FTX and When Foxes Guard Hen Houses

by Larry Hatheway | November 28th, 2022

A great deal has been written about the demise of FTX, the cryptocurrency exchange run by Sam Bankman-Fried (SBF). Many of the post-mortems have focused on potential fraud, drawing comparisons to Enron’s collapse in the early 2000s. Less ink has been spent on understanding the underlying flaws of digital finance, which must be addressed if the industry is to recover and flourish.

In what follows, we offer a few FTX lessons for digital finance that go beyond the journalistic narrative of intrigue, malfeasance, and sloppiness.

To begin, what do we mean by digital finance? On one level, it is nothing more than offering financial services — such as payments, borrowing, or investments — via computers, smartphones, and tablets. That transition is already well advanced, with digital financial services routinely offered today by traditional banks and asset managers.

A narrower, but increasingly oft-used definition of digital finance is the delivery of financial products and services via the blockchain. In this usage, digitalization encompasses cryptocurrencies, as well as non-fungible tokens (NFTs), which offer fractional ownership of non-traditional assets. For our purposes, we will focus on this second understanding of digital finance.

In this narrower form, digital finance ostensibly offers three goods.

The first good is private money as an alternative to government-issued fiat (or public) money. As is now commonly understood, such private money is created (‘mined’) via algorithms. The aim is to limit digital money supply and therefore enhance its appeal relative to public money, which can be (and in recent years has been) issued in massive quantities.

The second good is a platform for issuing assets (i.e., NFTs) that offer fractional ownership claims on private assets. In this sense, digital finance enables the securitization of nearly anything of value. It is akin to a stock market that offers savers access to asset returns as well as new sources of capital to asset owners.

The third good offered by digital finance is a secure platform (claimed to be hack-free) beyond the reach of regulators and perhaps even the tax collector.

Digital finance is relatively new. The blockchain dates to 2008. And like many new inventions that capture the public attention, digital finance has been prone to hype, fraud, and speculation.

As noted, that is not unusual. In their early stages many new technologies are susceptible to swindle and malfeasance. In the 1990s, for example, the advent of the internet and dotcom companies was accompanied by spectacular financial follies and failure. But for all the damage done by the greed and avarice of the late 1990s and early 2000s, the miscreants did not undermine the intrinsic value of the internet, namely connectivity and its commercial applications. However messy its arrival, the internet survived and laid the foundations for the subsequent commercial successes of search, networking, logistics, and much else.

In that sense, it is important to look beyond the particulars of the FTX collapse and whether it was a pyramid scheme, an attempt to defraud, or colossal case of stupidity. Probably all are true at some level, but none of those factors is of lasting importance. Fraudsters, hucksters, and dimwits are replete in financial history, but they are not terribly important for history. If digital finance is to overcome the stain of FTX, it must better understand its value proposition and its fundamental vulnerabilities.

What is the central value proposition of digital finance? It is not as a platform for private money (cryptocurrencies). Private money is highly unlikely to replace fiat (public) money for a host of reasons familiar to any first-year student of economics. It does not enjoy widespread acceptance, and it is far too volatile to be a store of value or a unit of account. It is not issued from a nation with a military to stand behind its promises, nor backed by central banks, which present a fatal flaw in the event of a ‘run’. The only exception may be in the case of failed states, which are unable or unwilling to ensure the stability of fiat money.

Rather, digital finance is far more likely to succeed as a low cost and flexible platform for securitization, offering savers access to returns from otherwise private assets and their owners new sources of capital. The blockchain, in other words, is less likely to disintermediate fiat money than it is to compete with investment banks in providing asset securitization services.

But to do so, digital finance must address a fundamental challenge of finance, namely the need to establish and subsequently maintain the trust of those it serves.

All forms of finance must overcome asymmetric information and misaligned incentives. Asset issuers know more about the intrinsic value of those assets than their potential investors. Asset managers may face a conflict of interest between their own profits and their clients’ best interests.

Customers are generally aware of the fact that they know less than the institutions and markets that serve them. Accordingly, they will generally refrain from participating if they believe the system is designed to take advantage of their informational inferiority.

Accordingly, the backers of digital finance must do more to ensure that investors deserve their trust. That need exists even if deceit, malfeasance or worse had never occurred at FTX. Equally, proponents of digital finance must underscore that the merits of their approach do not reside in cryptocurrency speculation and easy profits, nor that the industry merely represents a false libertarian ideal.

That last point is crucial. Because of the need to ensure trust in the presence of asymmetric information and non-aligned incentives, digital finance can only succeed within the boundaries of a financial system underpinned by law, not outside of it. It cannot survive, much less thrive, if the hen house is perceived to be guarded by the foxes.

Indeed, the sooner the digital finance industry invites regulatory oversight the sooner it will embark on a sustainable path towards realizing its potential. Trust is the bedrock of finance, and trust is best established and reinforced by a robust legal and regulatory framework that prevents insiders from taking advantage of outsiders.

In its original incarnation as a platform for cryptocurrency, digital finance emerged with the mistaken belief that it could succeed outside of the legal system and the institutions, private and public, that ensure today’s safekeeping of assets. If FTX has done any good, it is that it shattered that misguided belief.

In the aftermath of FTX’s collapse no one should lament the loss of a false libertarian ideal with no foundation in the practicalities of economics. Digital finance has too much promise to let false idols thwart its potential.

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