Following the crash of cryptocurrency exchange FTX, Senator Bob Menendez (D-New Jersey) declared (“US Lawmakers Call for More Crypto Regulation After FTX Collapse,” Financial Times, November 15, 2022):
This should be a renewed call for Congress to take a serious look at crypto exchanges and lending platforms, many of which engage in risky behaviours, while marketing themselves as safe for consumers.
We could say something similar with much more evidence and theory to back up our claim: “It’s time to take a serious look at government, which engages in risky behaviors while marketing themselves as safe for citizens.” Just think about federal power and the public debt, which increase with every emergency and in between, and very seldom recede.
The naïve conceit expressed by state rulers is not limited to one side of the aisle. The Financial Times continues:
Cynthia Lummis — the Republican senator from Wyoming, who has co-written a bipartisan bill that sketches out a complete regulatory framework for digital assets in the US — described the FTX turbulence as “awful and simultaneously not all that surprising”.
“It’s obvious that Congress needs to regulate digital assets,” she added.
That Sam Bankman-Fried, the entrepreneur who founded and ran FTX, was a big donor to the Democratic Party and allied groups does not make the episode less revealing (“Sam Bankman-Fried’s Fall Cuts Off Big Source of Funds for US Democrats,” Financial Times, November 13, 2022):
Before the fall of Bankman-Fried’s cryptocurrency exchange FTX, the entrepreneur had emerged as the second-largest donor to Democrats after George Soros. …
The entrepreneur was the second-largest donor to Democratic-leaning groups during the latest midterm elections, spending $36mn.
He did hedge his rent-seeking bets, but apparently only with small amounts:
During the 2022 cycle, Bankman-Fried donated $155,000 to rightwing Pacs: the Alabama Conservatives Fund, which backed Republican Alabama Senator-elect Katie Britt, a crypto supporter; and Heartland Resurgence, which backed Senator John Boozman of Arkansas, the top Republican on the Senate agriculture committee that oversees crypto.
That the Senate Committee on Agriculture, Nutrition, and Forestry “oversees” cryptocurrencies is not the less hilarious fact of the story.
READER COMMENTS
Craig
Nov 16 2022 at 11:19am
If it sounds too good to be true be on the lookout for some kind of scam.
FTX was offering people depositing their USD or BTC 8% on their deposits. Think about that for one second. For sure, it sounds enticing, but what does that mean? Well, first off it means that FTX is essentially borrowing money from you at 8%. Why? Why would FTX do that in an interest rate environment that, only until recently, saw much, much lower rates.
Of course even if its not a scam in order to generate that vig, well, that means FTX would need to use that money and to loan it out to somebody at an even higher interest rate or invest it in something expected to earn more than 8%.
What does that suggest about the overall risk level of this scheme?
“It’s time to take a serious look at government, which engages in risky behaviors while marketing themselves as safe for citizens.”
Well, quantitative easing distorted markets and caused people to engage in riskier behavior than they otherwise would have. How can you invest in a 60/40 portfolio if the bonds are earning a real negative rate of return?
And so people ‘reach for yield’ and its quite telling that even pension funds (which often have an assume rate of return of 6.9%) and quite appropriate for this post here the Ontario Teacher’s Fund (Not sure if Canadian pension funds operate on the 6.9% rule of thumb, but the point of course is that these large pension funds are supposed to be boring — boring is GOOD actually) wound up getting suckered into the FTX scheme. So too did relatively savvy investors like Mr. Wonderful himself who now seems to be calling for regulation.
Floccina
Nov 16 2022 at 3:38pm
I agree with Scott Sumner. People made risky bets on FTX and it went under, where’s the problem? Maybe the federal Government should regulate themselves more considering the Iraq and Afghanistan interventions.
Craig
Nov 16 2022 at 4:33pm
Well all forms of fraud of course, but even if we assume no fraud in the inducement or in the operations leading up to the bankruptcy, the current allegation being tossed about is that SBF kind’ve took off with the loot. That’s potentially straight up theft even.
robc
Nov 16 2022 at 6:08pm
We already have laws against fraud and theft.
Craig
Nov 16 2022 at 6:30pm
https://www.investopedia.com/ftx-is-not-insured-6501192
They were flat out telling people that they were insured. Now, for sure, that is against the law and SBF can ultimately be charged with some securities fraud, fraud, whatever.
The problem is that the remedy just isn’t remotely adequate.
Families don’t have due diligence departments in the family room. And when the counterparty risk becomes unknowable, few trust anybody and you have a situation like my great-grandmother lived in during the Depression with money under the mattress.
