MDS Insights on the FTX Failure vs 2008 Crisis: Same Bad Bets, Different Market
On Thursday, November 11, 2022, FTX International filed for Chapter 11 bankruptcy. This bankruptcy proceeding takes FTX from a company valued at $32 Billion to $0.
One of my early projects during my time at the Federal Reserve Board was called a Material Loss Review, which selected studies that explored why 300+ FDIC banks failed during the 2008 financial crisis. In many of these cases, these bank failures could be attributed to aggressive growth strategies (high concentrations of real estate loans) combined with insufficient credit risk management practices, which could not withstand a deteriorating real estate market. These factors almost always led to asset quality deterioration and bank failures.
The failure of FTX appears to be the same story in a different market. FTX’s sister company, Alameda Research had aggressive trading and lending strategies that overextended the company's reserves. It is reported that FTX extended loans of about $10 billion to Alameda using funds that customers had deposited on the exchange for trading. FTX's existing reserves and practices might have been adequate in a bull market –but in a deteriorating cryptocurrency market, where assets have been severely devalued for nearly 1 year (plus a liquidity crisis given Binance's massive sell-off FTX's token, FTT), the asset quality of everything deteriorates fast. In FTX’s case, it happened in several days.
High concentrations of leverage that risk customer funds have no place in the cryptocurrency markets. Swift regulatory standards are needed to ensure that cryptocurrency exchanges and cryptocurrency companies have adequate capital reserves and risk management practices in place to weather future financial storms.
Lastly - did we swear off the entire banking industry when several hundred banks failed in 2008? No - we didn't. But we did ask for our banks and financial services firms to do better and create the practices, guidelines, and internal processes to become stronger more resilient institutions. And we asked for regulatory guidance to make sure that happened. And the cryptocurrency industry is no different. Despite FTX and the other failures this year, there are thousands of amazing professionals and companies in the cryptocurrency space that are committed to making the industry safe, fair, and productive for the next generation.