In Ernest Hemingway’s 1926 novel The Sun Also Rises one of the disillusioned young adults of the interwar era is asked how he became bankrupt. “Gradually and then suddenly,” he replies. This quote, so apt that it has become a cliché, describes in a few words the exponential curve that defines so many events. Things happen to us little by little, and then all at once.
Less well known is the paragraph that follows, in which the young man is asked what “brought on” his financial ruin. “Friends,” he replies. “I had a lot of friends… Then I had creditors, too. Probably had more creditors than anybody in England.”
Sam Bankman-Fried, the 30-year-old founder of the now-bankrupt FTX cryptocurrency exchange, had many friends, with whom he did fun things like setting up a complicated mass of companies from the Bahamas or making large political donations. He now, reportedly, has fewer friends and more creditors. A lot more: according to his company’s latest bankruptcy filings, FTX and its associated companies could owe money to “more than one million creditors”. Many of these are retail investors who gambled their savings on FTX; others are institutions that are owed hundreds of millions of dollars.
The most important of these could be Genesis Trading, which supplies the kind of “prime brokerage” lending and trading services to professional investors using cryptocurrencies that banks in the City of London and on Wall Street provide to fund managers investing regular money. Genesis is particularly important, not just because it’s a big trading company in its own right but because it’s a subsidiary of Digital Currency Group, a major pillar of the cryptocurrency economy.
On 9 November Genesis stated that it had “no material exposure” to FTX or its plummeting FTT token, and estimated that the fallout from the FTX collapse could cost it around $7m. The following day Genesis remembered that it had $175m locked in FTX, which most people would consider at least a little bit material, but that it would “not impact our market-making activities”. By the middle of the following week, however, Genesis had suspended withdrawals from its lending arm, and the next day the Wall Street Journal reported that Genesis was seeking a $1bn capital injection to help it negotiate a “liquidity crunch”. In a statement, Genesis said it had “no plans to file bankruptcy imminently”.
For readers to whom a “liquidity crunch” is the result of attempting to eat a Cadbury’s Crème Egg in a single bite (is there another way?), this means Genesis has the money, but it’s in the form of something else that could take a little while to sell. Regrettably, the same phrase was used to describe FTX’s predicament in the days before it became evident that the illiquid assets on its balance sheet consisted largely of FTT and Solana – tokens that Bankman-Fried and his friends had, to be blunt, made up, and which were not the store of value that some people had previously believed them to be.
There is no suggestion that Genesis has done anything untoward, but Genesis, too, has a lot of friends. Its central position as a lender gives it exposure to the wider untowardness of the cryptocurrency market: its two largest borrowers are, a source told Reuters, Bankman-Fried’s bankrupt hedge fund Alameda Research and Three Arrows Capital (also a hedge fund, also now in bankruptcy proceedings). This also means that problems for Genesis are problems for other financial institutions that rely on it as a lender.
In fact Genesis doesn’t just have friends but siblings: Grayscale Investments, also owned by Digital Currency Group, is the single largest active holder of Bitcoin through the original and biggest Bitcoin investment fund, the Grayscale Bitcoin Trust. This is also looking a bit peaky at present, with its shares trading at a more than 40 per cent discount on the market value of the underlying assets.
Genesis, Grayscale and others are now imperilled by the very problem Bitcoin was designed to solve: trust.
Crypto evangelists have spent a decade cornering people at parties (I’m never invited to these things but I hear reports) and explaining that in their world, the messy business of trusting fallible humans is swept aside by the immutable, unhackable blockchain. But this immutable, unhackablah blahchain is also astonishingly wasteful – a single Bitcoin transaction can use as much energy as 1.8 million credit card transactions – and in the early days that made it costly and inefficient to trade. To create a liquid market they had to bring in all the other things that make modern financial markets fast and efficient: market makers, trading firms, lenders, exchanges and, of course, people.
Trust in people and institutions had not gone away: it had simply been moved from trust in established banks and regulators to trust in new companies like FTX and people like Bankman-Fried.
The reason a lot of people are hurriedly withdrawing their money (or trying to) from crypto exchanges, and testing the liquidity of that market, is that they have realised there may be more Sam Bankman-Frieds in a system which does, let’s face it, look rather like it was designed by and for exactly that sort of person.
It shouldn’t be difficult for crypto markets to overcome this lack of trust. Every exchange, currency provider and asset manager could publish a detailed, independent audit of its assets by a well-known auditor. But few are prepared to do so. It should be easy for Grayscale to demonstrate to investors exactly what and where its assets are (they are, after all, registered on the famously immutable and unhackable blockchain) but on Monday Grayscale refused to do so, citing “security concerns” (the company has since published a letter from the crypto exchange Coinbase stating that it holds Grayscale’s digital assets, but it did not share any of the “addresses” used to identify these assets). The largest “stablecoin” – a cryptocurrency backed one-to-one by real dollars, to facilitate trading – is Tether, which has similarly never released a full, detailed audit of its $65bn reserves. The largest crypto exchange, Binance, won’t even say where its headquarters are.
The cryptocurrency market is clearly aware of this problem, and companies are belatedly adding “proof of reserves” to their websites in an attempt to reassure investors that they are solvent, but the simple faith in crypto technology has been eroded. The crypto community is waking up to the fact that you can be a friend or a creditor, but you can’t be both.