What exactly happened at FTX and its sister company Alameda Research is unclear, and will be for some time. What we do know is that what’s currently unfolding is a sort of economic Jurassic Park; we are being given a brief glimpse of financial life in the 18th century, before centuries of bitter experience coalesced into the financial regulations we love to hate.
It’s a common joke that cryptocurrency is gradually learning why all the boring rules and regulations of the traditional financial world exist. It’s also entirely true. The earliest explanation for the sudden crash of FTX was very simple: the exchange had become something like a bank, taking in deposits, and lending them out. It had built up assets which it couldn’t access in the long term, and liabilities – customer deposits – which could be instantly accessed. This put it in a very tricky position. Technically, it was probably solvent: it may have had enough assets to cover all the money it owed. But it was also highly illiquid, in that it couldn’t actually get to those assets.
What can happen here is known as a bank run. If everyone thinks you’ve got enough money to meet the day-to-day demands for withdrawal, everything is fine. If, on the other hand, someone on Twitter starts making strange noises about your balance sheet, and you don’t come up with a convincing response, people might start to wonder just how safe their money is, and think that maybe it would be better to pull it out just in case. And then everyone does it at the same time, and you definitely don’t have the money on hand for that, and oh god there are lawyers everywhere.
Hong Kong and the surprising truth about the British Empire
The thing is, you might recognise the original description because it happens to apply to almost every traditional bank. But traditional banks generally don’t fail; Northern Rock was the first British bank run in 150 years, and the regulators who failed were exceptionally embarrassed to the point of strengthening the rules to make sure it couldn’t happen again. The reason these banks work out is threefold. Firstly, financial regulators watch them very closely, and set strict rules on what they’re allowed to do with your money.
Secondly, those long centuries of experience resulted in a major evolution of the central bank: when there is a financial crisis, it should be willing to lend at high interest rates against ‘good’ assets. This is a bit complicated, but essentially says that if you are a bank and you are in trouble – people are taking out their money, and you don’t have enough cash on hand to borrow it – then the central bank, which has all the money it could possibly want, will lend you the cash against your still viable assets. It will charge you a lot of money for this, but you will be able to get the cash to keep your business functioning.
Thirdly, and perhaps most importantly, traditional finance offers generous guarantees for customer deposits. If you have your money in a British bank account, and that bank goes bust, then the Bank of England will step in and make sure your deposits – up to a limit – are safe. This means that for most people there is no point in joining a bank run. If my bank goes bust, I’ll get my money back anyway. So why bother standing in line for hours to withdraw it?
In this line of reasoning, a proper central bank for cryptocurrency would have saved FTX. The problem is that the details we’ve learned since then show that the problem was much deeper. If you are at all involved with the financial and legal worlds, you will know that the words ‘highly entertaining’ and ‘bankruptcy filing’ occurring in the same paragraph is enough to make accountants recoil like vampires from a cross.
The filing for the FTX Group includes the details that payments to staff were approved by ‘personalized emojis’ in an online chat (not acceptable accounting practice since the Egyptians abandoned hieroglyphics), that corporate funds were used to buy houses for employees in the Bahamas, and that the financial statements prepared didn’t actually list the deposits made by customers.
This is very bad. An indication of just how bad things were can be found in the last attempt by FTX to raise funds before bankruptcy. A balance sheet from last week showed that FTX had about $9 billion in liabilities against about $900 million in liquid and $8.6 billion in illiquid assets. This is not an ideal start, but it did at least show positive equity until you start looking in detail.
A good $2 billion of the assets listed is in a cryptocurrency known as Serum. The total market cap for Serum right now is around $65 million. The fully diluted market cap is $2.5 billion. If you just yelled ‘WITCHCRAFT’ at your screen, I can’t really blame you. The vast majority of all the Serum coin in existence is held by FTX, which makes sense because FTX and Alameda Research created it. The actual market value of that Serum is unlikely to be anywhere near $2.2 billion. The bigger problem is that the spreadsheet contains a row outlining the regrets of its creator. This isn’t really something that can be neatly added into the valuation of a company, but certainly isn’t good news for any prospective purchaser.
No regulator is perfect, and disasters still happen in traditional finance. But it does give pause for thought that if Alameda and FTX had been subject to more stringent oversight, a lot of people would still have a great deal more of their money.