The FTX Saga Is Another Blow To The Viability Of Cryptocurrencies

The FTX Saga Is Another Blow To The Viability Of Cryptocurrencies
Sam Bankman-Freid fit into the mould of the computer-geek-turned-instant billionaire through his sheer genius – except that his genius lay in using other people’s money to take risky bets. Then, when the inevitable implosion happened, he merely said ‘sorry.’ This is an ongoing story so no one knows where this saga will lead us. What we do know is that before Chapter 11 bankruptcy proceedings for FTX could formally begin, both FTX International and FTX US mysteriously got hacked and around $600 million made its way out to cold wallets in the crypto world.

If a company’s financials are not opaque – which is asking for a lot – there is only one way to gauge whether a firm is financially healthy. Let’s say a financial firm raises $100 million from investors. It deploys $80 million in the markets, placing bets across multiples asset classes – taking gargantuan risks in some areas, playing it very safe in other arenas. Regardless of the company’s exposure to risk in multiple bets across multiple industries, its $80 million invested is for the most part illiquid at present – which means it cannot be converted into cash right away. The company keeps the other $20 million as cash on hand and the shareholders of the company have another $20 million equity in the company sitting as cash in the company’s coffers.

In such a scenario, the investment firm is financially healthy because its assets are $20 million more than its liabilities and it has enough cash on hand to meet the obligations of most of its investors if they want to draw down their funds. Yet this firm can still be illiquid because $80 million of its assets cannot be converted into cash right away and if because of a general panic in the market all its investors decide to take out all their money at the same time, this financially strong and healthy firm would still be short by $60 million because it only has $40 million in cash. The firm might decide to sell its assets to meet the obligations of its investors, but that would turn into a whirlwind fire sale, driving down the value of the $80 million in assets further, leaving the firm with even more of a cash shortfall and spreading fear amongst its investors.

Let’s be real: such a nightmarish scenario rarely happens – except when it does! Generally, not all the investors withdraw all their money at once – well, unless there is a ‘run on the bank’ inspired by irrational fear. In such a nightmarish situation, a fund asks other institutions or wealthy individuals or in the case of the banks, asks the government for a bailout. Those people are ready and willing to cover the difference of $60 million in return for hefty fees/interest or even equity, because the firm is financially solvent: its assets or investments – if sold off at the right time – are worth more than its liabilities.

Another scenario is where the same firm is financially insolvent. Let’s say instead of investing the $80 million in assets, the firm’s partners siphon off this sum to offshore accounts to fund their lavish lifestyle, or instead of diversifying their portfolio make some very huge bad bets. Either way, let’s assume the firm dilutes all this $80 million within two years. Now, when there is a run on the bank inspired by external events and the firm looks around for a bailout, no help is forthcoming because the firm’s assets at $40 million are worth much less than its liabilities at $100 million.
The premise behind using cryptocurrencies is wrong because they have nothing to back them: they are essentially worthless the moment people start disbelieving in them. Naysayers would argue that so is fiat money because it is not backed by gold. They are wrong

In the case of FTX, it is hard to tell where the company stands as of now. Most experts agree that the company has liquid assets of only $900 million. Sam claimed until Monday last week that the company was facing a cash shortfall of $8 billion and was in talks with venture capitalists in Silicon Valley to overcome the liquidity crisis. He failed in this. Then Binance, a much larger crypto exchange and a competitor, was about to bail-out FTX, probably acquire it completely at a significant discount, until it pulled the rug on the deal on Wednesday in a very public announcement stating that “the issues are beyond our control or ability to help.” Industry insiders allege that Binance is orchestrating this whole play to get rid of its strongest competitor in the cryptocurrency market.

FTX and its CEO Sam Bankman-Fried (popularly known as SBF) were seen as a posterchild for cryptocurrency, hanging out with the likes of Bill Clinton, signing up Tom Brady and Giselle as brand ambassadors, bringing on board the most renowned firms in the world such as Sequioa Capital and Blackrock as investors. FTX was formerly valued by private investors at $32 billion and was seen as lender of last resort, frantically bailing out cryptocurrency lenders such as Voyager Digital amid turmoil in the cryptocurrency World. SBF did this through FTX’s sister company and trading arm called Alameda. Critics point to this trading company as the source of all FTX’s problems.

Imagine a cryptocurrency exchange as a bank which holds people’s deposits and then lends them out to other people. If the bank begins trading on the stock market with the people’s deposits, it will quickly get a rebuff from regulators and most likely be forced to shut down and return all the depositors’ money. Since the cryptocurrency world is completely unregulated and all the gullible kids think that’s a cool thing, this is exactly what SBF did via his trading company Almeida, loaning out depositor’s money – sorry coins – to Alameda and using FTX’s self-manufactured coins, called FTT, as a collateral against the money. That is like a bank loaning money to companies against the bank’s own stock as collateral: something which is completely unfathomable.

Binance could have orchestrated FTX’s downfall so that it could gain back its market share. The sequence of events lends credibility to such a theory but the liquidity crisis and more so a solvency crisis can hardly be manufactured, and logic does not hold up when one begins to examine why Binance would want further instability in the already hemorrhaged cryptocurrency world. Anyway, what prompted the demise of FTX was a report by Coindesk stating that Alameda’s balance sheet was unsustainable because most of its assets were denoted in FTX’s self-made currency: FTT coins. After this report came out, Binance publicly announced that it would liquidate all its FTT tokens because they were worthless – which beggars the question: “Why sell-off an asset after you publicly call it worthless?”

Anyhow, after this announcement by Binance, rumours began to spread that FTX was insolvent and as fear spread amongst the depositors, they tried to pull their money out but to no effect, because FTX blocked all requests for withdrawals, realising that it had a cash shortfall of almost $8 billion. Let us give SBF and his companies the benefit of the doubt, by assuming that FTX is not insolvent, but that it is only illiquid because of all cryptocurrencies taking a beating and because of the whole charade orchestrated by a competitor. Even if this were so, who would rescue FTX – and why would they – since most of its assets are in a currency that the company made itself?

The premise behind using cryptocurrencies is wrong because they have nothing to back them: they are essentially worthless the moment people start disbelieving in them. Naysayers would argue that so is fiat money because it is not backed by gold. They are wrong. Fiat currencies may not be backed by gold, but they are backed by governments which have been the very foundation of every society since the time people decided that rather than live in a Hobbesian world, it would be better to give power to a few over them so that order could be maintained and stability ensured.

This is exactly what all governments try to do and to ensure reliability in transactions between people living in a country: they put the might of the state behind a medium of exchange and unless they are very ill-disciplined, they make sure that the currency remains stable and does not take a wild inflationary ride. Before the Great Depression, bank runs were very common in the United States. Then, the government under FDR decided to insure all depositors’ money at all banks because it could, as it printed the money. The government can do the same with cryptocurrencies, but then this would defeat the point of cryptocurrencies because they are meant to be unregulated.

Perhaps unregulated currencies are not meant to be, and the popularity of cryptocurrencies is a passing fad which utilised the ingenuity of the blockchain to fool people into believing that a new order is coming. This is because no matter how strong the celebrity endorsements for FTX may have been, the fundamental principles of finance cannot be overturned.