Malt Liquidity 61
Pandemic? Nah, Contagion
Story Time
In the 1970s, a small bank in Oklahoma called the Penn Square Bank switched from servicing housewives through a drive-through to making energy loans and packaging them together to sell to other banks. On the surface, this is what banks are supposed to do - as creditors, they are supposed to facilitate the velocity of money. The genius of fractional-reserve banking allows the money supply that would otherwise be doing nothing to be put to use and to facilitate growth. Banks are liquidity providers - if you want to withdraw money, they will return your money. If you want to borrow money, they will offer some of theirs. As long as there is sufficient cash to smooth over the uneven flow of borrowing and withdrawing, the bank can happily collect interest - payment for the service they have provided. Now, there’s an obvious tail risk - what if everyone whose money you’ve lent out wants their money back at once? Well, there’s not much you can do. You can call up the people you’ve lent money to and demand payment, but that’s not likely to suffice the withdrawing masses. And once you’re unable to pay back one withdrawal, the word spreads like a virus, and more and more people start to want their money back. The effect compounds on itself - it’s almost self-fulfilling. (Almost because, well, if the loans you made out are bad and aren’t getting repaid, then you really are unable to pay your debts and it was just a matter of time until insolvency/bankruptcy happened.) The only hedge against this tail risk is the maintenance of trust. It’s why we live in the era of the Federal Reserve backstopping the liquidity of the bond market and large banks, why FDIC protections and minimum reserve requirements exist, and more. It’s all about making sure that the majority thinks their money is alright.
The Penn Square Bank was a classic case of a bank over-leveraging itself. They made a bunch of high-interest speculative loans to people seeking oil and natural gas and sold portions of those loans to other financial institutions, presumably playing up the likelihood that these loans would pay themselves off. When oil prices finally dropped and the mark-to-market on these loans went kaput, rumor spread like wildfire, and in 1982, the bank was declared insolvent as they were unable to pay their debts.
Why did I bring up the Penn Square Bank? Mostly because there’s a high likelihood that you’ve never heard of it. We all know the stories of Lehman and Bear Stearns at this point. But this phenomenon of contagion - amplified in our modern financialization era where every institution ties itself to other institutions to offload risk - rears its head in situations where you really think the implosion might be isolated. The insolvency of a small Oklahoma bank took out a bank in Chicago and caused major losses at banks in Seattle, Michigan, and New York. (If you want to read more about the Penn Square Bank, you can peruse this book.)
A more modern example, perhaps?
We can think of financial transactions in a similar fashion to Newton’s Third Law: Every seller has an opposite buyer. Otherwise, well, the transaction wouldn’t complete. Note that I didn’t include “equal” - after all, if I sell $58000 of AAPL stock, it doesn’t necessarily mean that I have found $58000 worth of buyers. The difference in the money I receive, of course, boils down to liquidity. I am selling $58000 worth of stock by market value, but I might be paying for $200 worth of liquidity to find sufficient buyers. And so I receive $57800 for my stock sales and go happily about my way, able to cash out on a moment’s notice from checking my phone.
How much is liquidity worth? Well, we have discussed the various types of liquidity before. Let’s focus on FTX, the beleaguered crypto exchange/lender/front for a trading firm. How do you fix an $8 billion dollar hole? Given that Binance logically pulled out of absorbing this liability, as it would lead to a total loss trying to liquidate that balance sheet - remember that the unwinding of Bill Hwang’s stocks with market caps in the double-digit billions cost multiple banks 10 figures - FTX is stuck in a dire, dire situation. They not only played fractional-reserve lender, but levered off the deposits and presumably lost all the collateral they borrowed. What happens next?
In our modern financial markets, everything is tied together. I have talked about how “every single financial product movement has some sort of ‘reverb’ effect across markets.” At the very least, FTX was propping up SOL and FTT, so these markets get hit. Whatever exposure their counter-parties had to it is affected, and whoever Alameda borrowed from obviously has to balance their books. On top of that, the crypto ecosystem is highly correlated, so selloffs in one major altcoin hit the main ones as well - and a crisis of confidence probably induces some further liquidation as well. The question is, how deep can this go? We already have ETFs that track bitcoin that are getting hit, and the Michael Saylor stock/bond complex that will get hit - and to make matters worse, products that are built off of tracking others rely on the liquidity of the underlying. Without a major market maker smoothing liquidity provision, you’re due for price breaks across exchanges and products. But I think the thing to worry about most is the liquidations. Think about the banks in the Penn Square situation - it is highly likely that one lender borrowed from another lender who borrowed from another lender to offload risk who borrowed from another lender. Given that it is extremely hard to liquidate holdings outside of a few coins, if someone is in a cash crunch to pay another lender, how do they raise the funds? If I’m looking to “buy the dip”, a) I don’t touch anything that doesn’t have multiple utilities and b) I need sufficient liquidity within the ecosystem to justify holding something.
An industry based off of trading fees is going to run into the problem of being volume-dependent. You need some combination of constant inflows of new cash and new clientele, or otherwise fees will be siphoned off from people punting off lots to each-other until someone has had enough and takes their winnings away from the table and volume dies out. In poker, we’d call this “hit and running”. You lose the ability to win money back from the player who is running hot when they stand up and leave. Trading is zero-sum, at the end of the day. It’s a finite cash cow in isolation. So what does this all result in? I doubt FTX’s inevitable bankruptcy is anywhere close to systemic. At the end of the day, they valued their bullshit coin at a certain price and borrowed other bullshit coins against it. An altcoin has no value other than what people will transact it for. This is fundamentally different from a dollar, which, most importantly, pays $1 of your taxes, but is also liquid and exchangeable for goods and services. When people stampede to demand liquidity from the altcoin to realize a gain, it will inevitably go kaput. A demand for liquidity from the coin is no different from the demand for liquidity from a bank, except the “cash held” is just the market value of the coin. The more uneven sellers are to buyers, the lower the market value (or “cash held”) by the coin. (Which is why prices drop due to lack of bid, not because of “sellers overwhelming buyers”.) The realization of FTX’s positions relative to the liquidity of what they held is the equivalent of people finding out a hot air balloon is, well, full of hot air. Related coins and equities will take a hit. SOL and FTT are probably done for without FTX’s backing, and surely liquidity and volume will dry out in most altcoins now that a primary market maker has gone bust, but I can’t see ETH dying anytime soon.
Contagion has fallout other than just reduced liquidity across certain products, though. Are we going to get stricter regulations than what SBF was paying off politicians for? (Almost certainly.) Will COIN and HOOD be able to stay afloat? Do people even trust trading in the crypto ecosystem anymore, considering that most FTX clients are likely to lose their deposits? Contagion doesn’t just erode trust - it’s trust’s kryptonite. FTX’s failure was large enough to spill over into equities, private equity, VC, and pension funds, and strikes a disastrous blow to whatever reputation SBF was trying to build for himself politically and publicly. It’s hard to see this as anything other than a Theranos moment for crypto.
