Samuel Braithwaite The collapse of FTX
During the first week of November, the cryptocurrency market went into free fall. The market, which includes big names such as bitcoin and ethereum, lost more than US$150 billion in the space of three days.
The amount lost is equivalent to approximately 10 times the value of Jamaica’s annual output of goods and services. This massive crash was precipitated by the collapse of FTX, a cryptocurrency exchange company run by a 30-year-old American, Sam Bankman-Fried or SBF for short.
A cryptocurrency exchange allows customers to buy and sell cryptocurrencies.
Cryptocurrencies are not money. I cringe at the mention of the term. Cryptocurrencies do not adequately meet the functional requirements of money, the three basic ones being: store of value; medium of exchange – it is generally acceptable for the purchase of goods and services; and a unit of account – it allows use to assign a standard cost to goods and services. Cryptocurrencies can be used to purchase goods and services, however, they are not generally accepted as a medium of exchange. Cryptocurrencies are also a poor store of value given their volatility. Further, the unstable nature of cryptocurrencies, including the so-called ‘stablecoins’, undermines their function as a unit of account. Imagine if every day you turn up at your favourite food outlet and the bitcoin-denominated price of your meal keeps going up and down, you will be unable to budget for your meal. Thankfully, your food is priced in Jamaican dollars, which is actual money.
Why do some people support cryptocurrencies? They have been touted as an alternative to the current monetary system where governments and powerful financial interests control the amount of money in circulation. Some cryptocurrencies, such as bitcoin, have a fixed number of ‘coins’ in circulation, while others limit the amount of new coins that can be generated in a given period.
The ‘holy grail’ of the cryptocurrency world is its blockchain technology, a revolutionary technology that ensures that every transaction is recorded in a decentralised digital public ledger. It is decentralised because there is no central authority, no central bank, no government, that runs the system.
The blockchain prevents cryptocurrency users from cheating as it prevents double spending; users cannot spend more cryptocurrency than they have. Think about a system where every transaction is permanently recorded. So like physical money, you can only spend your cryptocurrency once.
The cryptocurrency system is marketed as an egalitarian democratic currency system, free from control by a minority of powerful actors: government and the wealth class. They are legal tender in El Salvador and the Central African Republic.
Cryptocurrencies allow people to send remittances, assuming, of course, that recipients can directly spend their ‘crypto-dollars’ or convert them to hard currency or their domestic currencies. On the downside, a system that operates without oversight is inherently exposed to instability and will allow for the movement of dirty money, undermining anti-money laundering efforts.
The rise and fall of FTX
Sam Bankman-Fried, an MIT physics graduate and son of Stanford professors, built a US$32 billion cryptocurrency empire in less than five years. At its peak, in the spring of 2022, his fortune was an astounding US$26 billion. Bankman-Fried was hailed as the next Warren Buffet, and his efforts in 2022 to support failing cryptocurrencies drew parallels with JP Morgan – the American businessman who saved the US financial system from collapse.
In 2017, Bankman-Fried created the firm, Alameda Research, utilising the quantitative trading skills he and his friends obtained from Jane Street Capital. Alameda Research basically engaged in arbitrage transactions – cryptocurrencies were bought in jurisdictions where they were cheaper (the United States) and then resold in jurisdictions (Japan) where they were more expensive. Out of Alameda Research the cryptocurrency exchange FTX was formed.
From all indications, Bankman-Fried ran FTX and Alameda Research without regard for fundamental financial best practices, for example, Alameda Research obtained large loans from FTX without rigorous financial oversight. Another egregious example of what was happening at FTX is that to cover its liabilities a significant amount of its assets was held in a crypto token called FTT.
FTT, which was created by FTX, gives users discounts on FTX transactions. Some have likened FTT to a reward points system.
When you take out a mortgage, the house you purchased with the loan is collateral for the loan, and it can be repossessed by the bank. Now consider a situation where you take out a business loan and the collateral for that loan is the reward points you created and give to your loyal customers. This is the ‘sand’ (FTT) on which Bankman-Fried’s empire eventually rested, and it worked as long as people believed in him and his ability to make them money.
As the world battled the novel coronavirus pandemic, the US Federal Reserve lowered its policy interest rate to stave off a recession. In this low-interest rate environment investors were hungry for high returns, and cryptocurrencies, risky as they are, promised good returns. It is during this period that bitcoin rose to its maximum value.
However, in early 2022, the US Federal Reserve Bank decided it was time to raise its policy rate to fight inflation. Higher interest rates caused a reduction in the demand for cryptocurrencies, causing prices to tumble. Bitcoin, for example, fell from a price of approximately US$60,000 in November 2021 to less than US$20,000 a year later. Over the summer of 2022, Bankman-Fried attempted to save failing cryptocurrencies. During this period he also earned the wrath of Changpeng Zhao, CEO of the world’s largest cryptocurrency exchange, Binance. Bankman-Fried was critical of Binance and urged regulators to investigate the firm.
On November 2, CoinDesk, a crypto news company, reported a leaked report which questioned the solvency of FTX, and Zhao saw a chance to retaliate. Binance sold its holdings of FTT tokens, triggering a run on FTX. Unfortunately, FTX could only cover about 10 per cent of its US$9 billion liability.
The year 2022 has been a terrible year for cryptocurrencies, but it is not the end of the road. Many are likely to give up on cryptocurrencies, but the revolution is still being supported.
Indeed, what keeps the revolution alive is that there are lots of people around the world who continue to believe in cryptocurrencies. Some might even use the current depressed prices to increase the size of their cryptocurrency portfolios.
Samuel Braithwaite is a lecturer in the Department of Economics, University of the West Indies – Mona.