BC
Nov 17 2022 at 3:23am
I have done close to zero due diligence on crypto but managed to avoid the FTX debacle…by not investing in crypto. Instead, I have invested in non-mattress traditional financial assets: stocks, bonds, mutual funds, ETFs, etc. Crypto is not part of, nor likely anytime soon to become part of, 401(k) plans, balanced funds, target date funds, and other mainstream investment vehicles intended for low due diligence investors. If crypto ever becomes part of a target date fund, that fund will be managed by a professional manager with fiduciary obligations appropriate for retail investors.
I have no doubt that some investors that lost money in FTX are *in other respects* normal everyday people. But, normal everyday people have not invested in FTX. Anyone invested in crypto is by definition a crypto nerd, at least right now. No one is required to become a crypto nerd, and we don’t need government to regulate crypto nerds other than perhaps to insulate the mainstream financial system from crypto nerd activity.
robc
Nov 17 2022 at 10:10am
A couple of points:
SEC regulations didn’t prevent Madoff.
However, while it isn’t perfect, over 80% of losses were clawed back and restored to victims. That isn’t fully adequate, but better than “isn’t remotely adequate”. Any reason they couldn’t claw back the FTX money too? I wouldn’t expect 80%, but some fraction.
The fact that the risk was unknowable is a good reason to avoid it. It takes little due diligence to realize you know nothing.
I can think of two quotes that are appropriate here:
Invest in what you know.
If you don’t own the wallet, you don’t own the crypto.
Jim
Nov 16 2022 at 5:18pm
People made risky bets on FTX and it went under, where’s the problem?
People did not make bets on FTX. They made bets on bitcoin, ethereum, FTT, and various other derivatives through FTX acting as the bank/broker-dealer holding their accounts and deposits.
People also make investments in high-yield bonds. They make their investments through, say, Charles Schwab — which then goes bankrupt costing them everything (because Charlie gave $8 billion of their deposits to his girlfriend to bail out her hedge fund and she lost it all).
Well, high-yield bonds are risky. Where’s the problem?
If you don’t see the answer, it is that they didn’t lose their money on any high-yield bond investment, they lost it to the bank/broker-dealer that explicitly promised to keep their deposits 100% on hand to fund withdrawals.
Now imagine that the oppressive regime of the state imposed a periodic random visit by a bank examiner to count up whether the customer deposits promised to be on hand actually are — like that jack-booted bully in It’s A Wonderful Life.
Perhaps then Charlie would’ve thought “maybe I shouldn’t give $8 billion of customer funds to my 28-year old admitted drug-using, math phobic, polyamorous, big Harry Potter fan girlfriend to manage in her hedge fund.” And his customers actually would have been able to lose their money on whatever risky investment they chose.
What would have been wrong with that? Too much state oppression?
Like that imposed on every savings bank in the nation? Then maybe we should free them too from the oppressive regime of published deposit reporting and reserve requirements, so their owners can have grateful young girlfriends too.
In the last four years 143 crypto exchanges have “failed” by disappearing without any explanation to their customers, and without a trace, taking all deposited funds with them (“failures” that sure seem like a success for somebody), while another 30 left enough of a trace to show they were set up as “outright scams”… and only 22% of all failed exchanges did so for “legitimate business reasons”.
What’s wrong with that? It’s just the price of liberty — from the bank examiner.
robc
Nov 16 2022 at 6:12pm
You realize it is possible to have independent auditors instead of government regulators. Of course, then the question is, how much do you trust the independent auditors to be honest? And my answer is, slightly more than government regulators.
And yes, I am making the Kosher argument for banking regulation.
Craig
Nov 16 2022 at 6:17pm
“independent auditors”
Who’s paying them?
Who was rating the creditworthiness of the MBS? The likes of Standard & Poors who were paid by the issuer.
Indeed see another big scam and the role Arthur Anderson played in the Enron debacle.
robc
Nov 16 2022 at 6:27pm
Arthur Anderson/Enron is why I only said “slightly more”.
If you don’t trust Standard & Poors (or whoever) dont use and bank they are auditing. Liek I said, just like with Kosher. Choose the option you trust. Careful choice may limit your options, but I trust the private Kosher certification more than I trust the goverment-defined Organic certification.
Craig
Nov 23 2022 at 3:02pm
“I trust the private Kosher certification more than I trust the goverment-defined Organic certification.”
As an aside here I specifically recall being in a Dunkin Donuts in Bloomingdale, NJ (that franchise subsequently moved down the street) which has a kosher certification by, wait for it, some entity licensed by the State of NJ to make kosher certifications! I remembered it at the time since I couldn’t help but think at the time that state licensure should somehow run afoul of the endorsement prong of the Lemon test which used to be the standard for I Amendment ‘establishment’ of religion cases.
