Zero Hour - liquidity, solvency and the demise of (crypto) currencies
While social media is awash with prurient details of the lifestyle and business shenanigans of Sam Bankman-Fried and his senior colleagues at the FTX crypto exchange, the actual narrative of what happened and why the apparently fraudulent practices at the company led to its swift demise will be disappointingly familiar to market historians.
The reported transfer of supposedly-segregated client funds to other parts of the business (in FTX’s case from its exchange arm to its investment arm Alameda Research) to fill a liquidity gap caused by trading losses seems at first blush to be a carbon copy of the scandal which brought down derivatives broker MF Global in 2011.
While the financial products involved were different (crypto currency and tokens for FTX, more ‘conventional’ financial instruments in the case of MF Global), the genesis of the misdeeds at both companies appears to be surprisingly similar - proprietary trading losses which resulted in client funds being illegally used to provide liquidity to keep the show running.
Seasoned traders know about the ego-related risks of doubling down on bad bets. Risk management, particularly stop-losses, are used to manage exposures during fund draw downs. Covering-up losses or using non-sanctioned funds to keep losing bets open when the market moves against you can only last so long. This was the story for Nick Leeson at Barings (Japanese equity futures, 1995), MF Global (European sovereign debt, 2011) and FTX (crypto-currencies, 2022). Eventually the truth outs, and the demise is always swift.
The outing of the truth in these instances is usually a question of liquidity which then becomes an issue of solvency, and in the most egregious cases, finally an issue of bankruptcy.
Liquidity is a funny thing - something that is there when you apparently don’t need it but never there when you really do. To understand liquidity better, one first needs to understand the accounting principle of going concern.
One of the key roles of company management is to prepare financial statements and to provide the company’s main stakeholders (especially equity investors) with an opinion that the company is a going concern from an accounting point of view. Declaring a company to be a going concern means that it can continue to meet its operational and financial obligations over a reasonable time horizon.
In practical terms, this often means that if the company is not generating enough operational cashflow to meet these obligations, the company can access funds (via borrowing or issuing more shares) in good faith to pay the bills when they come due. For financial firms like MF Global or FTX, the bill-paying means providing funds for margin calls, rolling over debt, settling trades and the like.
When people talk about liquidity, they often do so from the first-person point of view (I or we). If you ask a trader what liquidity means, they usually say it means being able to transact in the market without moving the price too much. For a brokerage or banking institution, it means accessing funds at a reasonable rate of interest.
In reality though, financial crises reveal liquidity to be an issue best viewed from the second-person point of view (you). It takes two to tango. To transact in the market, two people need to agree on price but they have to disagree on value. I’ll buy if I think a stock will rise, you’ll sell if you think it will fall. If I think a stock will rise a lot, i’ll buy a lot here. Likewise, if I firmly believe a company is a going concern, I would be willing to lend a lot to it at a suitable interest rate.
The degree of conviction about value will be reflected in how much we are willing to trade or lend at a certain price, and this is what liquidity is - strong liquidity reflects high levels of conviction about future value, low liquidity reflects correspondingly low levels of conviction.
When no one will lend to a company even on an overnight basis (think Northern Rock, Lehmans, and now FTX), then liquidity is zero - the counterparty sees no value at all, and hence no lending or financing transaction occurs. Insolvent companies don’t often trade to zero, they just get valued at zero (ie the equity is wiped out in bankruptcy).
While the proximate cause for crises at financial institutions is usually a sharp deterioration in financial conditions (the Eurozone crisis in 2011 for MF Global, the Fed’s aggressive rate hikes in 2022 for FTX), the best way to conceptualise this process is that the company or institution’s time horizon drops to zero - no one sees any value in it at all, and the ensuing insolvency is marked by the death-rites of bankruptcy.
Whether crypto currencies are really currencies or just speculative investment instruments is a topic all of its own, but in extreme situations such as the aftermath of wars, a country’s whole financial system (and thus its currency) can be valued at zero. Nowhere is this more clearly illustrated in language than in the case of Germany in 1945.
The immediate post-war period in Germany was known as zero-hour or Stunde Null. Hitler’s thousand-year Reich was reduced to rubble, and its economy descended into the post-monetary state of barter - cigarettes and soap where the money of necessity for most Germans at the time. There was no thought of investment or hopes for the future, merely a desperate struggle for subsistence amidst the ruins.
While comparing corporate bankruptcy to the collapse of the third Reich might seem an oblique and outlandish analogy, the purpose is to illustrate the importance of thinking about liquidity and solvency, whether of a company or a nation, in terms of an ever-varying time horizon. Zero-hour for Germany is the temporal equivalent to bankruptcy at MF Global or FTX, only the former involved a whole country not just a company.
In a world awash with debt and thus heavily reliant on debt being rolled over, companies and countries must be able to continue to find sources of finance. Yet rising interest rates resulting from high levels of inflation, and central banks attempts to react to them through raising policy rates, are symptomatic of the market’s time horizon rapidly falling. Luminaries such as Edward Chancellor in his recent book ‘The Price of Time’ describe interest rates as the cost of time. The higher the cost, the shorter the investment time horizon, and as this time horizon falls, so funding sources dry up.
It should therefore not be a surprise that as financial conditions tighten, so too does funding, and as Warren Buffett pointed out, it is only when the tide goes out that we see who’s been swimming naked. Over the last few days, it is clear that Bankman-Fried and his cohorts were skinny dipping.
This problem isn’t just one for dodgy crypto companies. In the UK, the Liz Truss and Kwarzi Kwarteng ‘mini-budget’ has now seemingly entered market and political lore as a sort of original sin that revealed to UK pension funds and mortgage holders a horrifying glimpse of what zero-hour might look like in Britain. The yield on UK gilt-edged bonds spiked, and the pound tanked to historic lows against the dollar as markets took fright - the classic symptoms of a sovereign liquidity crisis.
The UK’s new Chancellor of the Exchequer, Jeremy Hunt, appears to be about to deliver a budget littered with tax hikes and spending cuts to sure-up the national finances and to assuage the markets about the British government’s fiscal probity.
But such fiscal tightening, together with monetary tightening from the Bank of England at a time when the UK is apparently heading into recession, only highlights the profound nature of the problems facing governments and central banks during a period of high inflation, high levels of debt, and low growth.
It may be an exaggeration to suggest that the UK is navigating between the Scylla of hyperinflation and the Charybdis of debt deflation, but the path to success is clearly a razor-thin one. When one reads serious market professionals like hedge fund Elliott Management warning of a potential future financial crisis in terms of hyperinflation (FT Link), one ought to be in no doubt about how high the stakes currently are. It is always the weak hands who fold first.