Dear Crypto: You Have No Lender Of Last Resort

I said I wasn’t going to write about FTX and Sam Bankman-Fried, and God knows I don’t want to.

Crypto, Web3 and decentralized finance are, in my partially informed opinion, not fit for consideration by serious investors of any kind (let alone institutional investors), and may pose significant (but mercifully not systemic) spillover risk to traditional assets and even the broader economy.

It’s that latter consideration that ultimately compelled me to weigh in on what it’s fair to describe as the most dramatic development yet in a year of high drama for cryptocurrencies and everything to do with them. For new readers, note that I’m not a “no-coiner,” nor am I someone who didn’t try to embrace decentralized finance and Web3 more generally. The linked article (above) details my earnest efforts to get involved, both as an investor and as a well-meaning patron of tokenized photography (i.e., NFT art). I still own Bitcoin and I kept the NFTs I bought for posterity.

One thing I learned while editorializing breathlessly around decentralized finance this year is that most serious investors don’t care about the details, in part because the industry often seems to operate on a maddeningly self-referential loop. That’s a polite way of saying that for many skeptics, the pervasiveness of circular reasoning in the space suggests the ecosystem runs on Ponzi dynamics, and is therefore not worth analyzing.

Based on several private discussions I had Tuesday, some feel the same way about the Binance-FTX shotgun wedding. That is: Some crypto critics viewed it as one multi-level marketing business bailing out another, in the interest of keeping a pyramid they both shared from collapsing. My choice of multi-level marketing as an analogy is suboptimal, but it does allow me to make the point without suggesting malfeasance. Multi-level marketing isn’t illegal in most jurisdictions, and can be a completely legitimate way of doing business.

Without delving too far into details readers aren’t interested in, FTX ran into what it described as liquidity problems after Binance’s Zhao “CZ” Changpeng, the richest man in crypto, tipped his intention to sell more than a half-billion worth of FTX’s native coin, triggering an exodus. Bankman-Fried and Zhao subsequently announced a tentative deal for Binance to acquire FTX for an undisclosed sum likely not materially different from zero.

The entire episode was triggered by questions around Bankman-Fried’s Alameda Research, a quant-arb shop which, according to a report, held a significant portion of its assets in the FTX coin. As CoinDesk, which broke the story, wrote, “there is nothing per se untoward or wrong about that [but it] shows Bankman-Fried’s trading giant rests on a foundation largely made up of a coin that a sister company invented, not an independent asset like a fiat currency or another crypto.”

That prompted Zhao’s decision to sell the FTX coin, and FTX subsequently suffered $6 billion in withdrawals over just 72 hours prior to Tuesday, effectively forcing Bankman-Fried to ask Zhao for help. Over the past several months, Bankman-Fried embraced the role of crypto John Pierpont Morgan, after rescuing a series of ailing industry players. As Matt Levine put it, “CZ SBF’ed SBF.”

On Wednesday, Bloomberg said Binance was unlikely to go through with the deal after all. “At issue is Binance executives’ finding through due diligence that the gap between liabilities and assets at FTX is likely in the billions, and possibly more than $6 billion,” Vildana Hajric and Muyao Shen wrote, citing a source familiar. Binance later confirmed the reporting. “As a result of corporate due diligence, as well as the latest news reports regarding mishandled customer funds and alleged US agency investigations, we have decided that we will not pursue the potential acquisition of FTX,” the company announced.

The reference to “alleged US agency investigations” was to yet another sources story, in which Bloomberg said that in addition to questions about customer funds, the SEC and CFTC are investigating FTX’s liquidity crunch, and the relationship between the exchange and its US arm, as well as Alameda. “The SEC’s inquiry began months ago as a probe into FTX US and its crypto-lending activities,” sources said.

It’s possible this could be the tipping point for crypto. I won’t elaborate on that assessment. Instead, I’ll abstract myself from the specifics of the FTX-Binance story and speak in very broad terms in order to make this amenable to a general audience and thereby worth readers’ time.

Fractional reserve banking is a Ponzi scheme of sorts. If everyone comes to the bank at the same time demanding their money, in cash, right then and there, the bank fails. Everyone knows that. Or at least I hope so. Further, the entire financial system is self-referential, and, as we learned in 2008, liquidity crunches can collapse the system if everyone stops trusting their counterparties. Moreoever, our entire system of credit creation and, to a large extent, the entire economy, is built on maturity mismatches and liquidity transformation. The banking system generally borrows short to lend long (e.g., mortgages), and illiquid assets are bundled, alchemy-style, into ostensibly liquid ones (e.g., high yield credit ETFs). The reason all of that works is simple: There’s a lender (or, more aptly in modernity, a dealer) of last resort with the capacity to provide unlimited liquidity in a reserve currency and/or to make markets and close spreads.

Here’s the key: JPMorgan isn’t a lender of last resort. Neither is Bank of America. That wasn’t the role they played in 2008 with Bear Stearns and Merrill. The Fed is the only lender of last resort in the US financial system. Bankman-Fried might’ve been crypto’s JPMorgan (until Binance became his JPMorgan), but neither Bankman-Fried nor Zhao Changpeng are crypto’s lender of last resort. Crypto (proudly) has no lender of last resort. That’s supposed to be a selling point. But, as I’ve tried, with no success, to explain to innumerable crypto enthusiasts, a system that employs any version of fractional reserve banking, any sort of maturity mismatch or any sort of liquidity transformation, must have a lender (or dealer) of last resort. If it doesn’t, a serious liquidity crunch will, by definition, put the system at risk of collapse. It can’t be otherwise. That assessment is tautological. It’s not a debate. It’s true by definition.

Maybe that isn’t relevant for Bitcoin itself, in isolation. But it’s relevant for virtually everything else in the space. I’ll leave it there. Because there’s nothing left to say.