FTX: Crypto's Collapse Begins

Summary The FTX bankruptcy is the chirping canary in the crypto coal mine. Crypto’s central flaw is its self-importance. Money is most effective when it spotlights real goods and services values from the background. New financial market structures should always reduce costs and increase the simplicity and clarity of old valuation technology. Otherwise, they add cost without adding value. FTX is the first wave of a coming tsunami of collapsing bloated pretentious market structures. Less is more in financial valuation. Introduction The FTX (FTT-USD) bankruptcy raises the alarm for specialists in the creation of new financial market structures. The creation of assets such as cryptocurrencies -- assets with no role in the production of goods and services and that instead only substitute for cheaper more efficient fiat money will never succeed. The error behind the failure of ventures that produce a more grandiose version of money or a more elaborate means of asset valuation is the fundamental misunderstanding of the humble role of valuation. Money is the handmaiden of capital used in the production of consumption goods and services. It is never an end, always a means to an end. Early in the development of financial market structure innovation, creators should ask themselves a fundamental question. Why will the financial innovation in question reduce the cost and increase the simplicity and clarity of the process of market valuation? If there is no answer, the project is wasting scarce resources. Financial innovation, because it is not a change in pursuit of more goods and services, should be cheaper and simpler than the financial technology it replaces. Spending on new kinds of money and other financial innovations creates costs without resulting in increased production. New finance should thus be a cheaper simpler replacement for more expensive old finance. What have we learned from the collapse of FTX? The FTX bankruptcy is the predictable result of pouring resources into a complicated pointless enterprise. Yet the FTX bankruptcy is more significant to recent financial history than the end of a pretentious firm. This is the end of one of the many doomed assets that became popular during this decade of zero interest rates – assets that absorb resources for no purpose, promising nothing other than a profit from a glorified Ponzi scheme. Besides cryptocurrencies, non-fungible tokens and meme stocks are part of the pointless parade. Enough. Crypto began its life promising more. It promised to be a form of money that worked better than fiat money – cheaper to produce, more stable, and unencumbered by state control – unlike fiat currencies including the US dollar. But cryptocurrencies are more expensive to use, less predictable in value, and in dire need of the government regulation that crypto mavens eschew. Those of us intrigued by the crypto concept forgot an important rule of thumb that should be applied to all financial innovation – if a financial innovation is not simpler and more retail-investor-friendly than the old way, it fails to meet the test of market structure innovation – lower cost and greater simplicity . Did finance gain something from the gathering crypto disaster? Was it worth the cost? The primary gain was an increased awareness of the relative unimportance of money compared to assets used to produce real goods and services. Crypto is money that wants center-stage, seeking to impress and increase the relative importance of financial assets compared to assets that further consumer-saver objectives. The experience with crypto has been outrageously expensive and pointless, absorbing our most important asset, creative minds. If we are to recover anything valuable from the crypto experience, it must be a tally of mistaken judgments. Moreover, we should apply the lessons learned in the crypto debacle to other financial enterprises. In summary, we should rethink the inflated importance of money, exchanges, and derivatives. They are a means to the end of allocating resources used in the production of goods and services consumer-savers value. Thus, they should function in the background and on the cheap. Money, exchanges, and derivatives become less useful as they increase in number and complexity. Identification of value – the function of money, exchanges, and derivatives – should always be secondary to the creation of real production of goods and services. Things we got wrong with new forms of money Money is simply less important than crypto fanciers think it is. Crypto money attracts resources by masquerading as an important end. Since money is less important than real assets it should be like standard fiat money. Nearly free to create. The mining that creates Bitcoin (BTC-USD), for example, is ridiculously expensive, more than $1,000 per Bitcoin (see here for world costs of Bitcoin production). One measure of monetary value is enough – two or more is less useful than one (read here ). In other words, crypto wealth is worse than pointless. It removes resources from the production of goods and services while reducing the contribution of the existing fiat currency to the valuation of more important assets. Government, however imperfect, is the best source of money. Crypto taught us that money designed to avoid government control eventually relies on government-controlled money to measure its worth (read here ). Things we got wrong with new exchanges Fewer