Is Dunkin Donuts kosher? Well, I dunno, but they did sell bacon, egg & cheese sandwiches.
Perhaps some yellow-capped Coca-Cola will make people feel better?
Pierre Lemieux
Nov 17 2022 at 8:46am
Jim: Keynes-type of iconoclastic questions are not useless, but… Before the Great Recession, hundreds of federal “regulator” agents were present onsite in the large New York banks. Would you say that the next step would be to have a federal regulator in every house, so that individuals dont take foolish risks (or adopt bad lifestyles in general)? And what about the federal government, in the meantime, making risky investments, in residential mortgages for example? Or encouraging the poor to buy mortgages and forcing banks to sell them? One advantage of public choice theory is to compare government and the market on the basis of the same criteria.
Jim Glass
Nov 20 2022 at 8:37pm
I’ll be glad to answer your question, but think you should first answer the one I asked you, rather than ignore it:
A bank is required to keep and publish for its customers a tally of total customer deposits, plus the amount of the deposits and reserves it has on hand as funds available for its customers to withdraw. Subject to periodic audit.
(You know, rather than be able to lie unchecked about unpublished numbers, freeing the CEO to massively inflate claims about them, while giving $8 billion of customer deposits to his girlfriend as other insiders use the customer deposits to buy homes and yachts.)
“What would have been wrong with that? Too much state oppression”?
~~
My next question for you: Do you really compare a bank publishing a financial statement to “a federal regulator in every house, so that individuals don’t take foolish risks (or adopt bad lifestyles in general)?” Really???
Craig
Nov 22 2022 at 9:54am
I’d suggest this recent development adds to the discussion: https://www.cnbc.com/2022/11/21/grayscale-wont-share-proof-of-reserves-due-to-security-concerns.html
“Grayscale refuses to share proof of reserves due to ‘security concerns’ as shares trade at a 45% discount to bitcoin”
Hmmm…..
Pierre Lemieux
Nov 22 2022 at 11:34am
Craig: I am not sure I understand what your point is. From what I understand, the discount to net asset value of the Grayscale bitcoin fund even diminished after the article you linked to. Doesn’t that confirm that investors are quite happy with the risk they are taking?
Craig
Nov 22 2022 at 2:00pm
Bitcoin befuddles us a bit because its intangible but let’s take that away and suddenly the problem becomes clearer because here we have a bitcoin ‘trust’ but we could have a real estate trust too, indeed REITs are very popular investment vehicles.
Imagine if the REIT you invested in said, “We have absolutely no intention of proving that we used your money to buy real estate that we actually said we already spent on real estate.”
Jim Glass
Nov 22 2022 at 2:34pm
Doesn’t that confirm that investors are quite happy with the risk they are taking
You continue to fail to see the difference the bank and the investment.
People invest in a high-yield bond fund through Chase.
“Chase today revoked all its public information about the amounts of its reserve and deposit accounts and refused to provide further information about them, as top Chase executives fled the country among market rumors of illegal mass transfers of billions of dollars to Russia.” (Apart from the word “Russia”, a true description of many crypto exchanges.)
“But that fund is still trading. Doesn’t that mean that investors in Chase are happy?”
You really are against banks and brokers having audited financial statements of deposits, reserves, and customer accounts.
Jim Glass
Nov 22 2022 at 3:27pm
“Look, you guys are going to accuse me of making this up because it sounds too ridiculous to be true, but I’m not an we’re only getting going…”
FTX update.
For starters, FTX’s top people built a software system that hid what they did with customer deposits, a messaging system that auto-deleted their own messages, and had no (zero) accounting in house. (FTX’s accountant was in the Metaverse!!) Hmmm, what motivation could explain such odd behavior? (There’s a lot more – watch the whole thing.)
Now imagine if FTX had been required to publish statements of its deposits and reserves …hey! it would have had to have had an accounting department!
Note well: FTX got its market value by providing the service of trading investments created by others (bitcoin, ethereum, etc., and derivatives engineered out of them, plus its own FTT token) on its customers’ behalf — just as Chase, Schwab, Fidelity et al, do.
If we really think having an accounting department is a horrible cost imposed by the state on banks and brokers, then we should free them!
Let’s let Chase, Morgan, Citi, Schwab, Fidelity and the rest fire their accounting departments, publish naught financial statements, put in self-deleting internal messaging systems….
With the increase freedom, what could go wrong?
