In investing, there is an urge to look to the past and find previous events that look similar to what is going on now as a framework to predict the future. This works well with typical equities because they have hundreds of years of robust market dynamics, so there is a comp for just about everything. In crypto, the comparisons are usually pretty weak, mostly because they don’t capture the same market dynamics. Things have just gotten so fast and complex with advancements like high frequency trading, synthetic assets (gBTC and stETH), complex leveraged financial tools (think crypto native perps, which are open ended options).
All of that being said, I think there is a really good comp between the crypto market right now and the 1907 Knickerbocker Crisis. You’re right, that’s not the only name. Many people call it the 1907 Financial Crisis, the 1907 Banking Crisis, etc. We’ll be exclusively referring to it as the Knickerbocker Crisis, because it’s way funnier. Okay, first a quick history lesson on the Knickerbocker Crisis.
The 1907 Knickerbocker Crisis
In 1907, regulations were a lot looser. What we would today call stock manipulation wasn’t all that rare. People were trying to manipulate the price of the United Copper Company via a short squeeze–they failed. We’re not going to get too deep into it, but the idea was this: if we buy all the available stock, and you need to get it to fulfill your short position later, you’ll have to bid up the price to get what you need and we’ll sell it for a profit.
So with the plan in place, the group got some large loans (in part from the Knickerbocker Trust), bought a bunch of stock, and asked for the short sellers to cover their position (see: GameStop). Here’s the problem: they did. The price of the shares ended up collapsing, the loans weren’t paid back, and other loans who used United Copper as collateral were smashed.
People heard that banks didn’t have enough money to pay back all their deposits. What do you do when you hear banks are giving back your money first come, first serve, until they’re out? You withdraw! This is called a bank run, when everyone goes to pull out all of their money at the same time.
The thing about bank runs is that they’re not isolated to the affected banks. Even if you haven’t lost people’s money, people don’t trust that you’ll have the money tomorrow. The contagion spreads.
In the throes of this, JP Morgan stepped in to offer liquidity to the banks (and buy up some companies at a 70% discount). JP Morgan and his friends saved the US economy (for the second time). This whole episode led to the creation of the Federal Reserve.
The Stablecoin Crisis of 2022
Let’s jump to today. We’re seeing a run on the banks in crypto due to a liquidity crisis, where contemporary crypto banks are exchanges which hold your reserves (CEXs). A crypto bank run looks like freezing reserves, becoming insolvent due to large crypto funds going bust and being unable to pay back their loans, declining assets in circulation on exchanges, and stablecoin market caps dropping.
In the past few weeks we’ve seen a coordinated attack take down a large cryptocurrency (LUNA/UST), resulting in a liquidity crisis due to lenders being unable to reclaim their loans. This liquidity crisis has cascaded throughout the entire market, being the primary catalyst for a massive drawdown. Many individual companies like Stablegains had allocated customer funds into Anchor Protocol, which offered high yields from UST. The largest crypto hedge fund is currently in the process of going under. Celsius, which claimed to be the first crypto bank, has halting withdrawals due to insolvency. Projects like Solend are putting forward proposals to take management over large accounts to prevent a large liquidation event causing deeper network liquidity problems.
So the set and setting rhyme with 1907, let’s introduce our JP Morgan. Sam Bankman-Fried (aka SBF) is the founder of FTX, one of the largest crypto exchanges in the world and Alameda Research, a famous crypto quantitative trading firm. He is one of the richest people on the planet at only 30 years old. SBF lives with roommates, he’s said he will give up to $1B in the next presidential election, and makes sure every room in his office has a bean bag chair to sleep on.
While many in this current crypto liquidity crisis have been announcing layoffs, hiring freezes, or have gotten really quiet, SBF has been busy. On the typical equity side, SBF bought 7.6% of Robinhood, a broker that has attributed much of its revenue to cryptocurrency trading. BlockFi, a large crypto lender and Celsius competitor, got a $250M line of credit from FTX. We call that a bailout.
After that, it was announced that Alameda Research was bailing out Voyager Digital with $500M in financing. That took the form of $200M in cash and USDC stablecoins, and 15,000 BTC ($300M at current prices). At this point, the question isn’t if SBF will step in, it’s what he’ll have collected by the time the dust settles.
One of the big things that came to light in the 1907 crisis was that a strong central bank was needed. Europe had central banks that could provide liquidity during a crisis, but the US required individuals to step in. JP Morgan ended up losing $21M, though his company US Steel bought up a large competitor.
It’s entirely possible that we leave this present crisis with SBF expanding his exchange, FTX, by buying up a few smaller ones struck by a lack of liquidity. Buying smaller exchanges to gain access to new markets has been part of the playbook for FTX for a while, and this is a good buying opportunity.
It took 6 years from the start of the crisis for the government to pass the Federal Reserve Act, creating the nation’s bank. If we do see some form of lender of last resort for the crypto world, it won’t be coming this year.