Financial History at Warp Speed: Cryptocurrency and the FTX Collapse

As one of the most stable and respected names in cryptocurrency (crypto), FTX represented the rock that other firms could rely on. It had over one million users, investments from Japanese multinational firms to the multi-billion-dollar Ontario Teacher’s pension fund, and it sponsored everything from the Miami Heat’s arena to a Formula One racing team. Now policymakers, investors, and economists are scrambling to investigate what went wrong. Social media rumblings at the beginning of November 2022 sparked questions about the health of their balance sheet after revelations about accounting practices long since outlawed in traditional finance. The value of their cryptocurrency, FTT, has plummeted and every component firm – FTX, FTX US, Alameda Research – and over 100 affiliates filed for bankruptcy on November 11. Now lawmakers are demanding a crackdown.

Cryptocurrency may be the exact worst issue for the United States Congress. The implosion of the FTX cryptocurrency exchange retreads long-worn financial history, and, despite the flashy new technology the industry depends on, underlying securities laws still apply. The federal legislature has outsourced nearly all rulemaking regarding financial services to the Securities and Exchange Commission (SEC) and Commodities Futures Trading Commission (CFTC). With few exceptions, and despite the Fifth Circuit’s best efforts, these two agencies have checked Wall Street’s worst excesses while bolstering the U.S. market’s position as a global leader in both liquidity provision and financial services. Even their dalliances in repealing older banking regulations may have had arguably disastrous consequences. We should look at the records of these agencies and bring cryptocurrency into the same regulatory environment instead of leaving it to Congress.

But, we haven’t. Now the cryptocurrency industry is going through every historical lesson at phenomenal speed, each coming with new stories of consumers losing their savings or retirement on a purportedly “can’t miss” opportunity. After each crash, reporters look for a scapegoat and frequently point at lawmakers, but that misses the point. Congress’s ability and alacrity when it comes to regulating technology is somehow worse than their track record regulating financial services. Whether they are misunderstanding how the internet works, the core concepts of monetization, or even knowing which company is which, the relative luddites legislating in the Capitol have shown little interest in meaningfully regulating tech. The ongoing discussions of reforming Section 230, breaking up big tech, and improving privacy protection provide some hope for the future, but they have all struggled to get floor time. There may be committees in both chambers for financial services and technology, but neither legislate effectively. Cryptocurrency firms also employ an army of advocates to ensure that they remain outside of the regulatory structure. So, history repeats itself.

Each lesson can trace back to an equivalent in financial history, and financial historians can only wave their hands and hope that consumers can avoid the worst of the blowback. The crypto community maintains a misplaced philosophical exceptionalism, an unshakeable belief that the underlying blockchain technology inoculates them from the pitfalls of centuries of history. Looking at that history, the idea of exchanges offering leverage to trading firms, enabling them to buy greater stock, traces its roots back to before the Great Depression when excessive leverage eventually led to global financial catastrophe. In the case of FTX, founder Sam Bankman-Fried publicly stated that he misunderstood the amount of leverage that the exchange had. Essentially, the exchange melted down when a run on deposited assets revealed that the it did not hold nearly enough in assets to cover current liabilities. In equities, exchanges, and brokerage firms, federal law requires that all brokerages maintain sufficient capital ratios, given their outstanding positions. FTX’s management decided that they could ignore such risk management procedures – now they cannot meet customer withdrawals. The crypto community loves the regulatory neglect that enabled this. Industry evangelists repeatedly talk about disintermediating commerce and removing the government’s control of currency. Proponents argue that any government intervention will stifle innovation and cost the U.S. its treasured place as the center of global markets; however, several recent blow ups should force some introspection inside the cryptocurrency community.

In the decentralized finance world, random coins have experienced sudden meteoric rises in value. Famously, Doge Coin, a parody coin based on the Shiba Inu meme, skyrocketed despite no actual underlying value, particularly spurred by Elon Musk’s discussion of the token on Saturday Night Live. Many other tokens have skyrocketed similarly as groups of amateur traders have coordinated on chat servers to buy as many as possible and then sell them to anyone who comes in after. This scheme has a name in traditional finance: a “pump and dump” or “boiler room” scheme. Starting in the early 1960s through the 1980s, multiple groups performed the same basic tactics with municipal bonds and small cap stocks. In fact, one fraudster achieved such fame that Hollywood made two movies about him. Jordan Belfort defrauded unsuspecting investors out of millions as documented in Boiler Room (2000) and The Wolf of Wall Street (2013). So really, Doge Coin, Shiba Coin, or whatever the new coin of the week is are just digital boiler rooms where unscrupulous schemers go in search of the next greater fool.

History repeated itself again in 2021 when an artist named Beeple sold the first Non-Fungible Token (NFT) for $69 million. Naturally, the first question is what is an NFT? An NFT is a record in a digital ledger that says an address holds a digital asset – that someone paid a certain amount of money to say that they own a digital image or concept. On its face, this may seem pretty strange given that copying files between computers remains trivially easy. That objection notwithstanding, the NFT craze of 2021 and 2022 included celebrities spending millions on them, others intentionally burning pieces of art, and something called a Bored Apes Yacht Club. The bottom has since fallen out of this market with sales cratering by 97%. Many were left asking: “who could have seen this coming?” The Dutch. This is a textbook example of a bubble, a concept so old that it predates not only computers, but electricity. Even the most amateur financial historian must recall the original bubble: Tulip mania in the 17^th century Netherlands. Between 1634 and 1637, tulip bulb prices and demand rose so fast that people mortgaged homes, land, and businesses to buy tulip bulbs until the price crashed back down to earth. While the bubble and burst did little to impact the Dutch economy at the time, plenty of farmers lost their homes and lands to speculators. Fast-forward a couple hundred years: the NFT crash has left many taking to social media with various stories of despair, wondering how they could have seen this coming, while everyone in traditional finance rolls their eyes.

These events are going to keep happening until the regulatory environment changes, and that solution is not likely to come from the Capitol. Every so often a new technology comes along and changes the paradigm, but cryptocurrency and blockchain securities are not that. Crypto is an entire industry that can be captured in the cliché: “those who fail to learn history are doomed to repeat it.” If the crypto exchanges, like FTX, refuse to learn something from their traditional finance forbears, then it is up to Congress to bring the industry into the SEC and CFTC’s purview more fully.