The Crypto Meltdown Could Have Been So Much Worse

The cryptocurrency world is melting down, much as the subprime market did in 2007. Back then, scarcely understood financial products in high demand pitched the world into crisis. Is that about to happen again?

This is one question raised by the spectacular fall of FTX, a massive crypto exchange started by Sam Bankman-Fried, a press-loving billionaire (well, as of two weeks ago), generous financier of Democratic politicians and effective-altruism causes (as of two weeks ago), and young guy known as a good guy in the scammy world of crypto (you get the idea). Exactly what happened at FTX remains unclear, and how the sudden death of a $32 billion firm might affect the financial markets and the real economy remains unknown.

Yet, for now, the situation is demonstrating two things. The first is that, for all the hype about bitcoin, and for all the speculative money pouring into firms such as FTX, the crypto world remains a fringe niche within the larger financial system. And the second is that, precisely because regulators in the United States and other countries understood crypto’s risks, traditional financial institutions—the creators of the subprime mess—are walled off from the current meltdown.

The central problem is that cryptocurrencies remain little more than speculative assets and the crypto markets are little more than a casino, rife with fraud. For years, though, Wall Street has been desperate to pour money into crypto. And for years, crypto has been desperate to take Wall Street’s money. To facilitate that, crypto entrepreneurs and investors have pressed for laws and regulations that would let them operate without the scrutiny normally applied to American investment banks, commercial banks, exchanges, and trading firms. Regulators have slow-walked some of those carve-outs, while Congress has yet to pass legislation opening up financial markets to crypto, and thus Washington might have prevented catastrophe.

The FTX debacle started earlier this month, when Ian Allison at CoinDesk published a story showing that the main asset on the books at Bankman-Fried’s crypto-trading firm, Alameda Research, was a digital token issued by FTX; market watchers took this as evidence that Alameda might be using FTX assets to cover its trades. A drop in the value of the token would imperil both firms, and that drop soon materialized. The chief executive of Binance, one of FTX’s main rivals, announced that Binance was liquidating its holdings of the FTX token. Others followed suit. FTX investors began to pull their money from the exchange, causing a kind of bank run. Binance considered stepping in to support FTX, but pulled out after doing due diligence on the embattled company. After that, the exchange behemoth did not so much collapse as evaporate into thin air.

The fallout has been nuclear among cryptocurrency-related firms, leading to write-offs, asset freezes, and concern about the viability of the whole sector. The price of bitcoin, ether, and a number of other digital currencies and tokens has plummeted, as have the stocks of many crypto firms. “Today is a bad day,” Edward Moya, a market analyst at OANDA, wrote in a research note. “Many crypto companies will likely be vulnerable.”

The vulnerability is widespread because of numerous incestuous entanglements among crypto entities. Alameda and FTX seem to have been dangerously linked: Bankman-Fried might have been using what FTX customers thought of as safe deposits in custodial accounts to finance transactions involving Alameda. FTX was pouring money back into the very venture-capital firms that were pouring money into it. Problems with crypto firms are leading to sell-offs in cryptocurrencies; sell-offs in one cryptocurrency are causing sell-offs in other cryptocurrencies. The market is “extremely interconnected,” concludes Filippo Ferroni, an economist at the Federal Reserve Bank of Chicago, and thus extremely volatile. Price movements become self-amplifying and reverberate across the entire sector.

Yet the FTX debacle has thus far had no evident impact on the stock market, nor has it had any effect on the stocks of publicly traded financial firms. The Wall Street “fear index,” a measure of financial volatility, went down a touch when FTX went down in flames. A number of firms wrote down or are expected to write down the value of their investments in FTX. But there is little concern about systemic risk, at least for now. “There might be pension funds directly exposed to FTX,” Mark Hays of Americans for Financial Reform told me. “They’re starting to mark down their valuations to zero, and that could extend the circle of damage further. But if you’re not an institutional investor investing directly in crypto assets or firms like FTX, then you’re not exposed.”

Why is the contagion so limited? I asked that question of Dennis Kelleher, a co-founder of Better Markets, a nonprofit that advocates for financial regulation in the public interest. “The only reason we do not currently have a financial crisis, with a crash and with bailouts, is because regulators have withstood enormous pressure to allow interconnection and linkages between the crypto activities and the core of the financial and banking system,” he said. Because of their regulators’ stance, American banks are not collateralizing loans with cryptocurrencies, for instance. They are not freely trading crypto derivatives.

Meanwhile, an aversion to U.S. regulation has kept crypto businesses, many of which are based offshore, from getting more deeply involved in American finance. “If you are registered with the SEC and regulated by the SEC, you are required to have segregation of customer accounts,” Kelleher explained. “You’re required to have books and records. You’re required to have codes of conduct that include prohibitions on or identification of conflicts of interest. You’re prohibited from commingling funds. You’re required to have margin capital, and you have liquidity requirements.” Crypto companies “did not want that,” Kelleher said. He added: “It’s a Ponzi scheme. When there was tulip mania, at least when you lost all your money, you still had a tulip.”

Hays told me that members of Congress should keep the FTX debacle—and its so far limited impact—in mind when considering how to regulate crypto in the future. “The debate has centered around this idea that we need to foster special regulations for this new and growing industry,” he said. “Policy makers on both sides of the aisle really should be thinking about getting it right.”

A lack of financial contagion does not mean a lack of financial harm. The FTX collapse has caused billions of dollars of losses, and the crypto sell-off is clobbering the many small-scale investors who put a bit of cash into the volatile, moon-shot asset in the past few years. At least those kitchen-table investors are not being asked to bail out businesses caught making risky bets and misappropriating their clients’ funds.