The Centralised De-Centralised Crypto-economy

That White Paper and the creation of the first cryptoasset, Bitcoin, were inspired by the infamous collapse of Lehman Brothers Holdings Inc., which followed Bear Stearns some months earlier.  Faith in a centralised financial system had been thoroughly shaken.

Nakamoto's envisioned a decentralised financial system without the need to place cash deposits or trust in banks, and a payment method secured by cryptographic encryption, rather than trust in an institutional third party.  And so, blockchain technology and cryptoassets were born.

Exactly 14 years later, the FinTech and mainstream press are full of articles asking the question "Is this crypto's 'Lehman Brothers' moment" – the moment when trust in blockchain and cryptoassets is shaken: is this crypto's financial crash?

Crypto-Crash 2022:  A TradFi mentality

The answer to those questions are still being unravelled.  But there are certainly a number of similarities with 2008. 

As in 2008, the collapse of the crypto exchange FTX has had a collateral effect on investor confidence, with other exchanges putting restrictions on withdrawals  or even filing for bankruptcy.

And as in 2008, the enormous financial impact on consumers and the potential systemic effects of the collapse of a key market player has (perhaps belatedly) drawn the eye of regulators around the world.

And it appears, in light of the limited but increasing volume of information emerging over the past few days, that. as in 2008, the collapse of such a major player in the market was not because of a fundamental weakness in the system itself, but because certain market participants were playing hard and fast with the rules to make more and more money.

The 2008 financial crash arose from the over-investment in, amongst other things, collateral debt swaps – financial products given high credit ratings despite being based on underlying debts which were incredibly risky.  When the market suddenly lost confidence in them (precipitated, in part, by Michael Burry and others' 'Big Short'), there was not enough liquidity in the market to cover margin calls and investor withdrawals.

In 2022, it appears that the collapse of FTX has arisen from similar circumstances:  the artificial inflation of the value of FTX's FTT cryptoassets, and leverage based on that inflated value, despite the true value being far lower, followed by a fall in consumer confidence (precipitated by the announcement of a competitor exchange, Binance, that it would be liquidating all of its FTT holdings) led to a 'run' on FTX in circumstances where its liquid assets were insufficient to meet its liabilities.

This was not the 'decentralised' and 'transparent' cryptographic model envisaged by Satoshi Nakamoto: indeed, FTX appears to have more closely resembled a traditional discretionary fund manager – albeit one without any internal risk management controls or regulatory oversight. 

Market Recovery and Growth

Much of the news around FTX has focussed on its founder's lavish lifestyle – drugs, sex, A-lister endorsements, and donations to the Democratic party – but at its core, the collapse of FTX appears to have arisen because a centralised institution was trusted to be acting in a legitimate manner and taking appropriate care of its investors, and it was not.

In some ways, the fault for this lies with investors: the 'line always goes up', the 'fear of missing out' – investors saw other people making money from crypto-investments and wanted to be part of that.  And, in some cases, that led to them turning a blind eye to the potential risks. 

Some investors suffered, particularly non-sophisticated consumers who would usually have been protected from those investments by regulation controlling what and how the institution could operate, by consumer protection warning rather than glossy, enticing adverts, and by some form of independent oversight.

These losses arose because investors placed their trust in a centralised institution, and that trust was, seemingly, misplaced.  And that centralised institution wanted to earn their trust to make money from those investors, and the more the investors trusted, the more the institution could take.

The Future from the Past?

The financial system may have collapsed in 2008, but it did not disappear.   It was rebuilt, and reformed, with significant new levels of regulation introduced around the protection of client assets, and more stringent requirements on financial auditors, and a host of other measures which are still in the process of being introduced, not least the recent introduction of the 'New Consumer Duty' by the FCA.

The crypto market may have taken, and will continue to take, a confidence hit in 2022, but there is no doubt it will stick around, be rebuilt and reformed.  If it is too difficult for investors to move away from a semi-centralised system then perhaps centralised platforms, with a new systems of regulatory oversight – not only financial regulation, but regulation of governance, liquidity management and conflicts of interest – are the only way to make it work safely.

14 years ago Satoshi Nakamoto wrote of a decentralised financial system: peer-to-peer rather than investor-to-bank.   Perhaps the future of crypto is in self-hosted wallets, peer-to-peer payments, and decentralised autonomous organisation – a return to that 2008 post-crash vision.