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Will FTX's Collapse Ring in a Wider Market Crash Like Lehman Brothers

John Galt

Updated: December 1, 2022

crypto exchange bankrupt
Editor’s Note:

EDITOR'S NOTE: Crypto enthusiasts have generally accepted the dismal likelihood that the FTX debacle rendered what would have been a crypto Winter into an ice age. But is it a contagion that may affect the broader financial markets, say, something closer to a Lehman Brothers-style event? Will it have the same disastrous effect as the once-TBTF bank, one that can ripple throughout the markets and possibly the entire economy? Nobody wants to relive the 2008 financial crisis. Still, investors and financial institutions alike have continued to plow capital into high-risk assets (and, on a separate note, highly indebted companies). If FTX does have this effect on the financial system, there is no way anyone can call it a Black Swan event. The fragilities were out in the open, leveraged as much by greed as capital; and enough people decided to partake in it despite the risks. 

Will FTX's collapse ring in a wider market crash like Lehman Brothers in 2008?

  • With FTX at the center of a potentially major crypto collapse, parallels to the 2008 financial crisis continue to gain validity.
  • Some argue FTX could be the 2022 equivalent of the Lehman Brothers.
  • While markets have been relatively stable given the magnitude of FTX’s collapse, we could be in a sort of lag before the storm.

As fears continue to swirl that FTX’s bankruptcy may lead to a wider market crash, parallels are being made to another once-upon-a-time financial darling: Lehman Brothers. While some maintain FTX’s losses will be relatively self-contained, investors shouldn’t underestimate the lag between major market catalysts and eventual economic repercussions. It’s not too late for FTX to become the next Lehman Brothers.

In 2008, Lehman Brothers, the then-fourth largest investment bank in the country, declared bankruptcy due to overexposure to the collapsing subprime housing market.

For many, this was confirmation that the once-booming real estate industry would give way to a widespread, malicious recession. What followed Lehman’s demise was a virtual firestorm of government intervention in order to prevent a wider collapse of our entire economic system, bringing about a major recession in its stead. In 2022, it’s not hard to see the analogy with Sam Bankman-Fried’s monolithic crypto platform.

FTX was the crypto exchange. It had dozens of brand deals, endorsements from the biggest celebrities, billions of dollars in investments, and a renowned founder. FTX was the second-largest crypto exchange in the world.

On Nov. 8, FTX stopped allowing customers to withdraw cash from the platform in fear of a virtual bank run. This, it turned out, was because FTX is in deep money trouble. According to numerous media outlets, the company needed $8 billion to cover its debts. This forced Bankman-Fried to file for bankruptcy.

All the while, Bitcoin (BTC-USD) and other cryptos have been relatively stable. That isn’t to say there hasn’t been blowback; BTC-USD is down about 20% over the past month.

Unfortunately, however, the losses could be far more brutal. Some have already started calling FTX crypto’s Lehman Brothers moment, with Bankman-Fried earning the title of the “Bernie Madoff of crypto.”

Will FTX really ring in a market crash?

Housing in 2008 Is Crypto in 2022

It’s not hard to see the parallels between crypto today and housing in 2008. Just as crypto investors began endlessly buying any coin or token with a catchy name, in 2008, real estate investors were basically buying up every mortgage contract they could get their hands on. There were (and are) few mechanisms to hold brokerages accountable for selling unproven products.

Many crypto critics have demanded greater regulation in digital assets, using FTX’s recent destruction as the basis for more legislation. This is seemingly fair, if you don’t consider that MF Global, Lehman Brothers, Bear Stearns and Enron were all regulated by the Securities and Exchange Commission (SEC).  The Commodity Futures Trading Commission (CFTC) also has clear ties with FTX, so it’s not like the company was completely off the grid. Would further legislation actually make a difference?

Currently, FTX and its now-disgraced CEO are under the regulatory microscope. There’s some speculation Bankman-Fried may face time for violating wire fraud laws. Complicating the matter is the fact that FTX is based in the Bahamas, a sovereign country the U.S. justice system would have to communicate with to make action toward arrest or extradition. For that reason, it may be years before any real punishment is levied against Bankman-Fried. This, in some sense, only makes the situation more analogous to Lehman Brothers, which also suffered little legal blowback stemming from its overzealous lending mortgage lending practice.

FTX Could Be the Trigger to a Major Market Crash

Perhaps most troubling about the FTX situation is the potential domino effect it could have on the wider economy. Cryptos and the S&P 500 have trended parallel to each other for much of 2022. With an ever-growing number of companies gaining exposure to digital assets over the past few years, it’s common to see both markets go up on the same indicators. Now, we’re looking at a major bearish signal for both.

Michael Gayed, a portfolio manager, social media figure, and publisher of the Lead-Lag Report, told InvestorPlace that investors shouldn’t rule out FTX causing a wider downturn

Although Gayed doesn’t believe such a downturn is the “base case,” he does warn that there would be a lag until we see something. That “lag” could be where the market is right now.

“What we’re seeing is essentially a bank run, a digital bank run with the exchanges, everyone pulling out their money, that for all we know, could have knock-on effects, butterfly effects … that could reverberate to equities, even though it’s a much smaller portion of the overall dynamic of asset allocation. But the point more is that people, I think when they think they talk about Lehman Brothers, they think the market crash [happened] right away. That’s just not true. So it’s more hitting on the idea that we don’t know just yet if any of this is going to have a systemic effect just cause it hasn’t yet.”

Indeed, in September 2008, Lehman Brothers filed for bankruptcy, but the reverberations of the event weren’t fully digested by the markets until months afterwards. The S&P 500 didn’t hit its recessionary trough until almost March 2009, with home prices following a similar pattern. FTX may be the start of a wider market downturn, the full impact of which could be months or even years away.

Or much, much sooner. On Monday, BlockFi, a crypto lender and FTX financier, joined the disheveled firm in filing for bankruptcy, with estimated liabilities as high as $10 billion.

With both stocks and crypto already down significantly headed into the end of the year, all eyes will be on FTX as the next potential harbinger of a major market crash.

On the date of publication, Shrey Dua did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the Publishing Guidelines.

With degrees in economics and journalism, Shrey Dua leverages his ample experience in media and reporting to contribute well-informed articles covering everything from financial regulation and the electric vehicle industry to the housing market and monetary policy. Shrey’s articles have featured in the likes of Morning Brew, Real Clear Markets, the Downline Podcast, and more.

Originally published on Investor Place.

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