The FTX "bank run" and failed bailout by Binance is another milestone of the crypto industry speed-running the history of the wildcat banking era and relearning lessons regarding animal spirits, macro interest rates and why central bank regulators emerged to protect retail investors, provide capital liquidity backstop facilities and enforce minimum capital adequacy ratios. Here are my hot takes:
- FTX prints $FTT that Alameda Research (sister company) buys at a low price
- FTX pumps $FTT, so that Alameda can post "high-value" $FTT back to FTX as collateral (credit to Jon Wu)
- Alameda borrows real assets from FTX customers to invest in the crypto sector. "Rehypothecation" (banks and brokers use, for their own purposes, assets that have been posted as collateral by their clients) would be the legal term IF they had client consent AND disclosure. Regulators clamped down on this in the global and shadow traditional banking sector after the 2008 Global Financial Crisis.
- Alameda loses money in the broader crypto market from exposure to other collapses in the market, but it's not visible to the general public. Keep going and offer to bailout the collapses to minimize this. Warn the market that some crypto exchanges already “secretly insolvent” and they are here to save the day ala JP Morgan (naive truth-teller? subconscious confession? irony?)
- Someone leaks the above private relationship to Coindesk (well-meaning whistleblower? Binance? short-seller?)
- Binance pulls their capital out of $FTT, effectively successfully fleeing (preserving value) while attacking (spooking the market) the internal "peg" where the above relationship works (how aware were they of the above relationship? were they spooked by the disclosure of the magnitude? or they just opportunistically took the advantage to spike a competitor? or they intentionally leaked the relationship for a planned attack?)
- FTX has insufficient reserves to cover all customer withdrawals in the bank run due to both general crypto industry practice of maximizing returns/ minimizing reserves for "efficiency" coupled with having insufficient fiat/ quality reserves due to Step 3 AND Alameda not being able to bail out FTX due to Step 4.
1. Bank runs set up the fear underlying other bank runs. Collateralized $FTT with large counter-party risks blow a hole through the balance sheets of multiple industry players, who then in turn blow a hole through the next layer of industry players who didn't have direct exposure to $FTT. Expect significantly more fear (contagion) to cascade across consumers and operators through the crypto institutional system. Consumers conduct flight-to-safety from hot wallets to off-chain, fiat (USD) and "quality" institutions that display proof-of-reserves. Less-quality institutions will claim to start proof-of-reserves audits (or the process of looking for an auditor), with the process taking "effectively-forever-fingers-crossed-we-only-publish-post-this-crisis" to "basically-never."
2. Crypto winter will deepen as every startup relooks at their financial reserves (even harder), pulls even more working capital from other companies (one business's supplier is another business's customer) and has much more difficult board meetings that discuss compliance and risk mitigation. "Quality" institutions accelerate serious merger discussions to proactively shore up balance sheets and take money off the table, but mutual suspicion keeps dealmaking (potentially too) slow. Retail banks start soft-shopping for teams of talent.
3. Global regulators ramp up pre-emptive regulation of all other crypto startups in their various jurisdictions, while the tone sharpens at both formal and informal discussions. If the FTX acquisition falls through or consumers are unable to withdraw 1:1 (Update: the acquisition expectedly didn't happen and so consumers will be unable to withdraw their capital), regulators may dig deeply into financials and timeline with class-action lawsuits and legal charges in the realm of possibility. Private discussions may go public during legal discovery. Central banks, regulators and policymakers double down on their core banking regulation (systemic risk) mandates, beyond price stability and employment growth.
4. Politicization will happen for this issue. Sam Bankman-Fried, the FTX founder, had reportedly spent almost $40 million mainly supporting Democrats during the current political cycle. Senators Cynthia Lummis (R) and Kirsten Gillibrand (D) have worked on bipartisan pro-crypto resolutions. The question is whether bipartisan coalitions post-midterms emerge and coalesce around more strict "Elizabeth Warren (D)" style regulations. Regulators will look at US as benchmark, but may move ahead of them proactively.
5. Publicly-traded banks' leadership are going to sleep well tonight. Then they are going back to the government offices and media studios tomorrow to lobby for tight regulations (regulations that are of the "same level to be fairly applied" to both banks and crypto). Bankers will dogfight with crypto lobbyists with new ammo. Prior media reports regarding how minorities and the underbanked are adopting crypto faster than the mainstream will be inverted from success story framing to moral-of-the-story discussions.
