Reviews |  Idle Crypto is the devil's workshop

Reviews | Idle Crypto is the devil’s workshop

The newest monetary system in the world can be undone by the oldest problem there is.

A few weeks ago, Sam Bankman-Fried’s FTX cryptocurrency exchange crashed in a classic run. Investors were spooked by the evidence that the exchange had mismanaged their money and couldn’t refund them, so they panicked. And they were right. They couldn’t get their money back.

The blockchain technology behind the cryptocurrency was supposed to make such occurrences a thing of the past. But FTX’s business was to act as a gateway to (and out of) cryptocurrency. This company still depends on humans to serve as honest guardians. And we’ve seen time and time again that humans can’t resist the main temptation that comes with this role: using their customers’ money for their own ends.

The collapse of FTX could be the start of a wave of cryptocurrency exchange failures. Since these exchanges are largely unregulated, they are not subject to the same rules imposed on other exchanges to protect their clients’ money. And there is no one looking over the shoulders of exchange managers to keep them honest. Given that – and given my experience in studying the development and regulation of financial markets – I think it’s quite likely that other companies will do what FTX did with the money from its customers, and that some of them will similarly explode, especially now that crypto investors are nervous and looking for signs of trouble.

A similar wave of crashes occurred recently in China in the fintech peer-to-peer lending sector. P2P lending, which connects people looking for loans with people who have money to invest, took off in China in 2014 like nowhere else in the world, thanks to pent-up demand for consumption and China’s “wait-and-see” regulatory approach. But the operators of the P2P platform could not help but use their clients’ deposits for their own purposes. The problem was so widespread that when Chinese regulators stepped in, they chose to shut down the country’s entire industry. The last P2P lender closed in 2020.

Problems with mismanagement of customer funds occur even in advanced economies that have rules prohibiting it. US commodity brokerage firm MF Global went bankrupt in 2011 after misappropriating client funds to cover losses from the CEO’s bond trades. The managing director was Jon Corzine – a former Goldman Sachs executive, who would have been well versed in the rules. (Mr. Corzine said he was unaware that the customers’ money had been used.)

These examples show that cash, whether in the form of yuan, dollars, or lines of code, is the devil’s workshop. We say money burns a hole in your pocket because most of us can’t resist the urge to spend the money that’s left in our wallets. Likewise, idle money lying around in any business or financial organization naturally attracts people who want to invest it to make more money (or save themselves). In the case of FTX, there is growing evidence that Mr. Bankman-Fried diverted client funds to his crypto hedge fund, Alameda Research, and made loans to himself and others. company employees.

Companies have ongoing problems with managers wanting to spend their company’s extra money on pet projects. For operators of financial institutions, it is incredibly difficult to resist the temptation to dip into customer cash balances. If they could just use the money for a short time, they reasoned, they could make a good profit and then return the rest to its rightful owners. No one needs to be wiser.

In that light, Mr. Bankman-Fried’s downfall is dramatic and interesting – especially the revelations about his extreme disorganization – but really nothing new. He is yet another person in a long line of people who couldn’t stand seeing all that money sitting around doing nothing.

FTX was supposed to be the best crypto exchange. Mr. Bankman-Fried said he intends to donate his fortune to effective altruistic causes and is known as one of the few exchange CEOs actively calling for better regulation of crypto. If he couldn’t resist the temptation to treat client funds like his personal piggy bank, it seems likely that other crypto exchanges could do the same.

Many crypto exchanges, such as Binance, are already on regulators’ radar screens for possibly selling unregistered securities or potentially dangerous investment products. In addition to the hacking attacks that steal millions of dollars from crypto investors and the raffles and other outright frauds that occur in the creation of new cryptocurrencies, crypto investors are now realizing that their money can also be lost the old fashioned way.

The values ​​of cryptocurrencies and their exchanges reflect the nervousness of investors. The price of Binance Coin, a proxy for the value of the Binance exchange, has fallen nearly 25% since the FTX debacle. Trading volumes on almost all major cryptocurrency exchanges are falling, as are the prices of other cryptocurrencies.

The danger of executives playing with their customers’ money is why most countries require brokerages, stock exchanges and similar financial institutions that accept customer deposits to segregate their customers’ money from the company money and prohibit them from using their customers’ money for any purpose other than to make purchases expressly ordered by their customers. In the United States, only banks and mutual funds can invest their customers’ deposits, and they are highly regulated.

The best hope for crypto is for exchanges to agree to be regulated by the same ground rules that apply to other brokers and exchanges regarding segregation and the use of client funds. Some crypto advocates believe they can use “smart contracts” that run automatically without human intervention and other decentralized and automated protocols to ensure that customer funds are not misappropriated. These innovations would be a welcome improvement. But the first step is to adopt the rules and regulations that these protocols would then enforce. Crypto exchanges must also be transparent about their dealings, holdings, and dealings so that regulators can easily monitor their activities and enforce these rules.

For many, the lessons of FTX’s collapse are clear: there is something deeply wrong with cryptocurrency that makes it too dangerous to be included in the mainstream of finance. And the people who operate cryptocurrency systems and the exchanges where cryptocurrencies are bought and sold are crooks, not visionaries.

None of these conclusions is correct. FTX’s collapse had very little to do with the characteristics of cryptocurrency in general or the specific characteristics of the coins that FTX minted and distributed. FTX failed because the people running the company didn’t follow some basic financial rules that can be difficult to enforce even in well-regulated markets.

And Sam Bankman-Fried is neither a visionary nor a criminal mastermind. He is a human being who made the same bad choice that generations of fund managers have made before him.

Connel Fullenkamp is Professor of Practical Economics at Duke University. He writes on the development and regulation of financial markets.

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