FTX is the Perfect Example of the Dangers of Free Markets
If you haven't been following the crypto news, well, good for you. My advice to everyone who has asked over the last couple of years has been to avoid investing in crypto. It is all basically just an unregulated game theory carousel that was bound to come crashing down sooner or later. Perhaps I should have anticipated that it wouldn't crash until interest rates were higher--but that was a risk I wasn't going to take with my money, so I wasn't going to suggest someone else take that risk.
I guess it isn't fair to say that crypto is entirely unregulated. There are some regulations, but this gets us into the murky business of trying to decipher whether crypto is a currency, a security, a derivative like stablecoin, or some other asset class altogether. Crypto itself isn't a monolith, different crypto coins could easily fall under different asset classes.
But none of this stopped the free market scheming, like pump and dump parades, that would land people in prison for doing similar things with stocks. Nothing I write in this newsletter should ever be interpreted as investment advice, but this is why I was never going to invest in crypto. Sure, I could have made a killing while things were hot--but everyone can always make a killing when anything is hot. The key is to get out before it freezes, and given the free and unregulated nature of crypto, there was no good way of predicting when that freeze would happen.
Enter Sam Bankman-Fried (SBF).
SBF realized that crypto was pretty much useless by itself. In order to really gather investment clout it needed a market maker. I won't go into detail about market makers, but this is one of the best explanations out there (plus it's really kinda schadenfreude funny, at least since the author can laugh about it too), especially as it applies to the FTX collapse. So, SBF started FTX to be an exchange and market maker for crypto.
As a market maker, FTX itself was regulated in the standard US financial way. SBF wanted to avoid all of this regulation, so he housed the main operations of his crypto empire in the Bahamas.
I don't want to get into the details about what happened to FTX, there is also plenty of good stuff out there. I recommend (as usual) Matt Levine for any and all details about financial machinations.
Essentially what this all boils down to is a pretty much unregulated asset class being dominated by an exchange that had gone to the Bahamas to avoid regulation.
Now, I'm not a regulation hawk. I've said before, and will keep saying, that any regulation that does not make markets more competitive is a bad regulation. So, if you're new here and just thinking that I'm a utopian lefty who believes government regulations can solve all our problems, you should probably go back and read some of my other stuff.
If you do, one thing you'll see written over and over is this: free markets and competitive markets are not the same thing. Capitalism requires competitive markets, and the US made the mistake in the 80s of assuming free markets would be competitive markets. We were wrong, and the US doesn't look much like a capitalist country anymore. I think the data is pretty clear that the US would benefit from more capitalism. But this requires competitive markets. FTX is exactly what happens when markets are left to be more or less free from competitive enforcement.
The lure of crypto has always been that it operates as a decentralized financial instrument. No person or entity could control it or make governing decisions. This is a dream come true for anti-government and anti-competition types, but it creates at least two specific economic problems. The first problem with this setup is that it by nature excludes people who don't have the resources to participate. If someone can't understand how crypto works, or forgets their password, or isn't following all the subreddits about which crypto coin to pump a mile high and what day to sell it, they can lose everything. The entire setup of decentralization requires really high burdens of participation on would-be participants.
To solve this problem people like SBF come along and make companies like FTX. The market inefficiency of decentralization is solved by companies becoming a central hub, creating an oversized influence on the market itself just by their hubby nature.
This leads to the second big problem. Because there are basically no rules around crypto trading these schemes that would be illegal with more traditional asset classes are free game. People have to move fast or they can be caught standing when the music stops. In traditional economic theory people are rational, and one of the things that is supposedly done by rational people is to collect all the necessary information before making a decision. But, this isn't possible when things are completely decentralized.
When trading other financial assets, a trader can look up underlying financials pretty quickly. They can see how much debt a bank holds, they can see how much sales revenue a company had last quarter, they can see what lawsuits are pending for a manufacturer. None of this applies to crypto, so people have to make decisions quickly, and based on nothing but the best internetting they know how to do. Along comes FTX and gets fancy names and faces to endorse it, and in the fast paced decentralized world of crypto, people are basically like, "Yeah! Wow, bro! Tom Brady uses FTX?!?! They must be cool then. I'm in too!" And nobody ever worried about what was actually happening at FTX.
Turns out it was a clown car that made Enron look like a Mercedes S class.
SBF didn't even know how many people were working for him! Let alone any good books on their financials, or even the slightest hint at a governance structure. In a more competitive market big companies employ teams of lawyers to make sure all their ducks are in a row, and their customers and investors demand to see the work they lawyers do so they know what they are getting into. But in a totally free market there isn't time for that. Steph Curry says FTX is good, so it's good!
Essentially, SBF put FTX in a place where it could cure market inefficiencies that existed in the free market of crypto. But, because it was a free market, he had no enforcement mechanism to ensure he filled those inefficiencies in a safe, responsible way--so he didn't. The worst parts of the free market were cured by the worst parts of the free market. FTX bought legitimacy through celebrity endorsements, but didn't do anything to actually be legitimate. He used the free market to its fullest extent.