6. Crypto financial institutions eventually consolidate under "quality" teams that become defaults. Only 4377 banks survive today (through consolidation), vs. 30,456 banks in 1921 (86% death rate). Within the survivors, the top 10 banks control 89.1% of all assets. The decentralization anthem will slowly change tune into a centralized, self-regulated syndicate orbiting the largest players, similar to the Buttonwood Agreement signed by 24 stockbrokers under a buttonwood tree (thanks Jess Guglielmo for the contribution). Never forget that JP Morgan bank, market leader with 25% of all banking assets, is named after John Pierpont Morgan Sr. who consolidated the finance sector during the Panic of 1907 and created the Federal Reserve.
7. Survivors will keep building. Startups that use blockchain as a fundamental technology enabler (and not as an investment instrument) continue chugging along, albeit with a more skeptical (or discerning?) VC audience in the short and medium-term. Founders will answer "Is Web3 BS?" with "No, but the others are!". Friedrich Nietzsche: “Out of life's school of war — what doesn't kill me, makes me stronger.”
8. Growth-stage VCs pull back from crypto across 2023. Whole funds and investor teams have been built on the crypto thesis, with the assumption of high Web3 trend growth with commensurately lower late stage risk (venture death rate) similar to Web2. However, the speed (within a year of the last round) and magnitude (going to effectively zero upside with low preservation of capital) of the FTX valuation collapse will cause eye-wateringly painful mark-to-market revaluations of their portfolio in an already challenging macro environment. More critical eye emerges on crypto deals at investment committees, and partners now screen deals of the personal knowledge of it being a career-limiting/ fund-ending move in the eyes of their limited partners. Ontario Pension Fund, Sequoia, Paradigm, Tiger Global, SoftBank, Circle, Ribbit, Multicoin and Temasek as FTX late stage investors with significant exposure become very sensitive to this, especially those representing public sector stakeholders. Further late stage pullback ripples into early stage lower valuations and more argument for disciplined monetization, similar to how early-stage SaaS checkpoints have evolved from 2010 to 2022. (thanks Adriel Yong for the inspiration)
Note: The aggregate amount is the cumulative total of the capital rounds that investors participated in, not their actual size of stake.
Wildcat Banking Era: "Wildcat banking was the issuance of paper currency in the United States by poorly capitalized state-chartered banks. These wildcat banks existed alongside more stable state banks during the Free Banking Era from 1836 to 1865, when the country had no national banking system. States granted banking charters readily and applied regulations ineffectively, if at all. Bank closures and outright scams regularly occurred, leaving people with worthless money. Operating in remote locations with limited or absent financial infrastructure, wildcat banks supplied a medium of exchange in the form of bearer notes that they issued on their own credit. These notes were formally redeemable in specie (i.e. gold or silver coins) but typically collateralized by other assets such as government bonds or real estate notes, or occasionally by nothing at all. Hence they carried a risk that the bank could not redeem them on demand."
Bank Run: A bank run or run on the bank occurs when many clients withdraw their money from a bank, because they believe the bank may cease to function in the near future. In other words, it is when, in a fractional-reserve banking system (where banks normally only keep a small proportion of their assets as cash), numerous customers withdraw cash from deposit accounts with a financial institution at the same time because they believe that the financial institution is, or might become, insolvent; they keep the cash or transfer it into other assets, such as government bonds, precious metals or gemstones. When they transfer funds to another institution, it may be characterized as a capital flight. As a bank run progresses, it may become a self-fulfilling prophecy: as more people withdraw cash, the likelihood of default increases, triggering further withdrawals. This can destabilize the bank to the point where it runs out of cash and thus faces sudden bankruptcy. To combat a bank run, a bank may limit how much cash each customer may withdraw, suspend withdrawals altogether, or promptly acquire more cash from other banks or from the central bank, besides other measures.
Bank Panic: A banking panic or bank panic is a financial crisis that occurs when many banks suffer runs at the same time, as people suddenly try to convert their threatened deposits into cash or try to get out of their domestic banking system altogether. A systemic banking crisis is one where all or almost all of the banking capital in a country is wiped out. The resulting chain of bankruptcies can cause a long economic recession as domestic businesses and consumers are starved of capital as the domestic banking system shuts down. According to former U.S. Federal Reserve chairman Ben Bernanke, the Great Depression was caused by the Federal Reserve System, and much of the economic damage was caused directly by bank runs. The cost of cleaning up a systemic banking crisis can be huge, with fiscal costs averaging 13% of GDP and economic output losses averaging 20% of GDP for important crises from 1970 to 2007.
Several techniques have been used to try to prevent bank runs or mitigate their effects. They have included a higher reserve requirement (requiring banks to keep more of their reserves as cash), government bailouts of banks, supervision and regulation of commercial banks, the organization of central banks that act as a lender of last resort, the protection of deposit insurance systems such as the U.S. Federal Deposit Insurance Corporation, and after a run has started, a temporary suspension of withdrawals. These techniques do not always work: for example, even with deposit insurance, depositors may still be motivated by beliefs they may lack immediate access to deposits during a bank reorganization.