exchanges are better than many (read here , and here ). Just as a single measure of value is ideal, a single source of market valuation of financial assets is ideal. Exchanges share with money their essential secondary importance compared to the importance of the real goods-producing assets they were originally designed to trade. The proliferation of futures and securities exchanges of the past 50+ years has been wasteful (read here ). Separate futures and securities exchanges once made sense because there was no overlap of traded instruments. But now that the technology is mature, this separation should end. Duplicate futures and securities exchanges multiply transaction costs in the same way many forms of money do. Markets should be redesigned, listing instruments directly connected to the production of goods and services (read here ). Futures exchanges have become too much like crypto exchanges, trading products that are too remote to the finance of assets that support production. Futures markets integrated with securities markets would participate more directly in the creation of assets valued by their contribution to production. Things we got wrong with financial derivatives Derivatives valuation and trading should not be so peripheral to the valuation of the more fundamental assets that support the production of goods and services – private sector equity and debt (read here ). The spot and futures markets would both function more effectively if combined in the trading of the most liquid summary securities – broadly diversified debt and equity instruments. A typical futures contract increases the liquidity of its related spot market only once every three months when the futures price and the spot price are equated through futures settlement. The spot and futures markets would both be more supportive of value creation if their values matched more frequently. Moreover, the liquidity futures generate would become synonymous with the liquidity of the spot market, eliminating the possibility of another LIBOR crisis. Derivatives should apply their essential trading innovations – the futures-style clearing house and instant costless clearing – directly to spot trading. Derivatives should drop the term “derivative” and simply replace the disastrously inefficient securities exchanges. Derivatives and the securities from which they are derived could be more cheaply and more usefully traded on the same exchange using futures trading and clearing technology. A centrally cleared market, that clears instantly at zero cost as financial futures do now, could apply futures technology to securities that pay dividends and interest, becoming a far more efficient securities market without breaking a sweat (read here ). Most importantly, the private sector’s creation of sustainable value is best focused on assets that produce goods and services. To devote the resources of the private sector to multiple forms of money, multiple duplicative exchanges, and duplicative complicated derivative instruments – is to waste them. We have too many markets trading things of little significance for the real economy. What should we do about FTX? The crux of the problem of establishing a more productive direction for financial innovation than the phony wealth cornucopia that is crypto is the innate difficulty in attracting resources to ventures that profitably replace older financial technologies that were inefficient because they generated more rich people than they supported. Entrenched greed is even more difficult to overcome than Johnny-come-lately ambition. Crypto excites the human imagination and will, I hope, never disappear entirely. There is no reason to be sure that the theory behind Bitcoin will never have applications in producing new important goods and services other than money. But hopefully, fewer of our brightest minds will trash their careers in the pointless pursuit of instant wealth after FTX. Conclusion Financial innovation has a different look from innovation in the production of real goods and services. Innovation in financial markets inevitably takes Occam’s Razor to the financial share of GDP in the long run and often in the short run too. Less is more with financial innovation. We had developed a very simple efficient financial system globally at the turn of the 21st century. We have applied electronic and computer technology quite effectively to that system since then, drastically reducing the cost of financial transactions and dramatically improving price discovery throughout the globe. Electronic and computerized trading adhere to the dictates of Occam’s razor. But beginning with the collapse of the Bretton Woods agreements circa 1970, exploding financial market price volatility has encouraged financial innovation that expanded the function of trading, appropriately absorbing new resources to assuage the increased pressure on financial institutions and markets. New risks reasonably justified new expenditures on financial innovations such as financial futures. But financial futures are duct tape and baling wire, temporarily modifying mainline financial instruments. Where is the integration of securities and derivatives that applies the more efficient futures market tech to the more important trading of securities? We need to consolidate. Too many duplicative assets and transaction systems have become weeds in the garden that is our innovative financial structure. The FTX bankruptcy is just the beginning.