I would like to talk about lessons one can learn from the recent developments in the crypto industry which was valued at €3 trillion at its peak (and since then has lost two-thirds of it).
In high finance, liquidity and solvency are two separate issues, and rightly so. Liquidity is very easy to understand. Imagine you took your date to a Michelin star and after the meal you realise you forgot your wallet (and no, you don’t have Revolut on your phone). You have cash in your bank account/under your pillow at home but not with you at the restaurant when you need it. You have run into a liquidity issue.
Now to solvency. Imagine, after realising you forgot your wallet, you take out a card hidden under your shoe sole (inspired by some 007 style thriller) and try paying for the dinner with it. To your horror, the limit on the card is below the bill amount. Now you are insolvent as far as the restaurant is concerned.
From a financial perspective these are two different kinds of crisis (as for the dating perspective you can safely assume this is your last date with your current date). However, what I have just explained is when a liquidity issue turns into a solvency issue.
Imagine a bank having €100 deposits (liability) and €70 worth of lending (assets). Let’s assume all debtors are top quality, backed by good finances. As is typical with banks, where they borrow short and lend long, there is a mismatch between when the liabilities can be called and when banks can get their money back from creditors.
What I can safely say is once only €31 (out of total €100) worth of depositors ask for their money back (a liquidity issue), it may turn into a solvency issue.
Northern Rock in the UK failed in 2007 with serpent-like queues outside branches. Was Northern Rock insolvent to begin with? I don’t know. But it surely started with a liquidity issue.
If you must put money in a ‘ponzi’ scheme ensure you get out before others do– Somnath Banerjee
Now let’s turn to some of the major stories in the crypto area, i.e. stable coins (Tether), algorithmic stable coin (Luna-Terra) and FTX. It’s hard to argue with a straight face that any of these had any credible business idea backed with anything reasonably tangible; but what has changed now that exposed the insolvent nature of their business?
Its liquidity. If there was no run to redeem your Tether (arguably it has not failed, yet), Lunas (all ‘lunatics’, as fondly called by its creator Do Kwon, wanted to convert to fiat) and FTX’s depositors asking for their money back, who knows when we would have seen this comedy of ‘sound businesses’ failing like a house of cards, and some of the richest people in the world running, hiding and fighting extraditions.
So, my first lesson is, never take a liquidity concern lightly. If it can fail a bank (arguably with a much more sound business model than the crypto sector), it won’t need more than a few investors/depositors trying to get out of a ‘ponzi’ scheme (Sam Bankman-Fried popularly called SBF was proud to call it a ponzi scheme in one of his interviews last summer) for it all to go belly up.
The second lesson is far more relevant for the industry titans but still has significance for investors too. Just a few months ago, SBF was likened to John Pierpont Morgan who is credited with saving the American banking system in early 1900s. SBF was on a deal-making spree and buying out all troubled names in the crypto sector.
Fast forward to November and FTX is found swimming naked. The question is why was he giving his underwear to others? Because he knew if one piece falls in the domino, it will take down everyone.
And that’s exactly what’s happening now. All these ventures have interconnected stakes in each other, and above all, the only thing that can stop a ‘ponzi’ business from going down is the perception of ‘all is well’.
So, for SBF, it was a no-brainer. If others go down, he will take a fall too. So might as well roll the last dice and see if the gamble pays off. Changpeng Zhao (popularly known as CZ) of Binance (simply the biggest crypto exchange) tried to save FTX but then he knew its way too much with blatant fraud allegations against FTX. Not to mention there are similar ongoing fraud investigations going against his company Binance too.
And now even Binance is feeling the heat with billions of redemptions since FTX’s collapse.
So, what can investors learn from it? No, the obvious lesson of doing due diligence is not happening because investors don’t have that patience, and the crypto business owners will never reveal any meaningful information as secrecy is the reason why the crypto sector came into existence to begin with.
My take is, if you must put money in a ‘ponzi’ scheme, ensure you get out before others do. Easier said than done, but there are always signs that an investor can look for. Leave at the first sign of trouble.
When you invest in a business backed by a real business plan, you can afford to stay invested even if there are troubles, but when invested in a ‘ponzi’ scheme your best bet is to get out before others do.
Somnath Banerjee is head of investment management at Curmi and Partners Ltd.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.
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