The crypto ecosystem is undergoing a systemic stress test

Crypto is facing a time of crisis – and its ecosystem is proving much less capable of reacting in a predictable and fair way than the dollar-based system when companies crash.

Why it matters: There will always be entities that take on too much risk or that end up in bankruptcy proceedings. A well-functioning system will spring into action efficiently in such cases, while a chaotic system will be mired in ever-increasing problems.

The panorama: Much of the current crypto winter is a function of two familiar market phenomena: failed arbitrations and commingling of client funds.

  • Both were seen in the implosion of MF Global in 2011, the small brokerage firm taken over by Jon Corzine after his stints at the helm of Goldman Sachs and New Jersey.
  • Of note: MF Global clients ended up getting all their money back. So did the creditors of Lehman Brothers. Even Madoff’s depositors are nearly full. In each case, a strong legal system worked exactly as designed.

Driving the news: This crypto downcycle is being fueled by “long leveraged” trades unraveling. As in many previous market implosions (LTCM comes to mind), such trades are often associated with arbitrage moves.

  • The idea it’s using borrowed money to buy item X, which should be worth the same as item Y, at the same time you short-sell item Y. Then, when the two prices converge, you make a profit.
  • Operations that have exploded have included some saying that 1 Terra should be worth 1 dollar, or that 1 stETH should be worth 1 ETH, or that GBTC’s share price should be worth the same as the value of bitcoin in that fund.

Between lines: The borrowed money that financed such transactions did not come from arbitrageurs (they were the borrowers), but from depositors who are now rushing to get their money back from stores like Celsius and BlockFi.

  • Retrospective scene: MF Global clients will remember the feeling. His money was used to cover losses in an ill-fated arbitrage game involving European sovereign bonds.

What’s new: Crypto is a wild west in comparison. There is no established jurisprudence regarding the seniority of the depositors; in fact, there is not even a consensus on which jurisdiction companies should be incorporated in, and therefore which applicable law should be used.

  • the lehman brothers it was often described as “too interconnected to fail”. Perhaps crypto stores like Three Arrows Capital were in a similar position.

My thought bubble: FTX billionaire Sam Bankman-Fried is trying to play a similar role to the one played by John Pierpont Morgan during the Panic of 1907, before real institutions were created to stop bank runs. His possible fire sale acquisition of BlockFi deliberately puts depositors first, but that kind of individual intervention is difficult to scale or institutionalize.

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