 2008 financial crisis – pumping hundreds of millions into ailing brokers. To crypto insiders, SBF was the new FDR. He stemmed the contagion.
Bankman-Fried relished his public image as a gnostic sage of crypto. It inspired jealousy in others, however, not least in Changpeng Zhao, head of rival exchange Binance. In what turned out to be something tantamount to financial assassination, Zhao accused Bankman-Fried of engaging in the same kind of fudging that had caused Terra USD’s downfall.
Zhao’s analysis of how FTX was misleading investors about its reserves triggered a run on the bank at Bankman-Fried’s exchange. When clients demanded their money back, FTX was forced to admit it could not pay. FTX might have been able to drum up the cash when Bitcoin was trading at US$70,000. But with Bitcoin and other cryptocurrencies at multi-year lows, its practice of dipping into client funds for an affiliate’s trading activities was exposed.
FTX creditors, including cryptocurrency lending platform BlockFi and major brokerage Genesis, have already succumbed to this contagion. One or both may be following FTX into bankruptcy. These are big players in their own right. Genesis is affiliated with the largest Bitcoin exchange-traded fund, managed by Grayscale Investments.
The problem with contagion is that anyone connected in any way to a failed institution becomes a new source of contagion. Withdrawing links makes it tough or even impossible for companies to survive. Even Binance experienced a wave of client drawdowns recently.
Oanda’s Moya expects to see more crypto equivalents of bank runs: “What percentage of these stablecoins are really backed by fiat currencies and Treasuries? You’re going to see most companies don’t have the proper number of assets.”
Crypto companies have quietly mimicked the structure of “fractional reserve” banks, he added, holding assets that are a fraction of client deposits. “We’re not going to find out until it’s too late.”
The irony is that cryptocurrencies were invented to take trust – and contagion – out of money and banking. Satoshi Nakamoto, in his white paper on Bitcoin in 2009, responded directly to the wipeout of ordinary people’s wealth caused by the fractional reserve banking system.
Nakamoto thought it was absurd, in a modern society with high-powered computers and advanced mathematics, that so much of finance was based on blind trust. To transfer one Bitcoin from one person to another, no trust is required. It is a self-verifying mechanism, mathematically impossible to fake or complicate.
Yet, it was not the bank themselves or even the mortgage bonds they sold that almost brought down the financial system in 2008. It was the financial engineering, the vast derivatives structures built around the mortgage bonds, that opened up the possibility of unlimited losses. This undermined trust in the world’s largest banks and set contagion loose.
Bankman-Fried and others have embraced this same financial engineering. These past two years, the breathless talk of crypto loans, crypto options and crypto margin accounts recalled the excesses of Wall Street that had outraged Nakamoto in the first place. As in George Orwell’s novel, the pigs who had led the revolution against the men became indistinguishable from the men.
Lorenzo di Mattia, manager of hedge fund Sibilla Global Fund, believes it is possible that more brokers will go under but the asset class itself will survive.
However, if a big player such as Binance goes under, there may be no safe harbours left in the cryptocurrency world. The greatest experiment in modern money may fail irrevocably.
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