Episode 4

After FTX's Collapse, Can Crypto Survive Without a Savior?

Without a lender of last resort, crypto wasn't designed for a financial crisis. Maybe that's good.

By Zack Guzman

November 20, 2022


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The crypto industry is one that was built around Bitcoin — an alternative form of money founded to refute the failures of the traditional financial system.

In fact, Bitcoin’s genesis block includes the text of the New York Times headline seen as the precipice of the bailout era: “Chancellor on Brink of Second Bailout for Banks.” It’s as if Bitcoin’s founder was speaking directly to the old banking system to say, “We see your transgressions, and we are coming for you.”

The irony, therefore, that crypto itself could come to repeat the very same mistakes the old system committed in the 2008 financial crisis is not lost on us. But how did we get here?

Centralized crypto lenders have been going bust the entire year. In a way, it was completely predictable. They had been taking in customer deposits, promising a fixed yield, and loaning out assets without limits or much policing at all from regulators. Each platform was left to its own devices for how much risk they were willing to take on, and customers never really knew the default risks. That was fine in the bull market, but when crypto’s largest ever collapse kicked off the bear market back in May, the dominos were set for a cascading failure.

The hedge fund Three Arrows Capital, which had bet heavily on the failed crypto project Terra, defaulted on billions in loans from all the big players. First, lending platform Celsius filed for bankruptcy citing exposure to Three Arrows, then Voyager followed suit – later BlockFi looked destined for a similar fate until it was spared by a rescue financing coming at the direction of FTX founder Sam Bankman-Fried.

To many, Bankman-Fried had been crowned as crypto’s “white knight.” CNBC often compared him to a young John Pierpont Morgan, as the industry’s lender of last resort. In an interview with Bloomberg, Bankman-Fried admitted he had been rescuing more of the industry than he would have liked, but no one else was stepping up.

“I mean I would love someone else to go backstop the industry,” he said this summer. “I think it’s better for me to do it than for no one to, but look if someone else wants to do it, like absolutely be my guest. We’ve reached out to a lot of people, it has not ultimately ended in the way we were hoping it might.”

After Bankman-Fried’s trading arm Alameda Research stepped in to scoop up Voyager’s assets out of bankruptcy, it looked like those customers were on a path to seeing more than a majority of their deposits returned. As FTX stepped in to provide emergency credit to BlockFi, it appeared their customers were spared as well. The scale of support coming from Bankman-Fried through Alameda and FTX to backstop the entire industry became quite apparent, but how exposed were they both themselves becoming by rescuing everyone else?

In that same interview with Bloomberg this summer, Bankman-Fried tried to calm any concerns that he, as crypto’s savior, might eventually also need saving.

“We had to make snap judgment calls and we made them such that if things turned out well, they’d be good investments and if they turned out badly, they’d be bad investments but we sort of limited the amount that we could lose from it,” he said.

But when CoinDesk published leaked data about what assets Alameda Research held on its balance sheet, cracks started to appear. In fact, the report claimed a large portion of Alameda’s own financial health was tied up in FTX’s own token, FTT. Following the report, the leader of FTX’s rival exchange, Binance, revealed he would be selling more than $500 million in FTT tokens.

Tweets about concerns over FTX’s insolvency coming from Binance CEO Changpeng Zhao, or CZ as he’s known, might have been enough to spark a panic. Tweets about him dumping more than half a billion dollars worth of FTT all but ensured it. In the wake of FTT collapsing more than 95%, Bankman-Fried said more than $5 billion was withdrawn by FTX customers in just a matter of days.

On the brink, FTX was reportedly looking for help anywhere it could find it. And somehow, help looked to be coming from the last person you’d expect – Binance’s CEO himself. Bankman-Fried tweeted that the two had reached a deal to save FTX from disaster. However, in less than 48 hours, that deal was called off by Binance, citing a worse financial condition at FTX than expected.

With the bank run played out, Binance’s rescue deal off the table, and seemingly no other options, nearly all of Bankman-Fried’s empire filed for bankruptcy. Seemingly in a nod to the moves pulled by CZ, Bankman-Fried admitted defeat and congratulated his “sparring partner,” by tweeting, ”well played; you won.”

Reports since those events unfolded have claimed that FTX leveraged customer funds for bets made by Alameda Research. A hole approaching $10 billion looms large over any hopes of customers seeing anything near a total return of the funds they put in.