Pierre Lemieux
Nov 23 2022 at 11:22am
You may be right that there was fraud; hopefully we’ll know later. But you are probably and mostly wrong to believe that the state has any clear notion of what fraud is except for what it defines as such. And, with due respect, you seem to have no clear idea of what a contract between two adults is. Regarding your flashy last sentence, I am tempted to quote George Fitzhugh‘s aphorism (even if he applied it to a different issue):
Craig
Nov 23 2022 at 4:41pm
If I walked into the bookstore and stole a copy of Lemieux’ “What’s Wrong with Protectionism?” you’d be the first to admit that I should be carted off to jail for shoplifting. If, however, I were to lose a gazillion by fraud/theft like this turkey SBF, I suppose I should be a free man?
Pierre Lemieux
Nov 24 2022 at 1:32pm
Craig: It is not that simple. We cross each other in a bookstore and I punch you in the face; that’s an aggression and I should be condemned and punished. We are both on a boxing ring and you punch me in the face; you should not be arrested because I, as an adult, knew that this is the risk I was facing when I climbed into the ring.
Craig
Nov 25 2022 at 9:52am
“We are both on a boxing ring and you punch me in the face”
Well that escalated quickly to fisticuffs!
But the analogy is a bit off, perhaps try…
We are both in a boxing ring and I punch you in the face with loaded gloves. Would you be assuming that risk? Indeed if we participate in any athletic endeavor there is some assumption of risk and also risk associated with what one might call the ‘usual cheating’ in a game, ie holding in football, but there is a point where the cheating is such that it is so far beyond the scope of participation that it actually can rise to the level of a crime.
And the state does regulate boxing. Just doing a quick google on NY to get a license we have to make some demonstration of ability and the hand wraps need to be done a certain way.
Jim Glass
Nov 25 2022 at 10:29pm
[Pierre Lemieux wrote:]
You may be right that there was fraud…
Yes, possibly, just maybe … but, yet again, you don’t answer my question!
(I doubt anyone is still reading this, but for the record…)
You don’t answer, “OK, Yes!” or “Oh, gosh, No!”, or discuss the cost of “what could go wrong” and whether it is worth it.
You just respond with vitriol against “the state” and non sequiturs like me wanting a regulator in every house to monitor health habits. C’mon, where is the courage of your very strong convictions? Give a straight answer.
you are probably and mostly wrong to believe that the state has any clear notion of what fraud is
Irrelevant illogic. The issue is whether, not “the state”, but the customers and depositors of financial institutions are beneficially informed of risk via published audited financial statements showing whether a firm’s promised reserves against their deposits are real or not.
If you think customers, depositors and investors are too stupid to sense “fraud” when informed that $8 billion of deposits are secured by all of $595,000 of assets (as stupid as the state!) then your answer to my question should be “OK, Yes!”. So Chase, Morgan, Citi, et al., too can be freed from the state oppression of having accounting departments and publishing honest financial statements. So they (and all the new entrants in the industry, there’ll be a lot!) too can lie to their customers however they want as to assets securing deposits and liabilities — on an even playing field with the liberty-enjoying FTX and other crypto exchanges. With customers and depositors being as stupid as the state, what difference could it make? What could go wrong?
But, OTOH, as I mentioned before (and you ignored) 140+ crypto exchanges have disappeared, “without a trace”, taking all investor funds with them, in four years. While Wikipedia tells us that since 2010 zero (0) other financial firms have so disappeared, and there have been all of eight (8) bank runs, world-wide. Hmmmm …. could those oppressive state regulators actually be onto something?
“Liberty is an evil which government is intended to correct.”
And the Liberty of FTX went uncorrected! Happily for Sam and Caroline and you, if not for its depositors and investors. My simple question yet again is just, do you want such liberty extended to Morgan, Chase, etc.?
The quote from an 1854 polemic against slavery in the US south is an interesting historical artifact, but not the most up-to-date analysis in political economics.
I give you an entire book: Violence and Social Orders, by Nobelist Douglas North and compatriots, 2009.
Of course the founding thinkers of liberal democracy, like Smith and Jefferson, in no way would accept that quote either. But that’s for another time…
~~~
PS:
And, with due respect, you seem to have no clear idea of what a contract between two adults is.
After 40 years as a working lawyer, I’m fine going head-to-head with you on this one.
Though as the word “contract” doesn’t appear once in this entire discussion, I have no idea what your point is.
Pierre Lemieux
Nov 26 2022 at 12:49pm
“After 40 years as a working lawyer, I’m fine going head-to-head with you on this one.”
Perhaps that’s the problem and you should start reading, or read more, economics (or political economy, not “political economics”) ? It should help you formulate meaningful and analytically useful questions. A look at my latest post on this topic might be of interest too.
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