After FTX: Where Does Crypto Go From Here?

There is something odd about the apparent behavior of crypto market participants. In a normal financial market, catastrophic failures tend to produce over-reactions cratering prices, at least in the short run. One would certainly expect a flight away from those actors and practices shown to be sketchy.

Yet somehow, that isn’t what we see in crypto. Despite all the well-publicized hacks, scams, rug-pulls, and blow-ups in 2022, prices haven’t fallen all that much. The Terra/Luna, Celsius, and 3 Arrows Capital failures earlier this year moved the price of Bitcoin from around $30,000 to $20,000, where it largely stayed until the FTX collapse, which took it down to roughly $15,000. That’s a drop, but hardly the massive impact one would expect. Especially in such a speculative, volatile market.

I’m using Bitcoin here as a proxy for digital assets, since it’s by far the most heavily traded. The overall crypto market capitalization chart looks positively boring since the Terra/Luna began unwinding in mid-May.

There are two possible explanations for what’s going on here.

  1. Investors are keeping their faith in the asset class. They aren’t scared off by a few bad actors, when the prospects for digital assets are still so bright.

  2. The prices we’re seeing aren’t organic. These markets are manipulated behind the scenes by big players who have a strong interest in keeping prices at certain levels.

It would be nice to think the answer is #1. It’s just hard to look at market behavior in recent years and feel confident. While there are crypto and Bitcoin true believers who remain steadfast, the market since 2017 has been flooded by investors who are just in it for the money. We’re to believe Robinhood crowd and hedge-fund speculators are behaving like disciplined buy-and-hold investors? And not just for the “blue chips” like Bitcoin and Ethere; many DeFi tokens have shown incredible resilience even after being hacked. Look at that market cap chart again. The volatility often seems to be high when nothing obvious is driving it, and low when you’d most expect choppiness.

There are plenty of reasons to think explanation #2, market manipulation, is a very serious problem. I raised the alarm in my Congressional testimony back in February, as have many others. A major reason the Securities and Exchange Commission has rejected every proposed spot-market exchange traded product for digital assets is that it’s concerned about market manipulation and lack of visibility into offshore trading venues. There have been quite a few demonstrated examples of wash trading, pump-and-dump techniques, artificial short squeezes, suspicious trading freezes due to “technical issues,” strategic minting of stablecoins, and other activities that would clearly be illegal in the regulated financial world. And we know that digital asset holdings are, despite the promise of decentralization, extremely concentrated, creating major opportunities for manipulation. The revelations about FTX show that at least one major player was exploiting those opportunities. What gives us faith the other big offshore actors aren’t? Both regulators and Congress need to move aggressively to investigate and shine a light on what’s really happening in crypto.

The possibility that the market is systematically manipulated should be a cause for great concern. As I testified to the Senate Agriculture Committee, it would mean the real reckoning is being delayed and magnified.

There is something wrong when sizeable attacks and fraud are so common, and yet investors appear to shrug them off entirely. Researchers on trust generally identify ability, benevolence, and integrity as the three pillars for establishing trustworthiness. When digital asset and DeFi firms demonstrate their inability to safeguard assets, and engage in behavior that suggests ill-intent or inconsistency, it should result in a drop in trust. The fact that many such firms, and the market as a whole, do not experience such a reaction, indicates that investors may not rationally be assessing risks. This could be a recipe for disaster.

I’ll just leave that last sentence out there, with a coda: We’ve just seen something of a disaster with the collapse of FTX. And still the crypto market isn’t reacting rationally.

Be afraid.