The Bear’s Lair: Bernanke brought us Bankman-Fried

The collapse of Sam Bankman-Fried’s crypto-currency exchange FTX, resulting in the loss of at least $1 billion of customer money, will be used to demand more regulation of the crypto-currency business. Yet its growth, collapse and the murky web of corrupt connections surrounding it were a product of the decade of “funny money” that has allowed fraud to flourish, as it always does in such periods. The blame for the Bankman-Fried debacle, therefore, can be traced back to one source: the unjustifiable corruption of monetary policy by Fed chairman Ben Bernanke.

In their origins, cryptocurrencies owe nothing to Bernanke’s “funny money” campaign; indeed they were invented in opposition to the Fed’s monetary manipulations. Satoshi Nakamoto, the likely lone inventor of Bitcoin was relatively untouched by conventional economic forces. In his February 2009 introduction of Bitcoin, he wrote:

“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve.”

One can disagree with Nakamoto’s solution to the problems of fiat currencies, but not with his diagnosis of their central problem. An additional factor at the time of Nakamoto’s paper was the recent demise of e-gold, a virtual currency linked to gold which had been declared illegal by overreaching U.S. authorities; Bitcoin, with no link to gold, would be immune to presumptuous and spurious attacks of this nature.

In its early years, Bitcoin’s growth and that of other cryptocurrencies was largely confined to techies and hobbyists. However, the Bernanke-inspired zero interest rate policies that began worldwide in 2009 boosted cryptocurrencies’ explosion of value. With conventional fiat currencies bearing negative real yields, the search for something that would be immune to such manipulation became intense.

When Kevin Dowd and I wrote a paper on Bitcoin in 2014, we stressed that it was vulnerable to manipulation, but recognized that its central algorithm, whereby “mining” bitcoins became more and more difficult with each Bitcoin mined, was intrinsically deflationary, tending to preserve the value of Bitcoin. Theoretically, if the price of electric power remains constant, the “value” of Bitcoin should be correlated to the state of the art in “mining” hardware efficiency competing with the demand for Bitcoin. That demand would have been driven by the utility value of Bitcoin as more people started accepting and transacting in it.

If monetary policy had been stable in the 2010s, Bitcoin would probably have expanded in accordance with its utility value, with a modest number of altcoins joining it as the techies found alternative crypto structures that appeared attractive. No great fortunes would have been made, no great scandals would have occurred, and the total value of cryptocurrencies today would probably be a few billion dollars. Blockchain data structures would have been applied elsewhere in the payment system universe and cryptocurrencies would be merely one somewhat obscure application of its wizardry.

In the real world, interest rates were close to zero for more than a decade while inflation ticked along at around 2% before spiking upwards after the 2020 pandemic. It was therefore profitable for the well-connected to borrow money and invest it in anything that looked likely to preserve its real value. Initially, in 2009-11, gold benefited from this, but after 2011 gold prices fell and gold fell out of favor with the cognoscenti. Meanwhile, tech stocks, both publicly and privately held, enjoyed a startling boom with trillions of dollars flooding into funds devoted to them. Cryptocurrencies were a natural beneficiary of the search for hard assets other than gold; they also had an attractive techie flavor. Hence outside money began to enter the space and Bitcoin’s price soared far above its utility value.

Once that happened, cryptocurrencies’ integrity disintegrated. It became profitable for Chinese miners to manufacture Bitcoin using mispriced hydroelectric power. The first large scam appeared, with the Mt. Gox exchange, based in Tokyo, suspending operations in February 2014, leaving 760,000 Bitcoins “unaccounted for” at a then market value of $473 million. On the positive side, some large fortunes were made, often by those who had mined large quantities of Bitcoin in 2009-10 and not lost the “wallet” in which they were contained. The value of Bitcoin began to fluctuate uncontrollably, and a myriad of “altcoins” appeared, many of them jokes (Dogecoin) or without utility value.

