What to Glean From the Latest Crypto-Firm Collapse

The fallout from cryptocurrency exchange FTX’s collapse continued Monday, claiming its latest crypto victim: BlockFi, a smaller exchange that also offered crypto-backed loans. Its bankruptcy, which became official Monday, was largely a foregone conclusion after it halted withdrawals last month due to “significant exposure” to FTX. Another crypto lender with deep FTX ties, Genesis Global Capital, has also suspended withdrawals and is exploring its restructuring options but hasn’t filed for Chapter 11 yet. More crypto companies could follow. Yet stocks are looking past this saga, which seems right to us. There is no logical reason for a contagion in traditional financial markets—no transmission mechanism. In our view, this should gut worries about crypto’s woes spilling over.

If you simply look at crypto and stock prices over the past couple of years, we guess it is easy to see why some would presume there is a link. They have been highly correlated at times, with both up nicely in 2021 and both down this year. Whenever financial markets move concurrently, it can be tempting to presume causality. More often, it is a case of two asset classes having occasionally overlapping drivers—in this case, we think the overlapping factor is investor sentiment. Last year, we saw some evidence euphoria was beginning to emerge in some areas of markets. Crypto was a prime landing spot, as were special purpose acquisition companies and other niche corners of the stock market. This year, when sentiment soured greatly over inflation, Fed rate hikes, rising long rates, energy prices, sanctions and so much more, we think it hit stocks and crypto alike—with crypto crashing harder after booming much higher in 2021. Said differently, sentiment pushed crypto to a classic boom-and-bust while stocks endured a more traditional bull-to-bear market transition. Same directionality, different magnitudes, sentiment at the center.

Crypto’s crash was the prelude to FTX and the related collapses. Digital coin exchanges and lenders are backed by cryptocurrencies themselves (typically a mix of proprietary and third-party tokens), tying their balance sheets to the crypto market’s whims. A collapse in FTX’s self-issued token, FTT, is what eventually exposed the exchange’s apparent mishandling of client assets, which the authorities are now investigating. Meanwhile, the collapse of bitcoin and other cryptos hammered BlockFi over the summer, destroying the collateral backing the loans it had issued, leading it to take emergency funding from FTX—paving the way for this week’s Chapter 11 filing. This is all in line with how these things typically unfold: Asset crashes, companies with exposure to that asset fail, bankruptcies work their way through the system.

The specter of financial firms failing in bunches understandably recalls the Global Financial Crisis, Savings & Loan Crisis and other banking crises throughout history. Yet unlike them, the crypto failures haven’t sown market panic. Since November 7—the day rival crypto exchange Binance disclosed it would dump its FTT holdings over concerns about FTX’s balance sheet—the S&P 500 is up 4.1% in price terms.^[i] This figure includes Monday’s -1.5% decline, which most observers tied to Western jitters over the latest COVID happenings in China.^[ii] Meanwhile, bitcoin is down more than -20% in this short stretch and is bouncing around its year-to-date low.^[iii]

In our view, the divergence is logical. The recent crypto bank runs risk spiraling into a run on crypto itself as people more accurately weigh the risks. But all of this is insulated from most stocks and bank balance sheets. Financial regulations made it so costly and onerous for banks to hold crypto on their balance sheets that most didn’t bother. The lack of FDIC or SIPC protections for accounts at crypto exchanges means Federal entities aren’t on the hook to make accountholders whole in the event a crypto exchange fails and can’t meet withdrawal requests, taking taxpayer money out of the equation. Some publicly traded companies have crypto holdings but have already written them down throughout the year. These holdings have been public knowledge from the start, enabling markets to deal efficiently with them. Venture capitalists will take a hit, but that just means funding might—might—dry up a bit in Silicon Valley, hitting startups but not publicly traded firms.

Lastly—and apologies if this seems a bit callous—we see a small silver lining in this saga. For one, it is a reminder to those who dabbled in these highly speculative assets that core concepts like weighing risk and return are critical. It could also let the world see that the overall financial system can actually handle some failures just fine—contagion isn’t automatic and it doesn’t just happen with no transmission mechanism. We aren’t cheering on a collapse here, mind you, but if it prompts a revival in due diligence and chips away at too-big-to-fail jitters, we would see value in that.