Furthermore, FTX’s collapse now puts back into question all of the cascading contagion that it had stepped in to backstop. For example, Voyager’s assets are now back up for bidding – leaving their depositors once again up in limbo. Coincidentally, Binance’s U.S. arm has now stepped in to bid for that rescue. (Well played, you won.)

BlockFi paused customer withdrawals after FTX filed for bankruptcy, leaving many customers to assume they are also destined for a long, drawn-out bankruptcy process. Shortly thereafter, the crypto trading platform founded by Cameron and Tyler Winklevoss, Gemini, announced its interest-earning product had hit a snag. Gemini’s counterparty, Genesis, had announced it was facing its own liquidity issues. Genesis, which shares a parent company with CoinDesk, had revealed earlier this year that it suffered a more than $1 billion loss when Three Arrows went bust. They announced last week they were no longer able to honor withdrawals for Gemini’s customers.

The order in which the dominos fall seem to be of little significance if they are all doomed to fall on you. Despite efforts by Bitcoin to break free from the ways of the traditional system, crypto now finds itself battling the very same fate as big banks in 2008. But there is a very big difference. There is no Federal Reserve or central bank waiting to bail out its system. If FTX or Bankman-Fried were the so-called lenders of last resort, who will step in now? Binance? What happens if customers rush to take assets off of any exchange?

To get to the answers to those questions, Coinage spoke with Caitlin Long, the CEO and founder of Custodia Bank, a crypto-native registered bank in the state of Wyoming. Long has criticized lending practices in crypto for years and warned at the beginning of the year that leveraged crypto lenders were destined to go bust. She even debated Bankman-Fried on the dangers of leverage at the Bitcoin Miami conference last year.

“I don't take pleasure in the pain that people are feeling,” Long says in this week’s episode. “This is one of those situations where warning people and then being right is really not something that makes you feel good.”

As a markets expert with nearly three decades of experience on Wall Street, Long has seen this all play out before. She was working on Morgan Stanley’s trading floor when the financial crisis hit and she doesn’t hold back in pointing out a lot of the players at fault this time around were also former quantitative traders in traditional finance.

“Since you're linking the 2008 financial crisis here, some of the worst offenders in the crypto industry came from Wall Street,” she tells us. “But there's an underlying topic here, which is just human nature and greed. We're repeating these same things.”

There is, of course, one big difference. There will only ever be 21 million bitcoin created. There is no institution with the power to print more to bail anyone out, even if they wanted. By design, Long says it should reinforce the fact that people should not be taking leveraged bets on bitcoin.

“All of this leverage was inherently unsustainable and it was inherently rolling the dice. And good riddance,” she says.

For customers caught in the crossfire, that might seem like little solace as they see deposits go down with each failed lender. For Long, who also saw her own deposits snatched away years ago in the hack of crypto exchange Mt. Gox, there’s a real lesson to be learned. Back then, she learned the importance of custodying her crypto assets in her own wallet. Now, millions of others are learning the same thing.

By choosing not to depend on or trust a financial intermediary like FTX, taking custody of assets allows people to control their own funds and know that they aren’t being lent out. Furthermore, they can probably know they own a certain cryptocurrency and that a centralized platform isn’t just promising them that amount on paper.

As an observer of the old system, Long says there are more frequent examples of retail customers getting hurt when things aren’t tracked honestly. One of her favorite examples is the Delaware court case of Dole Foods shareholders. As the saga goes, about a third more than the total shares outstanding in Dole Foods were sold. Financial intermediaries made more money trading these “fake” shares, while holders of real Dole Foods shares were hurt by the share price being suppressed.

“People had their pockets picked, and if you stop and think about what that means, it means that somebody sold an asset that didn't exist and they pocketed the money,” she said, comparing it to what crypto lenders have been doing for years. “People are creating more claims to bitcoin through these insolvent intermediaries than there are actual bitcoins. But what happened in the Dole food situation? Everybody got off. What happens in the bitcoin situation? [Bitcoin,] the apex predator, bites and takes down all the insolvent intermediaries … the bitcoin system is inherently fairer.”

That could have been true were it not for a lot of fake paper bitcoin being sold. But now that it has, what is the path forward? To Long, it’s uncertain, but bitcoin and the rest of crypto has survived collapses before that flushed out other bad bets. 

“Bitcoin doesn't care what its market structure is. All that Bitcoin cares about is that there's hash rate to confirm transactions and add the next block to the blockchain … it's an incredibly stable system,” she said. “If you teach yourself how to self-custody [your crypto assets] and you stay away from all the shenanigans of all the Wall Street crowd, you can protect yourself. It's an incredible insurance policy.”