Why The Federal Reserve Was Created: "The National Banking Act of 1863 created a network of national banks and a single U.S. currency, with New York as the central reserve city. The United States subsequently experienced a series of bank panics in 1873, 1884, 1893, and 1907. In response, in 1913 the U.S. Congress established the Federal Reserve System and 12 regional Federal Reserve Banks throughout the country to stabilize financial activity and banking operations."
1. Fractional-Reserves: Banking institutions in the United States are required to hold reserves—amounts of currency and deposits in other banks—equal to only a fraction of the amount of the bank's deposit liabilities owed to customers. This practice is called fractional-reserve banking. As a result, banks usually invest the majority of the funds received from depositors. On rare occasions, too many of the bank's customers will withdraw their savings and the bank will need help from another institution to continue operating; this is called a bank run. Bank runs can lead to a multitude of social and economic problems. The Federal Reserve System was designed as an attempt to prevent or minimize the occurrence of bank runs, and possibly act as a lender of last resort when a bank run does occur.
2. Check Clearing System: Because some banks refused to clear checks from certain other banks during times of economic uncertainty, a check-clearing system was created in the Federal Reserve System. It is briefly described in The Federal Reserve System—Purposes and Functions as follows: By creating the Federal Reserve System, Congress intended to eliminate the severe financial crises that had periodically swept the nation, especially the sort of financial panic that occurred in 1907. During that episode, payments were disrupted throughout the country because many banks and clearinghouses refused to clear checks drawn on certain other banks, a practice that contributed to the failure of otherwise solvent banks. To address these problems, Congress gave the Federal Reserve System the authority to establish a nationwide check-clearing system. The System, then, was to provide not only an elastic currency—that is, a currency that would expand or shrink in amount as economic conditions warranted—but also an efficient and equitable check-collection system.
3. Lender of last resort: In the United States, the Federal Reserve serves as the lender of last resort to those institutions that cannot obtain credit elsewhere and the collapse of which would have serious implications for the economy. It took over this role from the private sector "clearing houses" which operated during the Free Banking Era; whether public or private, the availability of liquidity was intended to prevent bank runs.
4. Fluctuations: Through its discount window and credit operations, Reserve Banks provide liquidity to banks to meet short-term needs stemming from seasonal fluctuations in deposits or unexpected withdrawals. Longer-term liquidity may also be provided in exceptional circumstances. The rate the Fed charges banks for these loans is called the discount rate (officially the primary credit rate). By making these loans, the Fed serves as a buffer against unexpected day-to-day fluctuations in reserve demand and supply. This contributes to the effective functioning of the banking system, alleviates pressure in the reserves market and reduces the extent of unexpected movements in the interest rates. For example, on September 16, 2008, the Federal Reserve Board authorized an $85 billion loan to stave off the bankruptcy of international insurance giant American International Group (AIG).
John Pierpont Morgan Sr.: The Panic of 1907 was a financial crisis that almost crippled the American economy. Major New York banks were on the verge of bankruptcy and there was no mechanism to rescue them, until Morgan stepped in to help resolve the crisis. Treasury Secretary George B. Cortelyou earmarked $35 million of federal money to deposit in New York banks. Morgan then met with the nation's leading financiers in his New York mansion, where he forced them to devise a plan to meet the crisis. James Stillman, president of the National City Bank, also played a central role. Morgan organized a team of bank and trust executives which redirected money between banks, secured further international lines of credit, and bought up the plummeting stocks of healthy corporations.
A delicate political issue arose regarding the brokerage firm of Moore and Schley, which was deeply involved in a speculative pool in the stock of the Tennessee Coal, Iron and Railroad Company. Moore and Schley had pledged over $6 million of the Tennessee Coal and Iron (TCI) stock for loans among the Wall Street banks. The banks had called the loans, and the firm could not pay. If Moore and Schley should fail, a hundred more failures would follow and then all Wall Street might go to pieces. Morgan decided they had to save Moore and Schley. TCI was one of the chief competitors of U.S. Steel, owning valuable iron and coal deposits. Morgan controlled U.S. Steel; he decided it had to buy the TCI stock from Moore and Schley. Elbert Gary, head of U.S. Steel, agreed, but was concerned there would be antitrust implications that could cause grave trouble for U.S. Steel, which was already dominant in the steel industry. Morgan sent Gary to see President Theodore Roosevelt, who promised legal immunity for the deal. U.S. Steel thereupon paid $30 million for the TCI stock and Moore and Schley was saved. The announcement had an immediate effect; by November 7, 1907, the panic was over. The crisis underscored the need for a powerful oversight mechanism.