FTX and Crypto Bust Show Capitalism’s Limits

Capitalism failed crypto. Or perhaps they failed each other.

Flying drone with camera

No, I’m not trying to exonerate Sam Bankman-Fried and all those who have abused people’s trust and destroyed faith in this industry.

And, no, I’m not a Communist. I am as strong a believer as any reasonable reader of history that market economies do a far better job of allocating capital than centrally planned ones.

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I just want to acknowledge that capitalism doesn’t always deliver desired results. For its “invisible hand” to work, the market needs to be open and competitive. For the reliable, constantly adjusting price signals that economic actors need to form well-reasoned investment decisions, there must be sufficient information about the factors behind the demand and supply conditions determining those prices.

Until 2022 and, most importantly, until the collapse of FTX exposed a gaping difference between image and reality, such transparency did not exist, not at the level required for the crypto industry to enjoy trustworthy price signals.

It’s not just FTX, it’s the entire industry

I’m not just talking about FTX’s mind-boggling accounting practices (or lack thereof). I’m referring to what we knew, or didn’t, about the conditions driving the soaring token prices that attracted millions of retail customers into multiple crypto exchanges and lending platforms, inflows that spun up billions of dollars in fees and, by extension, attracted great gobs of venture funding to those companies.

We’re all astounded that FTX, now essentially worth nothing, was valued at $32 billion a few months ago, and that lending service Celsius Network clocked in at $3.5 billion before it went under. But we should be asking similar questions about the investments and deposits that poured into Binance, Coinbase, Kraken, Crypto.com and other such exchanges. I’m not suggesting that they too are on the verge of bankruptcy or are suspected of fraud, rather that we should reflect on the inflated expectations for long-term growth that drew the influx into the entire industry.

Investors fell for a kind of capitalism head fake. For a time, the spectacular outsized profits generated by these centralized rent-extracting machines suggested to venture capitalists that they were the businesses into which they should be investing. According to the rationale of the market, they were onto something. The market was saying “this is the future.”

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Tragically, we now know this was a false signal. There was no there there. A good chunk of the token exchange and lending business was built on a house of cards, an elaborate interconnection of leveraged positions across a crypto ecosystem sustained by a collective belief in “number go up.” It was really just a toxic mix of momentum trading, opportunism and rehypothecation (allowing assets to collateralize several transactions). It was never sustainable.

We should have recognized from the start that the triple-digit yields offered on various decentralized finance (DeFi) platforms during boom periods in 2021 were unjustified, not just because they were insanely high relative to traditional finance but also because there was insufficient real-world utility underpinning them. The same could be said for the trading activity and fees earned by centralized finance (CeFi) platforms.

For there to have been enough base-level utility to sustain the trading prices higher up the chain, there needed to be a lot more investment in underlying real-world use cases for tokenized value exchange, such as in decentralized energy. But the market wasn’t signaling that that’s where the money should go. It was saying “go all in” on FTX, Celsius and their ilk.

Read more: Need a Use Case for Decentralization? Start With Energy

Fixing information asymmetry

How do we fix this?

Sadly, we can’t just exhort people to reject get-rich-quick promises in favor of smaller, more sustainable opportunities in cross-border remittances, non-fungible token (NFT) loyalty projects, distributed digital identity solutions or any number of other real-world applications. Speculators are gonna speculate.

What we need is more reliable information about crypto businesses and industries, not just data on the short-term profitability of exchanges and lenders but in-depth details on the underlying foundation of those returns and their long-term sustainability.

Perhaps with that information, venture investors will ignore short-term opportunities associated with speculation and instead invest in real, longer-term projects.

But there’s still a problem here and it lies with Silicon Valley. Given that token models now offer venture capitalists the prospects of a much earlier exit than the five-year liquidity lockups they’re traditionally subjected to, they may still be incentivized to ignore indications of long-term challenges and continue to bet on short-term bubble moments, knowing they can always pass their bags to the next greater fool. They can do this because they get early access to exclusive “data rooms” during funding round deals, giving them an informational advantage over later-arriving small investors.

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This is the “information asymmetry” problem that securities laws are supposed to guard against. We can think about it in terms of the parties in any later-stage funding round: the investable entity itself, which knows everything; its early investors, who know a lot but not everything; and the prospective targeted investors, who are much more in the dark. These kinds of asymmetries are one of the fundamental causes of price signal distortions. Forced disclosures by securities regulations narrow that information gap.

Regulate or self-regulate?

It should be obvious by now that for CeFi exchanges such as FTX, tougher regulation, including registration with the Securities and Exchange Commission, is unavoidable. The question is how far should such regulation go?

Despite everything, a strong argument remains that excessive regulation – for example, the draconian bill introduced this week by Senators Elizabeth Warren (D-Mass.) and Roger Marshall (R-Kan.) – could easily backfire by killing innovation. There are especially big risks if securities laws are unreasonably targeted at the software developers of DeFi projects for which there is no identifiable centralized authority.

Read more: How Crypto Can Repair Its Reputation in Washington

This is where industry needs to come to its own rescue. It’s time to call on leaders in this space who truly want the technology to foster a growing, sustainable economy of real-world value to align with each other on  standards to increase transparency.

Whether it’s a universally accepted approach to proof of reserves, ratings agencies that use on-chain and other records to assess the risks of different assets or protocols, or common standards for software audits and bug bounties, there is much that the members of this community can do to incentivize mutually beneficial disclosure requirements on each other.

It’s either that, or never enjoy the benefits of capitalism.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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