FTX, S&Ls, and the problem with a “grow out of it” mindset

Friends,

Some thoughts and analysis in the wake of FTX, and a quick take on what this means for our industry.

1. First, for the avoidance of doubt, we don’t have any direct exposure to FTX:

As a company, we do not use FTX for any services, we do not trade on FTX, and more generally, we do not keep investor’s funds in crypto assets. We are a software company that keeps cash in a bank account, and uses the funds to build software.

2. Some perspectives as an entrepreneur that’s new to the space:

The FTX saga is disheartening to say the least. Perhaps the most striking aspect of the FTX debacle is how shockingly simple the issue appears to be. There are many things that businesses should never do, and 2 of the obvious ones are:

• Take short maturity customer deposits and use them to fund risky illiquid investments.
• Engage in business dealings that create blatant conflicts of interest (eg sending billions to fund another company you majority own).

I tend to over-index towards empathy. I genuinely believe that people make mistakes for all sorts of perfectly legitimate reasons, and deserve forgiveness in most circumstances. But this is not one of those situations. These are exceedingly simple concepts.

3. S&Ls and their relevance:

The Savings and Loan crisis of the 1980s holds some lessons for today. What happened there was:

• S&Ls took deposits from customers and promised a % return with short maturity.
• They then took those deposits and lent them to longer-maturity homebuyers as fixed rate mortgages.
• When interest rates rose, the value of those mortgages got wiped out and, unsurprisingly, led to huge losses. Note, these mortgages were $480bn in 1980 (about half of all mortgages outstanding at the time). This is equivalent to $1.7tn in today’s dollars.
• Regulators decided to deregulate the industry in response to this to allow S&Ls to “grow out of” their problems. The S&Ls proceeded to offer higher rates, attract more deposits, and under newly granted authority, make even riskier loans. Despite clear insolvency problems, the industry grew from 1982–1985 by 56% largely by taking on more and more risk.
• Unsurprisingly, the S&Ls never actually “grew out of it”, and 747 S&Ls with assets of $407bn were closed by 1995, with an ultimate cost to taxpayers of $124bn.

4. The lesson as applied to today:

• The danger of “grow out of it”. When the only option is to “grow out of it” (in any industry, including crypto), it incentivizes terrible behavior, and the crypto industry MUST figure out how to better prevent these scenarios (the field of tokenomics will specifically need to reckon with this). The hard part is that in distressed situations, a “grow out of it” mentality is often rational from an expected value perspective because of 0 lower bounds. Take the example where there are 2 paths: 1. Taking lower risk that leads to a 100% probability of going to 0 (bankrupt), and 2. Taking on extreme risk leads to a 30% probability of being above 0. In this scenario, the expected value calculation financially incentivizes the latter path, even if it leads to a high probability of tremendous collateral damage (whether to creditors, depositors, or taxpayers). If crypto can’t figure this out, it will suffer the same fate of S&Ls, or be reduced to a novelty.
• Depositors bearing consequences. In the S&L crisis, taxpayers (not depositors) bore the costs. In the 2008 financial crisis, over 450 banks failed, but depositors in American banks didn’t lose any of their deposits. In the case of FTX, depositors will likely bear a large cost. This is hugely problematic because customers expect deposits to be safe. Once again, if the crypto industry can’t figure out how to facilitate that, it presents a tremendous barrier to adoption.
• The trust bar for adoption has been raised for both our current users, and the next billion. We often hear the argument that users are in crypto because of community, enthusiasm about crypto’s principles, or enthusiasm about the tech. But we’ve spoken to hundreds of users at this point and the vast majority are there because they are looking to make money, or invest for retirement. To convince these users to come back, the industry will need to offer either 1. Utility or 2. Financial returns. But none of those matter if we can’t get to a base layer of safety.

5. Back to first principles: Decentralization, Transparency, and Immutability. The silver lining in this FTX episode is that it will hopefully cause the industry to get back to focusing on customer use cases where web3 principles create a distinct advantage: So far, arrows are pointing in the right direction for DeFi. The potential for a faster/better/lower cost financial system is still there. Tokenization is compelling. But in order for these to flourish, we have to lower users’ required effort and level of risk associated with accessing decentralized, transparent, and immutable web3 tech. Right now, it’s too complex, difficult to understand, and scam-prone (even for experts). This is where we’re trying to help as a company on a mission to make web3 safe for all.

Regaining user trust will require both creativity and mature leadership. I hope to work with all of you to make this happen.

Sincerely,

Ricky