Nov 19, 2022 - Economy

The huge risks embedded in the cryptoverse

Illustration of the "mind blown" emoji as an exploding coin.

Illustration: Shoshana Gordon/Axios

The 2008 financial crisis was caused when a formerly boring industry — banking — got taken over by risk-seekers. Crypto was dominated by risk-seekers from the beginning, making the current implosion all but inevitable.

Why it matters: The bankruptcy of FTX has precipitated renewed calls for tougher and more effective regulation of the crypto markets, with the idea being that such regulation would make the industry safer and less risky.

  • The catch: Almost no one in crypto has any real desire for it to be safe and boring. The only thing it's proved really good at is providing a venue for high-risk speculation.
  • Indeed, there's a strong case that the best thing to do with crypto is to keep it entirely unregulated, lest regulation confer undeserved legitimacy on the asset class.

Driving the news: In an interview with Kelsey Piper of Vox this week, FTX founder Sam Bankman-Fried admitted that his repeated calls for more regulation of the crypto industry were insincere and done only for their PR value.

  • "F*ck regulators," he said.

The big picture: Nick Dunbar, in "The Devil's Derivatives," his masterful account of the financial crisis, draws a distinction between "the men who hate to lose" and "the men who love to win."

  • Most humans are in the "hate to lose" camp. As Dunbar says, "normal people are constitutionally, genetically, down-to-their-bones risk averse: they hate to lose money."
  • Crypto speculators are in the risk-seeking minority: "somebody who, when confronted with uncertainty, sees not danger but opportunity ... For them, the misery of losing barely merits a moment’s consideration. Such people have a very high tolerance for risk. To be more precise, they crave it."

It's the mindset captured by Adam Fisher in his (sadly now deleted) profile of SBF: "Very high risk multiplied by dynastic wealth trumps low risk multiplied by mere rich-guy wealth."

  • "SBF needed to find a path on which he’d be a coin toss away from going totally bust."

The catch: If you take that path and flip enough coins, you're almost certain to go totally bust sooner or later.

  • SBF was explicitly unworried about that. He calculated everything in terms of "expected value," even if the probability of actually realizing that value was tiny.
  • "SBF would have kept flipping double or nothing," tweeted Harvard's Jason Furman. "With probability 0.00001% he would have ended up owning the entire universe. And with probability 99.99999% bankruptcy."

What they're saying: "SBF needed extreme risk to maximize the expected value of his lifetime earnings," wrote Fisher.

By the numbers: SBF told Fisher that his goal was to make $5 trillion.

  • If his plan had a 0.02% chance of succeeding, and would otherwise go to zero, that would give it a positive expected value of $1 billion — a number high enough to make it well worth pursuing, even with a 99.98% chance of ignoble failure.

The bottom line: As SBF explained in 2020, his philosophy was that "all-in maximizes long term growth." Always keep risking everything.

  • That helps explain why his back-office and compliance teams were so small — and why FTX ended up going to zero.
  • It also helps explain why crypto more broadly is so volatile and prone to blow-ups.
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