And everything crashed.
When it did SBF had nowhere to turn because crypto was a free market, not a competitive one. And this decentralization meant nobody was willing to bail out a company that traded in an asset that had nothing to back its value. So, it didn't have value. And because it didn't have value, nobody was willing to buy in or bail him out.
This isn't to say that crypto itself is bad, or that market makers are gonna screw people. This isn't true at all. But in the wild west that is the current crypto market, a lot of people lose their hats.
The solution is not to get rid of crypto--it can be a useful financial instrument for some things. The solution is to make the market operate like a market, not the O.K. Corall. In a competitive market the system isn't designed for most online bros to make a killing while people who don't have the time to check threads all day long get stuck. This is pretty close to exactly what the free market system did. But in a competitive market--a capitalist market--these inefficiencies get worked out. With regulation to make sure the market is competitive there are exchanges and market makers that have to be legit, or people can go to prison.
If you are objecting right now because banks did something kinda sorta similar in 2008 and nobody went to prison, I'm agreeing with you. The US markets have not been competitive enough for a long, long time. Where the competition has been enforced in crypto markets, it has worked well. We are seeing a wave of crypto exchange bankruptcies in the wake of FTX because competitive markets are working well. Companies that are unable to compete for market share go bankrupt--that is how capitalism works. If a company isn't in a strong enough position to withstand the FTX tsunami, they don't survive; if a company didn't do the rational thing and look in to FTX's operations before exposing themselves to FTX's leverage, they don't survive. If the market is not competitive, companies can go FTX.
Part of the reason no bankers went to jail after 2008--and 2008 even happened in the first place--is due to one of the worst trends in policy: big companies regulating themselves. This happens in two forms, both leading to non competitive outcomes. Sometimes, regulators let companies run regulatory in house. Boeing is the best example of this, and it led to planes falling out of the sky. But an even larger problem is companies writing their own regulation.
I detailed this when the Facebook scandal broke. Mark Zuckerberg came to DC and said he needed to be regulated, then told lawmakers how he should be regulated. Facebook still hasn't seen any meaningful regulation. They continue to be anticompetitive, and papered over their infringements by renaming themselves Meta.
Believe it or not, SBF was in the middle of helping DC regulate crypto. The Digital Commodities Consumer Protection Act (DCCPA) has been slowly cooking for a while in DC, and none other than the FTX man himself has been in the kitchen. Given the collapse of FTX, and the now infamous details of the company's operations, it seems outrageous that this guy was ever anywhere near a regulatory bill. But he was, and this is completely normal in DC. Banks, drug makers, tech, and a number of other industries more or less write their own regulations these days. The belief that the free market will solve all problems gave lawmakers the confidence to lean on the expertise of industry leaders, and more time to spend fundraising so they can make us all more angry about politics. It has become so common that the movement from DC to big companies has come to be known as the revolving door.1
If free markets worked, this would make sense. Industry leaders understand their industry better than anyone else (ideally), so having them help would lead to good outcomes. But free markets don't work. Instead of working for good outcomes these executives have an incentive to work for outcomes that will benefit their companies. When their stay in DC ends, they want to go right back to the corner office at the top floor of their industry. Writing regulations that force big companies to compete won't make them friends at their old playground. This regulatory capture was a significant factor in the 2008 crash where banks were caught with their pants down.2
In hindsight, it seems clear that SBF shouldn't have been anywhere near a regulatory bill. But it shouldn't take hindsight to see what a bad idea this is. Rather than relying on free markets, which lead to FTX outcomes, Congress should push for competitive markets. If companies write their own rulebook they will put in rules that help them and hurt competitors.3 In free markets companies will inevitably pursue what economists call rent seeking; it's our fancy way to say an entity extracts more out of a transaction than would be expected in a competitive setting. The decentralized nature and free market dynamics of crypto led straight to SBF seeking rent. The deals may have seemed fair to the traders, but FTX carried on an incestuous and highly profitable relationship with its sister company, Alameda. On top of this, FTX was skimping on all the legitimizing work that was expected by traders using them as an exchange and market maker. Even if FTX wasn't gouging traders they were seeking rents by making traders believe they were legit and well run.
This is the expected outcome in a free market. If freedom is defined as the ability to have unencumbered decision making then companies will always seek rent to grow larger. This isn't because companies are bad, this is because it is the easiest way to get ahead of competitors in a free market. Free markets lead to companies like Amazon owning everything. What the United States needs are more competitive markets, and FTX is the perfect example of just how severe this need has become.
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Brezis, Elise S., and Joël Cariolle. "The revolving door, state connections, and inequality of influence in the financial sector." Journal of Institutional Economics 15, no. 4 (2019): 595-614.
Boubakri, Narjess, Ali Mirzaei, and Anis Samet. "National culture and bank performance: Evidence from the recent financial crisis." Journal of Financial Stability 29 (2017): 36-56.
Laffont, Jean-Jacques, and Jean Tirole. "The politics of government decision-making: A theory of regulatory capture." The quarterly journal of economics 106, no. 4 (1991): 1089-1127.