Lack of Crypto Regulation Means the Economy is Safe. But Your Money Isn’t

Cryptocurrency companies are in the news again, and like the last few times this year, it's not good. Another collapse, this time of the exchange FTX and its associated hedge fund Alameda Research may be the worst yet. The cryptocurrency industry and the wider world, is learning the reason cryptocurrency projects, tokens, and yield-farming was held at arm's length for so long by regulators and traditional finance. Fear of change wasn't the concern, it was fear of contagion.

Our US economy and the broader world economy will weather this as nothing more than a blip on the radar. However, it is likely to attract serious attention from Congress and regulators. The cryptocurrency ecosystem was still very disconnected from the real financial system and our real economy. This protected our financial system from another calamity. However, this doesn't mean real money from smart people, big institutions, and average mom-and-pop investors wasn't completely erased in the blink of an eye. Real damage was done, but little of it will spread to the economy in the same way as the mismanaged housing risks of 2007–2008.

VCs and institutional investors are likely to flee the space for a while if not indefinitely after the extremely public collapse of FTX and its CEO/cryptocurrency poster boy Sam Bankman-Fried. There are lessons to be learned from this situation (if they weren't already during the first four major collapses this year). For regulators, this should solidify the resolve to keep cryptocurrencies in their box and not open it up to be connected to the wider financial industry. For individual investors, the lesson is simple: The risk of total loss when investing in cryptocurrency is substantial. No one has your back.

For those catching up, here is a brief timeline of some of the notable events of 2022 that led us to the most recent (and ongoing crisis). This story is certainly not over, and it seems like more details are released daily. The true assessment of the damage may not arrive until a proper audit of FTX (and others) is conducted through bankruptcy proceedings.

2022 Major Cryptocurrency Company Collapses (YTD)

  1. Terra/Luna: The bottom of the purported stablecoin fell out around May which was a major factor in the ensuing collapse which is still playing out as we speak

  2. 3 Arrows Captial (3AC): A hedge fund focused on cryptocurrency which managed ~$10B in (illiquid) assets. They were unable to pay back lenders and the founders are still on the run.

  3. Voyager Digital: A brokerage service that was forced to pause customer withdrawals before eventually filing for bankruptcy. The primary reason for failure was due to a loan to 3AC they could not repay.

  4. Celcius Network: Marketed as a "bank", Celsius offered users interest on their deposits (some as high as 15–17%). Customer deposits were lent out, and like Voyager, they halted withdrawals before filing for bankruptcy in July.

  5. Alameda Research: A cryptocurrency hedge fund founded by Sam Bankman-Fried and run by Caroline Ellison. Alameda predates FTX and is the cause of FTX's downfall.

  6. FTX: A cryptocurrency exchange that was closely tied to the hedge fund Almadea Research and both were founded and owned by Sam Bankman-Fried. Due to an ongoing list of sins, FTX was unable to pay back depositors and filed for bankruptcy on Nov. 11.

  7. BlockFi: A cryptocurrency exchange that was on thin ice during the Voyager and Celcius bankruptcies but remained active until the FTX collapse. Customer withdrawals are currently paused after the expected acquisition by FTX is obviously not going to proceed.

  8. Others? Almost definitely, but it's anyone's guess who will be next. (Clue: Gemini Warns of Withdrawal Delays, DCG Writes Letter to Investors)

2022 is shaping up to be a year of historical significance (like 2021 and 2020 before that…). While 2020 was unique due to a contagious virus in the form of the Covid-19 pandemic, 2022 is proving to be memorable for a very different kind of contagion.

Contagion (original definition): the communication of disease from one person to another by close contact.

In an economic context, contagion refers to the spread of an economic crisis from one market or region to another and can occur at both a domestic or international level. Like a disease, economic or market contagion can spread risk and financial calamity from one entity to another due to interconnectedness and poor risk management.

Famous examples of economic contagion are The Latin American Debt Crisis (1987–1989) and The Asian Financial Crisis (1997) and the pièce de résistance: The Great Recession (2007–2009). At the time of the first two, the world was beginning to become more interconnected and this kind of regional and worldwide impact was not as expected as it is today when we have such significant worldwide economic overlaps. Although The Great Recession (TGR) in particular was American-Made, the entire world caught a nasty cold. During 2008–2009, global trade fell 15% and estimates by the IMF suggest that economic output declined in 50% of all countries in the world.

We can draw a straight line from The Great Recession to our exact financial circumstances today, including the boom in cryptocurrencies. A few factors impacted how we got here:

Firstly, Bitcoin was created in the aftermath of the 2008 recession as a response to the dependence on traditional financial institutions and reliance on banks as financial intermediaries. By creating a decentralized, peer-to-peer monetary system, Bitcoin can move and transact without the need for middlemen to be involved. Bitcoin was and is a rallying cry for independent and libertarian-minded idealists who don’t want other people, companies, or governments interfering with their money. Bitcoin’s 21 million coin cap seeks to maintain a hard limit on the amount available, therefore creating scarcity as demand rises. That’s the theory at least, we can discuss how it works in practice another time.

