How The Decline Of Crypto Could Benefit The Economy

This year’s crypto collapse has all the characteristics of a classic banking crisis: runs, fire sales, contagion.

What it doesn’t have are the banks.

Check out the bankruptcy filings of crypto platforms Voyager Digital Holdings Inc., Celsius Network LLC and FTX Trading Ltd. and hedge fund Three Arrows Capital, and you won’t find any banks listed among their biggest creditors.

While the bankruptcy filings are not entirely clear, they describe many of the largest creditors as customers or other crypto-related companies. In other words, crypto companies operate in a closed loop, deeply interconnected within that loop but with few apparent significant connections to traditional finance. This explains how an asset class worth about $3 trillion could lose 72% of its value, and significant intermediaries could turn to the financial system, with no discernible consequences for the financial system.

“The crypto space is largely circular,” Yale University economist Gary Gorton and University of Michigan law professor Jeffery Zhang write in a forthcoming paper. “Once crypto banks receive deposits from investors, those firms borrow, lend and trade on their own. They don’t interact with businesses that are involved in the real economy.”

The collapse of FTX has set off the biggest crypto bankruptcy ever, and court filings are revealing what went wrong and how complicated things could have already been. Here are three things you should know about the company bankruptcy process. Photo: Lam Yik/Bloomberg News

A few years from now, things could be different, given the increased pressure on regulators and bankers to accept crypto. The crypto crisis may have prevented that—and a much wider crisis.

Crypto has long been marketed as an unregulated, anonymous, frictionless, more accessible alternative to traditional banks and currencies. But its mushroom ecosystem looks very similar to the banking system, taking deposits and making loans. Messrs. write. Gorton and Zhang, “Crypto lending platforms have reinvented banking… if an entity engages in lending and borrowing, it is economically equivalent to a bank even if it is not labeled as one.”

And just like the banking system, crypto is leveraged and interconnected, and therefore vulnerable to run-ins and seizures. This year’s crisis began in May when TerraUSD, a purported stablecoin – ie, a cryptocurrency intended to maintain a constant value against the dollar – collapsed as investors lost faith in its backing asset, a sign that Luna’s name. Rumors that Celsius lost money on Terra and Luna caused a run on its deposits and in July Celsius filed for bankruptcy protection.

Three Arrows, a crypto hedge fund that invested in Luna, had to liquidate. Losses on a loan to Three Arrows and contagion from Celsius forced Voyager into bankruptcy protection.

Meanwhile FTX trading affiliates Alameda Research and Voyager lent to each other, and Alameda and Celsius were also exposed to each other. But it was the connections between FTX and Alameda that undid the two companies. Like many platforms, FTX released its own cryptocurrency, FTT. After revealing that this was Alameda’s main asset, Binance, another major platform, said it would dump its own FTT holdings, ending the run that fueled FTX’s fall.

Genesis Global Capital, another crypto lender, had exposure to both Three Arrows and Alameda. He has suspended withdrawals and is looking for outside money after the demise of FTX. BlockFi, another crypto lender to be exposed to FTX and Alameda, is preparing to file for bankruptcy, the Journal reported.

The density of connections between these players is nicely illustrated with a sprawling diagram in an October report from the Financial Stability Oversight Council, which brings together federal financial regulators.

Historians, this litany of captures and falls is reminiscent of the free banking era from 1837 to 1863 when banks issued their own bank notes, when fraud and runs rose, when withdrawals were suspended, and panic occurred regularly. But while those crises regularly disrupt business activity, the economy is largely outpacing the crypto economy.

An illustration from an October report by the federal Financial Stability Oversight Council that illustrates the interconnected nature of the crypto universe.

Some investors, from unsophisticated individuals to venture capital funds and large pensions, have sustained losses, some of them life-changing. But these are qualitatively different from the types of losses that threaten the solvency of large lending institutions and the stability of the wider financial system.

To be sure, certain loan or investment losses from banks cannot be ruled out. Banks also provide custodial and payment services to crypto companies and hold their money, such as returning stablecoins. Several small banks serving crypto companies have been hit by a large outflow of deposits.

Traditional finance had little incentive to build connections with crypto because, unlike government bonds or mortgages or commercial loans or even derivatives, crypto played no role in the real economy. It is largely avoided as a payment method except where untraceability is critical, such as money laundering and ransom goods. Much-hyped crypto innovations like stablecoins and DeFi, a kind of automated exchange, largely facilitate speculation in crypto rather than useful economic activity.

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Crypto’s grubby reputation has put off mainstream financiers like Warren Buffett and JPMorgan Chase & Co. CEO Jamie Dimon, and made regulators nervous about the banks’ involvement. Over time this was bound to change, not because crypto was becoming useful but because it was generating so much profit for speculators and their supporting ecosystem.

Many banks have made private equity investments in crypto companies and many including JP Morgan are investing in blockchain, the distributed ledger technology that underpins cryptocurrencies. A flood of crypto lobby money has been asking Congress to create a regulatory framework under which crypto, having failed as an alternative to the dollar, could become a riskier, less regulated alternative to equities.

Now, stained by bankruptcy and scandal, cryptocurrency will have to wait longer – perhaps forever – to be fully accepted by traditional banking. Ending banking crises required a single national dollar to replace private currencies, the creation of the Federal Reserve as a lender of last resort, deposit insurance and comprehensive regulation.

It is not clear, however, that the same prescription should be applied to crypto: Effective regulation would eliminate much of the efficiency and anonymity that explains its appeal. And while the US economy obviously needed a stable banking system and a stable currency, it will do fine without encryption.

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