Rapidly increasing interest rates have punched a hole in the cryptocurrency bubble, exposing fragility, mismanagement, and even fraud in many companies, especially on the cryptocurrency exchange FTX. FTX’s massive collapse follows other recent failures of crypto companies, such as Terra-Luna, Three Arrows Capital, or Voyager Digital. No one should be surprised by this fiasco, but even by the number of people it took by surprise.
Ecclesiastes reminds us that “there is nothing new under the sun.” And at FTX’s headquarters in the Bahamas sun, the company’s advertisements warned clients not to miss the next big opportunity – blockchain-based currencies, financial products and non-fungible tokens. But assets are the new thing about this opportunity. The narrative of the cryptocurrency crisis began a long time ago.
As often happens, the crash started with a bubble. Investor demand has exceeded reasonable near-term expectations of what cryptocurrencies can achieve. Because Bitcoin, Ethereum, and other currencies are impractical as mediums of exchange, their use has been limited to financial speculation and illegal activity. But the historic low in interest rates has fueled the mania about the future of crypto. Scouting efforts have fallen below asset prices, which have been skyrocketing. Cheap cash made it easier for companies to take excessive leverage. Investors needed ever-increasing returns to beat the market and their competitors. This means more leverage and risk.
And when bubbles burst or shrink, profits falter. Milder circumstances reveal the fragility of the system, inadequate regulation, mismanagement, and bad actors that were once easy to hide. Companies go to great lengths to hide losses by fraud. When a company goes down, the infection spreads to vulnerable entities.
The brilliant founder of FTX, Sam Bankman Fried, wanted to make cryptocurrency mainstream, and major funds, such as Sequoia Capital and Singapore’s sovereign wealth fund, Temasek, invested in the project. Celebrities like Tom Brady and Larry David promoted the swap in Super Bowl ads. Former heads of state, such as Bill Clinton and Tony Blair, added their votes to Bankman Fried’s voice. A new financial era began to emerge, and the only thing investors feared was missing out on its opportunities.
But their enthusiasm was like a house of cards. The cryptocurrency collapse began with the collapse of the stablecoin ecosystem of Terra-Luna, a group of cryptocurrencies that completely lost their currency peg to the dollar, when the Federal Reserve began raising interest rates in early 2022. The contagion spread to Three Arrows Capital, which is now a fund. Defunct crypto hedge that was greatly influenced by Terra-Luna. FTX tried to stop the infection, bailing out companies like Voyager and BlockFi. Some have likened Bankman Fried to the legendary J.P. Morgan, who became famous for his private financial intervention in curbing the Panic of 1907.
While the details remain fuzzy, FTX’s sister hedge fund, Alameda Research, has faced…
Problems in the summer period due to the widespread uncertainty in the world of the cryptosphere. In violation of FTX rules, Bankman Fried used $8 billion in client funds to try to save Alameda, which is run by his former romantic partner. However, Alameda’s loans were allegedly backed by FTT, which is now a worthless internal cryptocurrency for FTX.
The ominous alert began with a public dispute between Bankman Fried and Changpeng Zhao, founder of rival stock exchange Binance. Zhao said that Binance planned to sell $529 million in FTT tokens, prompting FTX clients to start withdrawing funds from the platform. FTX faced a massive liquidity crunch and quickly became insolvent. After saying that Binance would buy the crippled exchange, Zhao backtracked when he saw FTX’s books. Bankman Fried resigned as CEO shortly thereafter, and the company went bankrupt. Allegations of fraud, waste and abuse of FTX have flooded the cryptosphere.
Investors were not prepared for the sudden crash. Nearly 40 percent of crypto hedge funds have invested in FTX. It is likely that many would have assumed that large funds such as Sequoia had carried out proper digging efforts, and had replaced excitement about FTX and its founder with a sound assessment of fundamentals, covering up a deep imbalance. John Ray III, the current FTX director who oversaw the liquidation of Enron, said, “This complete failure of company controls, and complete absence of reliable financial information is unprecedented.
The collapse of FTX severely damaged the vision of the crypto envelope of an unregulated and decentralized financial system, but that does not mean that technology is to blame for the chaos. Other forms of digital finance and blockchain technology, such as smart contracts, may improve payment systems and expand financial inclusion. Many central banks are participating in the process, launching their own digital currencies to support monetary sovereignty and financial stability.
Regulators face this conundrum: overreacting to the unfolding cryptocurrency crisis could turn the technology’s potentially beneficial applications into collateral damage. While they may welcome cryptocurrency markets into regulation, they run moral hazard, as investors seek public protection against private loss. On the other hand, if regulators ignore cryptocurrency markets, instability could build up even though cryptocurrency markets do not pose systemic risks as they are still very young.