As Bitcoin grew in prominence and the ideas behind it spread, other cryptocurrencies were created and they themselves have increased in value and notoriety (Ether, Cardano, Litecoin, Monero, etc — there are literally thousands). As interest in these coins grew, prices grew, which brought interest from people who believed less about the libertarian ideals and more that they can become wealthy.

This is where the second effect of the 2008 crisis comes into play. Low-interest rates and accommodating monetary policy funneled unprecedented amounts of money into both public and private companies. There has been so much money available, it didn’t take much of a business plan to attract investment. The lack of sufficient due diligence from OG VCs like Sequoia has proven just how easy it was for fraudulent companies like FTX to thrive in a pumped-up, free-for-all market mania.

Fueled by the economic policies of the 2010s which were designed to get the country back on its feet after a crisis, the cryptocurrency industry expanded rapidly through unregulated Initial Coin Offerings (ICOs), forks (when coins split), and the magnetic pull of nearly consequence-free fraud (shhh…). With abundant money sloshing around the economy, it flowed everywhere from nascent and established real companies to the most nebulous cryptocurrency ideas. Even parodies were being bid up by amateurs and professionals alike.

As the world entered 2020 and the pandemic hit, abundant stimulus money accelerated the growth of internet stocks and internet money. Everything hit a fever pitch and there was no better place to make a few quick (billion) bucks on the backs of unsophisticated individuals than cryptocurrency’s eternal (but still not at all realized) potential. Institutional adoption has been growing and there was a clamor for broader access to investable products like cryptocurrency ETFs or NFTs. Continued institutional adoption and more acceptance of cryptocurrency as a legitimate financial tool will lead to greater overlap for traditional banks, credit cards, lending, etc with the new, hot crypto-related companies. This should be discouraged.

Many evangelists in the space are claiming that the wait-and-see approach of the SEC or CFTC is holding back investors and disadvantaging the little guys who aren’t comfortable or can’t figure out how to access cryptocurrency investing themselves. As it turns out, the regulators were right. And they will continue to be right if they decide to keep our financial system as far away as possible from the cryptocurrency industry.

One of the many curious wrinkles in the unfolding FTX story is the amount to which Sam Bankman-Fried had been pushing for meaningful regulation and was actively working with government institutions such as the SEC to implement new rules and guidelines. Had his company not imploded, and had regulation been implemented it would have allowed traditional finance and crypto-finance to intertwine and endanger the broader economy. If this year has shown us anything it is how precarious and illegitimate these organizations are as a financial ecosystem.

If the cryptocurrency industry is to be allowed to continue, two things must be firmly established.

First, a separate and parallel regulatory infrastructure built solely for cryptocurrency should be avoided. It might sound attractive to rush into creating custom oversight that fits the world of cryptocurrencies but this would be a mistake. Fitting regulations on top of an industry that was built to be an anonymous, might-makes-right libertarian playground that is unfriendly towards smaller, lower-information users will not fix it. It will institutionalize those dangers while opening the floodgates for traditional institutions to get tied up in the next catastrophe. If cryptocurrency cannot fit into our existing financial rules, it is because it seeks to subvert those rules and protections.

SPACs were an excellent example of this within the traditional financial system. Despite the structure being around for decades, SPACs grew in popularity recently. Since 2019, many companies that could not or would not be able to meet the burden of a proper IPO went public via SPAC and turned out to be disastrous for investors. Loose guidelines that can hide a lot of sins allow company insiders to dump equity on an unsuspecting market. Cryptocurrencies, existing outside of any regulatory framework, have taken this to an extreme by promoting world-changing projects and delivering nothing of value. A recent research paper that studied the Uniswap decentralized exchange writes “we labeled 26,957 tokens as scams/rug pulls and 631 tokens as non-malicious.” This amounts to 98% of the studied tokens being deemed fraudulent.

Second, traditional financial institutions should remain wholly separated from cryptocurrency business activities in the same way that investment banking and commercial banking used to be (and should be) separate. Removing the barriers between the two financial systems would be drastically more dangerous than the risks brought on by the removal of Glass-Stegall. Can you imagine if FTX and others had been able to access lending through the traditional banking system instead of fellow cryptocurrency companies? In a study by the Basel Commission on Banking Supervision using data from 2021, it was shown that banks’ exposure to cryptocurrency amounted to only 0.14% of total asset exposure. This proved to be prudent. Keeping cryptocurrency business activity in a walled garden protects our financial system even while it may still risk the money of the individual investor who isn’t properly managing their risk.

While both small and large investors are certainly in danger of losing money in both cryptocurrencies themselves and the public or private companies associated with them, all investments are a buyer-beware situation. What many investors are learning this year, and unfortunately will continue to learn is that cryptocurrency exchanges, tokens, lenders, and projects are largely not trustworthy. While I imagine there are those that are above board, it appears to be the exception rather than the rule. Endangering non-investors by paving the way toward more interconnectedness when the risks are so apparent would be foolhardy.

If we are to protect our economy, which includes investors and non-investors alike, policymakers should be careful not to allow traditional financial companies to become entwined with cryptocurrency organizations. Legitimizing cryptocurrency by offering to give it special treatment via loose and permissive rules will allow it a lifeline to entrench itself deeper into our economy when it should be left alone to survive or die on the merits of its own business practices.

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