Fallout from the FTX bankruptcy and the future of crypto

The digital world is going to survive. Digital is the future of finance.

But digital is going to be regulated.

The recent experience with the failure of FTX (FTT-USD) shows us, as stated in the Financial Times, that the digital world will become as fully regulated “as financial services businesses.”

The current situation is going to accelerate the move to greater regulation.

At present, the digital world is going through “the weeding out” stage of what works and what doesn’t work in a space that is remarkably changed. The transformation the world is moving through is breathtaking. But a world that is transforming can be a painful process.

Lots of people have lost lots of money.

But as Andy Kessler states in The Wall Street Journal, “Bubbles collapse when no one else buys in.”

The problem right now, as Kessler notes, is that the crypto market “is backed by nothing but air.” But the technology behind the crypto market, behind the digital market, is incredible, and will find a place in the financial world.

After all, finance is nothing but information, and modern information technology is providing the world with the tools to grow and spread information.

Originally, cryptocurrencies were praised as the new “medium of exchange” for the world. They were to provide the payment system for the future.

The fact that cryptocurrencies would also be a “store of value” was important, but was not originally at the top of the list of characteristics that would cement the role of cryptocurrencies in the world.

Serving as a medium of exchange would guarantee the role of cryptocurrencies in the world. There was a real purpose for these cryptocurrencies, cementing their value to the world.

Whoops! Something went out of line. The medium of exchange ability of the cryptocurrencies was not secured when the asset was introduced to the world. As a consequence, cryptocurrencies had to justify their existence by being just a store of value, but it was not readily apparent that they really brought something of added value to the world.

The bubble

Cryptocurrencies did not catch on quickly after their introduction. For example, Bitcoin was introduced in 2009.

As I showed in a recent post, nothing much happened for the first ten years or so of Bitcoin’s existence. Then in 2020, the price of Bitcoin began to rise.

The apparent cause of this rise was the massive amount of money that the Federal Reserve System was injecting into the US financial system. These monies were being injected to protect the United States against a financial collapse that might be started by the consequences of the Covid-19 pandemic and the subsequent recession that followed.

The price of financial assets rose dramatically during this time, and the rise in these prices took on the form of a financial bubble. The spread of financial resources moved into most sectors of the financial world. Traditional asset managers benefited from the spread of this money, but new areas also benefited from the movement.

One highly reported sector that benefited greatly from this spread was the “blank check” company, or Special Purpose Acquisition Company (SPAC), that flourished during the 2021-2022 period. Blank check companies are having problems all over the place now, and deals are just not being cut.

Bitcoin made its move, and its price rose to over $67,500 on November 8, 2021. Since then, the path has been downward. In the past day or so, Bitcoin has been down around $16,000.

And the S&P 500 Index (SP500) reached an all-time high on January 3, 2022, but has since tumbled as the Federal Reserve has tightened up its monetary policy. A lot of sectors prospered during the past two years, but now a lot has changed and many of those same sectors have suffered in the reversal.

This is what happens when you have asset bubbles.

The other side

FTX is now “on the rocks.” It is struggling for its life.

Sam Bankman-Fried is said to have apologized for his failure. He is also looking for $8 billion to plug the hole in his ship and keep it afloat for the near term.

As we read in the Financial Times:

“The nascent crypto industry was already struggling with a price crash triggered by the end of the cheap money era. The humbling of Sam Bankman-Fried (SBF) is a further blow.

“The collapse of FTX has been likened to a bank run: Account holders were rushing to get their crypto assets but were being blocked from doing so.”

The next step: regulation, and lots of it.

Gary Gensler, chair of the U.S. Securities and Exchange Commission, has already accelerated the move. Gensler was already on the track to greater regulation for the crypto world.

Now the door has opened wide for him. If he doesn’t get most of what he wants now, I would argue that he has really muffed a “gimme putt.”

This is the history of innovation.

Eventually, the sector comes to the point where regulation is almost required. When the market consequences connected with the innovation become hurtful and much is lost, people step back and let the regulators in the door. In fact, they welcome them in.

The future is digital, there is no question in my mind about that. The future includes crypto. Information grows and spreads. That is what history tells us.

But getting there can be very painful to many and it can be very difficult finding the “best” path to the future. It happens. FTX is just another step down the road.

Regulation coming

Regulators are facing something that they have never really faced before: globalization. The collapse of FTX, which filed for bankruptcy in the U.S. in November, has set the scene.

The regulators cannot back off now. Events are thrusting markets into places of no return.

First, the regulators are dealing with modern information technology. The advancements in this space are enormous and are a challenge to oversee even in their simplest form. But the evolution of modern information technology advancements is global in nature and hence outside of any real geographic oversight.

As Martin Arnold states in the Financial Times: “One of the biggest problems confronting regulators (is) the difficulty in pinning down where many crypto asset providers were based.”

Historically, regulation is set up for specific legal entities and specific geographic territories. This specificity does not exist for current crypto asset providers.

In the case of FTX, there is a “multijurisdictional web of wholly owned subsidiaries and intercompany loans including entities in the Bahamas, Cayman Islands, Antigua and Barbuda, as well as the U.S., Japan, Germany and Switzerland.”

Modern information technology is global and must be perceived to operate in a global fashion. Unfortunately, all this liquidity floating around is enabling crypto players to take advantage of opportunities that are available to them. FTX was just one of those players.

But the situation is getting more serious. The crypto world must be brought under control.

This, I believe, is going to be quite some battle. Unfortunately, this battle is going to be taking place at the same time that world central banks are facing very severe inflationary problems.

The world is in a great disequilibrium and these problems are going to have to be worked out over time. My concern is that many individuals are going to suffer a lot of pain.