Crypto's systemic stress test
Crypto is facing a crisis moment — and its ecosystem is proving much less capable of reacting in a way that's predictable and fair than the dollar-based system generally does when firms implode.
Why it matters: There will always be institutions that take on too much risk or that end up insolvent. A well-functioning system will swing efficiently into action in such cases, while a chaotic system will spiral into ever-greater troubles.
The big picture: Much of the current crypto winter is a function of two familiar markets phenomena — failed arbitrages and commingling of customer funds.
- Both were seen in the 2011 implosion of MF Global, the small brokerage that was taken over by Jon Corzine after his stints running Goldman Sachs and New Jersey.
- Of note: MF Global's clients ended up getting all their money back. So did creditors of Lehman Brothers. Even Madoff depositors are almost whole. In each case, a robust legal system worked exactly as it was designed.
Driving the news: This crypto down cycle is being driven by "levered long" trades getting unwound. As in many previous market implosions — LTCM springs to mind — such trades are often associated with arbitrage plays.
- The idea is to use borrowed money to buy item X, which should be worth the same as item Y, at the same time as shorting item Y. Then when the two prices converge, you make a profit.
- Trades that have blown up have included ones saying that 1 Terra should be worth 1 dollar, or that 1 stETH should be worth 1 ETH, or that the share price of GBTC should be worth the same as the value of the bitcoin in that fund.
Between the lines: The borrowed money that funded such trades came not from arbitrageurs (they were the borrowers) but rather from depositors who are now rushing to get their money back from shops like Celsius and BlockFi.
- Flashback: MF Global customers will remember the feeling. Their money was used to cover losses on an ill-starred arbitrage play involving European sovereign bonds.
What's new: Crypto is a wild west by comparison. There's no established jurisprudence surrounding the seniority of depositors; indeed, there's not even any consensus on which jurisdiction companies should be incorporated in, and therefore which governing law should be used.
- Lehman Brothers was often described as being "too interconnected to fail." Perhaps crypto shops like Three Arrows Capital were in a similar position.
My thought bubble: Billionaire Sam Bankman-Fried of FTX is trying to play a role akin to that played by John Pierpont Morgan during the panic of 1907, before actual institutions were created to stem bank runs. His fire-sale potential acquisition of BlockFi pointedly puts depositors first, but that kind of individual intervention is hard to scale or institutionalize.