In 2017, the total value of cryptocurrencies outstanding touched $1 trillion, with a genuine “bubble” taking place in the second half of that year. Naturally, at that point Big Wall Street got involved. Once Goldman Sachs and other big players entered the cryptocurrency “space,” after a temporary retreat in 2018-19 valuations blew up still further, to a peak of over $3 trillion in 2021. Sam Bankman-Fried also got involved at the peak of the 2017 bubble, founding his trading firm Alameda Research in November 2017. Big-time fraud, along with Wall Street, had arrived at the Bernanke-fueled party.

In the bubbles of today’s bloated-government world, the most effective fraudsters are politically connected. To a certain extent, this has always been true in bubbles – John Law was able to get special privileges for his Mississippi Company and Banque Royale through his connections with the Regent of France, Philippe d’Orleans. Bernie Madoff, also was a doyen of the New York charity/political circuit, and former chairman of the NASDAQ stock exchange.

Bankman-Fried was the son of two Stanford Law School professors and had become a proponent of “effective altruism” – a fashionable nostrum inspiring billions of leftist charitable tax deductions. Through his upbringing and his education, he thus acquired connections with the billions of Silicon Valley and the fashionably “woke” politicians that they funded. When he sought funding after an initial arbitrage profit, Bankman-Fried obtained it from Sequoia Capital, the $85 billion venture capital fund that was grandfather to many of Silicon Valley’s greatest hits. With connections like that, infinite Bernanke-fed cheap funding for Bankman-Fried’s embryonic empire was never going to be a problem.

Having founded Alameda Research, made some initial profits in Japanese arbitrage, attracted funding and engaged in wildly speculative but often successful trading activity in a cryptocurrency bull market, Bankman-Fried then in 2019 founded FTX, a cryptocurrency exchange, where outside investors could buy and sell cryptos, and hold them on deposit at the exchange. FTX, considered somewhat better run than other cryptocurrency exchanges, coupled with Bankman-Fried’s connections and massive Democrat political donations, was in an excellent regulatory position to attract U.S. investors. FTX issued a cryptocurrency token, FTT, which was used to fund Alameda and other activities; this token was listed as “Cash” in FTX’s accounts, apparently a common practice in the cryptocurrency sector. By 2021, when the Bitcoin price hit $60,000, Bankman-Fried’s net worth was claimed to total $26 billion. $40 million of that net worth was used to fund the Democrats in the recent midterm elections (their second largest donor after George Soros), while FTX set up an FTT-based donation website to fund Ukraine.

Then in September 2022, Bankman-Fried quarreled with the owner of another cryptocurrency exchange Binance. Binance threatened to sell their holdings of FTT, the FTT price collapsed, and Bankman-Fried, his net worth now below $1 billion, was forced to declare FTX bankrupt. It then emerged that customer funds held on FTX had been used to fund Alameda, a no-no that appears to have amounted to outright fraud.

A typical funny-money collapse, in other words. Yet Bankman-Fried was indeed well connected in leftist circles; the New York Times advertised a November 30, 2022 conference, ticket price $2,400, whose featured speakers would have been Bankman-Fried, President Volodymyr Zelenskyy of Ukraine, Blackrock CEO Larry Fink and Treasury Secretary Janet Yellen – a level of left-Establishment acceptance that poor Bernie Madoff never quite attained. (One can imagine however that John Law would have been a star at such conferences until the Banque Royale fell.) It is a pity one cannot force the Times to hold the conference – the belly laughs from everybody’s embarrassment would be worth $2,400 of anybody’s money!

There will be many more such bankruptcies. The Bernanke funny-money era inflated irrationally the value of assets of all kinds, conventional and truly strange alike. Now interest rates are ever so slowly moving back to reasonable levels, those values must inevitably collapse, taking down with them all kinds of apparently impressive and solid structures. (In Bankman-Fried’s case, the collapse of FTX may prove the last straw that breaks the back of Masayoshi Son’s Softbank empire, though it appears to form a relatively small element in that group’s world-spanning tech disasters.)

Where interest rates are kept artificially low, asset prices will explode upwards. In such an atmosphere, fraudsters will inevitably appear in profusion. Their collapse will make us all feel poorer because, in J.K. Galbraith’s formulation, the “bezzle” of their embezzlement will disappear. But it will be for the best in the end.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)