How the Crypto Collapse May Have Done the Economy a Favor

This year's crypto collapse has many of the same features as a classic banking crisis, including runs on banks, fire sales, and contagion.

What it is lacking are banks.

If you look at the bankruptcy filings of crypto platforms Voyager Digital Holdings Inc., Celsius Network LLC and FTX Trading Ltd. and hedge fund Three Arrows Capital, you won't find any banks listed as their largest creditors.

Bankruptcy filings don't give a clear picture, but they suggest that many of the largest creditors are customers or other crypto-related companies. In other words, crypto companies operate in a closed loop, deeply interconnected within that loop but with few apparent connections to traditional finance. This explains how an asset class that was once worth roughly $3 trillion could lose 72% of its value, and prominent intermediaries could go bust, with no discernible spillovers to the financial system.

Crypto space is largely self-contained, according to Yale University economist Gary Gorton and University of Michigan law professor Jeffery Zhang. In a forthcoming paper, they write that once crypto banks obtain deposits from investors, they borrow, lend, and trade with themselves. They do not interact with firms connected to the real economy.

A few years from now, the regulatory and banking landscape might look very different if it weren't for the crypto meltdown. The intensifying pressure on these industries to embrace crypto may have prevented a much wider crisis.

Crypto has long been marketed as an unregulated, anonymous, frictionless, more accessible alternative to traditional banks and currencies. However, its mushrooming ecosystem looks a lot like the banking system, accepting deposits and making loans. In an article, Messrs. Gorton and Zhang write, “Crypto lending platforms recreated banking all over again… if an entity engages in borrowing and lending, it is economically equivalent to a bank even if it’s not labeled as one.”

Cryptocurrencies are just like the banking system in that they are leveraged and interconnected, and thus vulnerable to debilitating runs and contagion. This year's crisis began in May when TerraUSD, a purported stablecoin, collapsed as investors lost faith in its backing asset, a token called Luna. Rumors that Celsius had lost money on Terra and Luna led to a run on its deposits and in July Celsius filed for bankruptcy protection.

Three Arrows, a crypto hedge fund that had invested in Luna, was forced to liquidate its holdings after the company defaulted on a loan. The resulting losses forced Voyager into bankruptcy protection.

Meanwhile, FTX's trading affiliate Alameda Research and Voyager had lent to each other, and Alameda and Celsius also had exposure to each other. But it was the linkages between FTX and Alameda that were the two companies' undoing. Like many platforms, FTX issued its own cryptocurrency, FTT. After this was revealed to be Alameda's main asset, Binance, another major platform, said it would dump its own FTT holdings, setting off the run that triggered FTX's collapse.

Genesis Global Capital, another crypto lender, had exposure to both Three Arrows and Alameda. In the wake of FTX's demise, it has suspended withdrawals and sought outside cash. The Journal has reported that BlockFi, another crypto lender with exposure to FTX and Alameda, is preparing a bankruptcy filing.

The density of connections between these players is nicely illustrated in an October report by the Financial Stability Oversight Council, which brings together federal financial regulators. The report includes a sprawling diagram that shows the interconnectedness of the financial system.

This litany of contagion and collapse is reminiscent of the free banking era from 1837 to 1863, when banks issued their own bank notes and fraud proliferated. Yet while those crises routinely walloped business activity, crypto's has largely passed the economy by.

Some investors have certainly sustained losses from investing in cryptocurrencies, with some losing significant amounts of money. However, these losses are not the same as the losses that could threaten the solvency of lending institutions and the financial system. While it is possible for such losses to occur, banks' exposure to cryptocurrencies comes primarily from providing custodial and payment services, and holding cryptocurrency companies' cash.

Traditional finance has had little incentive to get involved with cryptocurrencies because, unlike more traditional investments like government bonds or mortgages, cryptocurrencies don't have any real-world applications. They've mostly been used for illegal activities like money laundering and ransomware, and even the much-hyped innovations in the space like stablecoins and DeFi mostly just facilitate speculation rather than actual economic activity.

Crypto's reputation as a dirty and dangerous investment has kept mainstream financiers like Warren Buffett and JPMorgan Chase & Co. CEO Jamie Dimon at bay. However, this was bound to change eventually, not because crypto was becoming more useful, but because it was generating huge profits for speculators and their supporting ecosystem.

Several banks have made private-equity investments in crypto companies and many are investing in blockchain, the distributed ledger technology underlying cryptocurrencies. A flood of crypto lobbying money has prodded Congress to create a regulatory framework under which crypto, having failed as an alternative to the dollar, could become a riskier, less regulated alternative to equities.

Cryptocurrency has been stained by bankruptcy and scandal, and this has caused traditional banking to hesitate in fully embracing it. In order to end banking crises, private currencies need to be replaced with a single national dollar. The Federal Reserve needs to be established as the lender of last resort, and deposit insurance and comprehensive regulation need to be put in place.

It isn't clear whether the same regulatory approach should be applied to cryptocurrencies. Effective regulation could eliminate many of the features that make cryptocurrencies appealing, such as efficiency and anonymity. And while the U.S. economy clearly needed a stable banking system and currency in the past, it may not need crypto in the future.