As recently as July last year, Sam Bankman-Fried – the founder of FTX, the high-flying cryptocurrency group valued at US$32 billion before it filed for bankruptcy protection in the United States last Friday – said he could envision buying Goldman Sachs.
After what has been revealed about the depth of the financial hole in his cryptocurrency empire – FTX’s main international exchange had just US$900 million in liquid assets against US$9 billion in liabilities just before its demise – such aspirations seem grotesque.
Yet, what is remarkable is not that Bankman-Fried, known to the cryptocurrency world as SBF, thought he could be taken seriously but that some of his most prominent financial backers were cheerleaders for FTX. Bankman-Fried himself cosied up to regulators and politicians, presented himself as altruistic and was seen as one of the most trustworthy entrepreneurs in a freewheeling and fraud-ridden industry.
While much is unknown about the circumstances leading up to FTX’s collapse, its governance and financial controls were shockingly weak. The company’s exchange – which was the second-largest in the cryptocurrency space – lent billions of dollars of customers’ assets to fund risky bets by SBF’s proprietary trading firm, Alameda Research, setting the stage for the implosion of the business.
The reverberations of FTX’s meltdown are just beginning. The reputational damage to cryptocurrency – particularly the institutional adoption of digital assets – is huge while the scope for financial contagion is substantial.
However, it should have been clear to investors some time ago that FTX was a time bomb. The financial excesses that contributed to its demise – rapid leverage-led growth, reckless investments and heavy losses – were bound to come home to roost as the era of cheap money came to an end, putting the finances of companies and countries under much more scrutiny.
Is cryptocurrency too risky for China?
Is cryptocurrency too risky for China?
FTX’s collapse is the third major financial landmine to go off since the US Federal Reserve began raising interest rates aggressively in June. It is also the one that was most predictable given the blow-ups in the cryptocurrency space earlier this year which contributed to a 73 per cent fall in the price of bitcoin, the dominant digital currency, since its peak in October 2021.
Yet, it is the first two shocks that are more troubling because they emanated from supposedly safe corners of the financial system, showing the extent to which assets – even those in mature economies – can be mispriced. While all three are distinct and triggered by different factors, their impact is more severe because of the sharp tightening in monetary policy.
The first shock was the fiscal recklessness of former British prime minister Liz Truss’s government, which was a red rag to a bull. Aside from Truss’s premiership, the other main casualty of the market revolt against her package of unfunded tax cuts was the UK’s defined benefit pension schemes.
The near collapse of a large number of pension funds, which are supposedly the most stable assets, revealed how a dramatic change in financial conditions can expose hidden vulnerabilities in the safest parts of the debt markets.
Once again, poorly managed leverage was the main culprit. Pension funds’ so-called liability-driven investment strategies, in which funds use derivative contracts to help them match their liabilities with their assets, backfired spectacularly when Truss’s fiscal irresponsibility sent UK bond yields soaring.
This led to a fire sale as the funds were forced to dump assets to meet collateral calls, sending yields higher. John Ralfe, a pension consultant, noted that “by increasing leverage, many UK pension funds have been operating as badly run hedge funds”.
The second shock was a rare default in the domestic corporate debt market in South Korea, one of the most resilient and creditworthy emerging markets. A missed payment in late September by the developer of a Legoland theme park outside Seoul caused a fierce sell-off in the country’s credit market, with yields on South Korean commercial paper – which companies use to raise funds for short-term payments – hitting their highest level since 2009.
The turmoil was exacerbated by uncertainty earlier this month over whether Heungkuk Life, a local insurer, would delay exercising a call option to redeem its perpetual bond, a highly unusual occurrence anywhere in the world. While South Korea’s central bank continues to raise interest rates to counter the surge in inflation, the government was forced to pledge 50 trillion won (US$38 billion) to relieve pressure from the credit crunch.
Such acute tensions in policy are a foretaste of things to come in other countries as central banks keep raising rates despite a sharp slowdown. Although market sentiment has improved recently because of signs inflation has peaked, prices remain exceptionally high, requiring more tightening.
Patrick Harker, a Fed policymaker, noted last week that inflation “is known to shoot up like a rocket and then come down like a feather”.
This means more landmines will go off in the coming months. Further blow-ups in the wild west of cryptocurrency are inevitable. The real question is where the next shock in mainstream finance will occur. A fair bet is that it will be in a corner of the market investors least expect.