Before the 2008 financial crisis, trading firms began to act like shadow banks packaging subprime mortgages into securities and distributing them throughout the financial system.
One particular trading and brokerage firm, Lehman Brothers, accumulated a risky portfolio of securities derived from home mortgages worth four times more than the company’s equity without regulators having any insight into its business. When the real estate market crashed, and homeowners began defaulting on their mortgages, the securities derived from them collapsed too. The crisis bankrupted Lehman Brothers, threatening much of the rest of the financial sector with insolvency, leading to the foreclosure of 10 million homes and a doubling of unemployment to 10%.
What just happened to FTX this week looks a lot like Lehman’s collapse for the cryptocurrency world. Earlier this week, shadowy business dealings by FTX, a crypto exchange that also acts as a brokerage, lender, and owner of a subsidiary proprietary trading company Alameda Research, came to light. As the price of FTX’s token tanked, FTX received $8 billion in withdrawal requests from panicked depositors. Without assets to back up their holdings, and no one willing to bail them out, the firm teetered on the edge of insolvency. Virtually overnight, the company’s valuation plunged from $32 billion to near zero.
It’s still too early to know if the panic will spread to the rest of the crypto world, but on Nov. 9 JPMorgan analysts wrote in a research note “that a new cascade of margin calls, deleveraging and crypto company/platform failures is starting.”
The core problem with Lehman Brothers and FTX is the same: the secrecy and lack of regulatory oversights required of traditional banks.
It’s all about risk
The financial crisis proved that the problem of banks being “too big to fail” was not about size. It was that financial risk-taking had exceeded regulators’ ability to oversee it, writes economic policy analyst Gregg Gelzinis for the Center for American Progress. In 2008, this new set of rogue financial actors from General Electric to AIG created novel systematic risks that upended the US economy while leaving average citizens paying the bill.
In 2022, the financial deception by crypto firms was similar. This time, however, the fallout has been contained within the cryptocurrency world—at least for now. Over the summer of 2022, well before FTX, the crypto market had already crashed along with the price of the TerraUSD algorithmic stablecoin. Crypto lenders Celsius and Voyager digital went bankrupt, erasing $2 trillion in wealth. FTX may be an acceleration of these trends.
So far, the real economy appears to be unscathed for two reasons. First, the entire crypto market is valued at $936 billion, relatively small compared to the rest of the economy. Secondly, the losses are mostly speculative investments by investors rather than productive assets such as real estate. In theory, even if crypto’s market cap went to zero, US unemployment would not go up much except in the tech sector.
What’s next for crypto? Breaking up the exchanges
It’s possible that the FTX crash could accelerate the regulation of crypto exchanges as securities exchanges, said Tyler Gellasch, executive director of the Healthy Markets Association and a former SEC lawyer. This would require crypto exchanges to no longer be brokers or lenders in addition to being exchanges, and the SEC would choose what types of cryptocurrencies are listed on the exchanges.
If so, it would mirror the learnings that from the global financial crisis when the US imposed several reforms on shadow banks. Two of the most critical were:
- creating a Financial Stability Oversight Council (FSOC) which has the authority to subject risky shadow banks to consolidated supervision and higher regulatory standards.
- imposing reporting requirements about firms’ risk exposure to the US Securities and Exchange Commission (SEC), giving the regulator insight into what shadow banks are doing.
“After the crisis, we got insight into the interconnectedness,” said Todd Phillips, an independent progessive policy advocate and former Federal Deposit Insurance Corporation (FDIC) lawyer. “We still don’t have that with crypto. We really don’t know what’s going on.”
If crypto does avoid regulation, it may only be because it doesn’t threaten the US economy the way shadow banks did in 2008, said Steven Kelly, a research associate at the Yale Program on Financial Stability. That means agencies will step in to regulate stable coins backed by US Treasuries (those claiming to be pegged 1:1 to the US dollar), while leaving the rest up to the market.
“Like what’s left to regulate?” Kelly said. “I think stable coins are easier, because you have more clear interconnections with the banking system, and there’s a story to tell about payments that may matter in the future. For some of this more fringe stuff, it’s like online gambling. You have to make it illegal and hope people don’t jump through the hoops to get around that.”