Happy Friday!
I feel like I write about the debt ceiling every 12-18 months, but it’s important to remind clients, or else they can succumb to the dangers of the nightly news. But if the Republicans split the government, I’d wager this drama could become the next big story over the coming months.
Spoiler alert: The world won’t end.
What a day!
The S&P 500 rallied 5.5% on Thursday. That’s the biggest day for the index in over 2.5 years. The Nasdaq rallied 7.4%. While we never know why markets do what they do daily, I’ve got a pretty good hunch.
The odds of the Fed hiking by 0.75% in December fell from 43% on Wednesday to 14% on Thursday. Four months of falling inflation, including the better-than-expected print this week, finally brought some good news to the bulls.
Less inflation = lower rates = higher stock prices.
FTX
I’m not going to recap this story because I still don’t think anyone really knows what happened just yet, but it brings up an interesting paradox of decentralized finance.
Most banks have a liquidity mismatch. They borrow short-term deposits from you and me, then create long-term loans to businesses, etc. They have to be able to give us our money back when we want it, but if a bunch of depositors asked for their money back at once, even though it may be in high-quality loans, the bank doesn’t have 100% of the cash on hand.
Back in the old days, if a bank ran into this problem, they’d call another bank and ask for a loan to cover client withdrawals. The lender would look at the bank’s loan book and determine if it was good enough, and if so, they’d loan the money.
But think about the vulnerability of the borrowing bank. The lender could basically charge whatever interest rate they wanted, but that’s the best-case scenario for the borrower.
The worst case is saying something like, “we’d be happy to help out a competitor and save your business.” Then, at the 11th hour, they say, “we changed our minds,” while sporting a Mr. Burns evil grin. The next day, the borrowing bank files for bankruptcy, and the CEO takes a swan dive from the 33rd floor on the corner of Wall and Broad.
This precise scenario is one reason why central banks exist today. Sure, they do stupid stuff like call inflation “transitory” and use words like “pain” twice in one speech at Jackson Hole, but they also act as the lender of last resort.
Today, if a bank faces a liquidity crisis, they don’t have to go begging a competitor who’s probably going to shove a hose down their throat while they are drowning. They can just pick up the phone and call J-Pow.
And the price? Well, it’s being subjected to a litany of debatably-effective stress tests, clinically insane regulations, and political stuff like producing reports on the impact of climate change on client deposits, etc. But the point is that Uncle Sam has your back.
But one of the foundational doctrines of the crypto religion is not having a central authority. It’s decentralized. Central banks are bad!
This week, its disciples may realize that the cure is worse than the disease. The second-largest crypto exchange is a fraud, its equity investors got zero’d, and Sam Bankman-Fried’s (SBF) net worth has mostly been eviscerated. Why?
Aside from the fraud, FTX and SBF had no lender of last resort. They tried going to the largest crypto exchange, Binance, and asking for a bailout, but that didn’t work. Binance did a savage “we changed our minds” to FTX.
And now there’s presumably nowhere else to go except maybe jail for SBF. Because lending 60% of client assets from FTX to your affiliated trading shop that you tell everyone isn’t affiliated but clearly is and then losing all that money in risky trading backed by collateral issued by and tied to the financial health of FTX cannot possibly be legal anywhere. Not even in the Caribbean.
But getting back to my point. How does the Church of Crypto solve this conundrum? How do they stay decentralized without a lender of last resort? Because without it, earning the trust required to transact in society today seems incredibly difficult.
Of all the fascinating things that have happened this year in global financial markets, this story is top-tier. And obviously, the memes have been exceptional. Most are NSFW, so I won’t be forwarding them along, but a basic search on Twitter will keep you laughing for hours.
Enjoy the weekend…
Mike on Markets 