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Leaders | Crypto's downfall

Is this the end of crypto?

The collapse of FTX has dealt a catastrophic blow to crypto's
reputation and aspirations

[20221119_L]
Nov 17th 2022
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The fall from grace was hard and fast. Only a fortnight ago Sam
Bankman-Fried was in the stratosphere. ftx, his cryptocurrency
exchange, then the third-largest, was valued at $32bn; his own wealth
was estimated at $16bn. To the gushing venture capitalists (vcs) of
Silicon Valley he was the financial genius who could wow investors
while playing video games, destined, perhaps, to become the world's
first trillionaire. In Washington he was the acceptable face of
crypto, communing with lawmakers and bankrolling efforts to influence
its regulation.

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Today there is nothing left but 1m furious creditors, dozens of shaky
crypto firms and a proliferation of regulatory and criminal probes.
The high-speed implosion of ftx has dealt a catastrophic blow to an
industry with a history of failure and scandals. Never before has
crypto looked so criminal, wasteful and useless.

The more that comes out about the demise of ftx, the more shocking
the tale becomes. The exchange's own terms of service said it would
not lend customers' assets to its trading arm. Yet of $14bn of such
assets, it had reportedly lent $8bn-worth to Alameda Research, a
trading firm also owned by Mr Bankman-Fried. In turn, it accepted as
collateral its own digital tokens, which it had conjured out of thin
air. A fatal run on the exchange exposed the gaping hole in its
balance-sheet. To cap it all, after FTX declared bankruptcy in
America, hundreds of millions of dollars mysteriously flowed out of
its accounts.

Big personalities, incestuous loans, overnight collapses--these are
the stuff of classic financial manias, from tulip fever in
17th-century Holland to the South Sea Bubble in 18th-century Britain
to America's banking crises in the early 1900s. At its peak last
year, the market value of all cryptocurrencies surged to the giddy
height of almost $3trn, up from nearly $800bn at the start of 2021.
Today it is back at $830bn.

As at the end of any mania, the question now is whether crypto can
ever be useful for anything other than scams and speculation. The
promise was of a technology that could make financial intermediation
faster, cheaper and more efficient. Each new scandal that erupts
makes it more likely that genuine innovators will be frightened off
and the industry will dwindle. Yet a chance remains, diminishing
though it is, that some lasting innovation will one day emerge. As
crypto falls to Earth, that slim chance should be kept alive.

Amid the wreckage of the past week, it is worth remembering the
technology's underlying potential. Conventional banking requires a
vast infrastructure to maintain trust between strangers. This is
expensive and is often captured by insiders who take a cut. Public
blockchains, by contrast, are built on a network of computers, making
their transactions transparent and, in theory, trustworthy.
Interoperable, open-source functions can be built on top of them,
including self-executing smart contracts that are guaranteed to
function as written. A system of tokens, and rules governing them,
can collectively offer a clever way to incentivise open-source
contributors. And arrangements that would be expensive or impractical
to enforce in the real world become possible--allowing artists to
retain a stake in the profits from the resale of their digital works,
for instance.

The disappointment is that, 14 years after the Bitcoin blockchain was
invented, little of this promise has been realised. Crypto's frenzy
drew in talent from bright graduates to Wall Street professionals,
and capital from vc firms, sovereign-wealth and pension funds. Vast
quantities of money, time, talent and energy have been used to build
what amount to virtual casinos. Efficient, decentralised versions of
mainstream financial functions, such as currency exchanges and
lending, exist. But many consumers, fearful of losing their money, do
not trust them. Instead they are used to speculate on unstable
tokens. Money-launderers, sanctions-dodgers and scammers abound.

Presented with all this, a sceptic might say that now is the time to
regulate the industry out of existence. But a capitalist society
should allow investors to take risks in the knowledge that they will
make losses if their bets go sour. Even as crypto has imploded, the
spillovers to the wider financial system have been manageable. ftx's
backers included Sequoia, a Californian vc firm; Temasek, a
Singaporean sovereign-wealth fund; and the Ontario Teachers' Pension
Plan. All have lost money, but none catastrophically.

Moreover, sceptics should acknowledge that nobody can predict which
innovations will bear fruit and which will not. People should be free
to devote time and money to fusion power, airships, the metaverse and
a host of other technologies that may never come good. Crypto is no
different. As the virtual economy develops, useful decentralised
applications may yet appear--who knows? The underlying technology
continues to improve. An upgrade to Ethereum's blockchain in
September radically reduced its energy consumption, paving the way
for it to handle high transaction volumes efficiently.

Instead of over-regulating or stamping out crypto, regulators should
be guided by two principles. One is to ensure that theft and fraud
are minimised, as with any financial activity. The other is to keep
the mainstream financial system insulated from further
crypto-ructions. Although blockchains were explicitly designed to
escape regulation, these principles justify regulating the
institutions that act as gatekeepers for the cryptosphere. Requiring
exchanges to back customer deposits with liquid assets is an obvious
step. A second is disclosure rules that reveal if, say, a gargantuan
and dubiously collateralised loan has been made to the exchange's own
trading arm. Stablecoins, which are meant to hold their value in
real-world currency, should be regulated as if they were payment
instruments at banks.

Tulip bulb or light bulb?

Whether crypto survives, or becomes a financial curiosity like the
tulip bulb, will not ultimately depend on regulation. The more
scandals ensue, the more the whole enterprise and its aspirations
become tainted. The lure of innovation means nothing if investors and
users fear their money will disappear into thin air. For crypto to
rise again, it must find a valid use that leaves the dodginess
behind. #

For subscribers only: to see how we design each week's cover, sign up
to our weekly Cover Story newsletter. And you can listen to Money
Talks, our podcast on markets, the economy and business, which this
week discussed the rise and fall of Sam Bankman-Fried and the future
of crypto.

This article appeared in the Leaders section of the print edition
under the headline "Crypto's downfall"

Leaders November 19th 2022

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Crypto's downfallCrypto's downfall

From the November 19th 2022 edition

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