This year’s crypto crash had all the classic characteristics of a banking crisis: cash runs, flash sales and contagion. What she didn’t have were banks.
Look at the bankruptcy filings of the cold platformsVoyager Digital Holdings, Celsius Network and FTX Trading and the hedge fund Three Arrows Capital will be fired, and you will not find a single bank on the lists of the largest creditors.
While the bankruptcy filings are not entirely clear, they describe many of the largest creditors as customers or other crypto-related companies. Crypto companies, in other words, operate in a closed loop, within which there are many internal connections, but with few meaningful connections to the traditional financial world. This explains how an investment channel worth about 3 trillion dollars can lose 72% of its value, and prominent players in the field could collapse, without all of this having a material effect on the financial system.
“The crypto space … is largely circular,” wrote Yale University economist Gary Gorton and University of Michigan jurist Jeffrey Zhang in a paper expected to be published soon. “Once crypto banks receive deposits from investors, these companies borrow, lend and trade among themselves. They have no interaction with companies connected to the real economy.”
A few years from now, things may look different, given the growing pressure on regulators and banks to adopt cryptocurrencies. The crypto crash may have prevented that – and a much wider crisis.
Ecosystem is very similar to that of the banks
Crypto has long been marketed as an anonymous, contactless, accessible and unregulated alternative to traditional banks and currencies. But its flourishing ecosystem looks very similar to that of the banking system, which accepts deposits and makes loans.
Researchers Gorton and Zhang write, “Crypto lending platforms founded banking from the ground up…if any entity engages in lending and borrowing, it is economically equivalent to a bank, even if it is not labeled as a bank.”
And just like the banking system, the crypto is leveraged and connected within it, therefore vulnerable to customer runs and contagion phenomena. This year’s crisis started when the TerraUSD currency, which was supposed to be a stablecoin – that is, a crypto currency that is supposed to maintain a constant value against the dollar – crashed when investors lost faith in the asset that backed it, a currency called Luna. Rumors that Celsius was losing money on Terra Velona led to a panic to withdraw deposits from it, and in July Celsius filed for bankruptcy protection.
Three Arrows, a crypto hedge fund that invested in Luna, was forced to liquidate. Losses on a loan to Three Arrows and exposure to Celsius caused Voyager to file for bankruptcy protection.
Meanwhile FTX’s trading partners Alameda Research and Voyager were lending to each other, and Alameda and Celsius also had mutual exposure. But the connections between FTX and Almada were what caused the companies to collapse.
Like many platforms, FTX has issued its own cryptocurrency, FTT. After it was revealed that this was the main asset held by Almeda, the Binance exchange, another major platform, announced that it would dispose of its holdings in FTT, causing a run that ended with FTX collapsing.
Genesis Global Capital, another crypto lender, had exposure to both Three Arrows and Almada. The company stopped withdrawals and requested cash from external sources in light of the collapse of FTX. Another crypto lending house, BlockFi, with exposure to FTX and Alameda, is preparing to go bankrupt, the Wall Street Journal previously reported.
A paste reminiscent of 19th century banking
For historians, this long contagion and collapse are reminiscent of the period of free banking that was from 1837 to 1863, when banks issued their own bonds, and cases of fraud in quantities and runs on the money, stoppages of withdrawals and panic, were commonplace.
But while these crises have always hit business activity, the crypto crisis has largely passed by the economy.
Some investors, from unsophisticated private individuals to pension funds and venture capital firms, suffered losses, some of them for the second time.
But these changes are quantitatively different from the kind of losses that threaten the liquidity of large lending institutions and the stability of the financial system more broadly.
Of course, a certain degree of loss on investments or loans suffered by some banks cannot be ruled out. Banks provide crypto companies with custodial and payment services, and hold their cash, for example as a backup for stablecoins. There are small banks serving crypto companies that have been hit by the large withdrawals of deposits.
Crypto plays no role in the real economy
In the traditional financial sector there has been little incentive to build connections to crypto, because unlike government bonds or mortgages, or commercial loans or even derivatives, crypto plays no role in the real economy. For the most part, this field has been rejected as a means of payment, except in cases where the inability to track is very important , as in money laundering or ransom demands.Crypto innovations such as stablecoins and DeFi, a type of automated exchange, primarily facilitate crypto speculation rather than useful economic activity.
Crypto’s bad reputation has put off mainstream financiers, such as Warren Buffett and JPMorgan Chase CEO Jamie Dimon, and has made regulators very nervous about getting banks involved. Over time that should change, not because crypto became useful, but because it generated so much profit for speculators and the ecosystem that supports them.
Several banks have made private equity investments in crypto companies, and many, including JPMorgan, are investing in blockchain, the distributed ledger technology that underpins cryptocurrencies. A flood of lobbying money has flowed into Washington to help create a regulatory framework under which crypto, having failed as an alternative to the dollar, could become a higher-risk, less-regulated alternative to securities.
Now, with the taint of scandals and bankruptcies, cryptocurrencies will have to wait longer – perhaps forever – before the traditional banking system fully embraces them. An end to the banking crises required the replacement of the private currencies with a single national dollar, the establishment of the Federal Reserve as a lender of last resort, deposit insurance and extensive regulation.
It is not clear whether it will be possible to apply the same recipe to the crypto field: effective regulation will eliminate much of the efficiency and anonymity that are at the bases of the field’s attractiveness. And while the US economy clearly needs a stable banking and currency system, it can do just fine without crypto.