Too Big to Fail: Lessons from the Latest Crypto Saga

According to Wikipedia, the idea behind the phrase "too big to fail is that institutions in the banking and financial industry shouldn't have to bear the entire cost of failure on their own. If such institutions are big enough that their failure would hurt the economic system, then a government or central intervention to prevent such an event from happening is necessary.

On September 15, 2008, Lehman Brothers declared bankruptcy after a failed intervention by the Federal Reserve to get several banks to discuss the possible reorganization of the financial services firm. However, because these discussions failed, they triggered an effect throughout the whole economic system of the United States of America.

There was panic when the announcement was made, which worsened the situation. There was an exodus of funds from the Money Market Fund and a tightening in the interbank lending Market; this resulted in a drop in the Dow Jones average of about 4.5% daily. The funds' exodus prompted the Federal Reserve and the Government to respond with different measures.

Recently, there have been questions asked by well-meaning people, and the common ground with these questions is what happens when a crypto service firm, that is considered too big to fail, faults.

Retail Investors Funds; How Are They Protected?

Different events have occurred in crypto that left retail investors at the mercy of the market. A good example is the crash of the Luna network and the nosedive that occurred when the Terra stablecoin(UST) lost its peg. 

Before the crash, the coin dumped below $1 from an all-high of $116. The trouble started with the Anchor Lending Platform built on the Terra blockchain. It promised depositors a whooping twenty percent yield on their deposited tokens; due to this promise, a massive amount of UST got staked on the platform.

On May 7, $2 billion of the UST was un-staked off the anchor lending protocol and liquidated. The considerable selloff caused the coin to dump below $1, prompting people to exploit this by selling this value of UST for $1 of the stablecoin.

The increased market panic led to Luna's crash; the post-market implications of the event caused the bankruptcy of Celsius, Voyager, and Three Arrow Capital(3AC). For retail investors, this was more felt; however, law enforcement did nothing for those who staked in the anchor protocol, and Do Kwon, a co-founder of Terraform labs, is still free.

From the aftermath and how most people have moved on, retail investors' and depositors' money is certainly at the mercy of significant crypto failures. And no one takes responsibility and cautions against these failures, primarily due to decentralization.

The FTX Saga

It all began when Changpeng Zhao saying that Binance was to sell its remaining FTT holding to protect itself after it came upon some information.

In response, Sam of FTX made a now-deleted tweet on Twitter saying all asset was fine and there was no need to panic.

After a couple of back and forths, some revelations on FTX holdings were revealed, which caused a market panic and drove high withdrawal requests amidst a liquidity crunch at the exchange. FTX halted withdrawals for customers outside the United States to keep customers safe and prevent insolvency.

At first, Binance offered to buy into FTX to prevent a collapse from happening. However, after checking the FTX books, they announced that they were backing out of a $2 billion deal. Immediately after the announcement, many people panicked and tried to get their funds out.

After a while, FTX declared bankruptcy, and depositors weren’t protected, unlike traditional finance, where there is insurance and the government can intervene to protect depositors' funds. In Web3, due to the decentralization mantra, many depositors are left at the hands of bad actors driven by greed.

Final Thoughts

Since the gospel of Web3 is decentralization, people need to understand and agree that certain things in Web3 need to have regulations to prevent depositors from being casualties of bad actors. Seeing that the FTX saga is an example of what could go wrong with any significant entity regardless of the size and how negatively their fall could impact unsuspecting individuals. 

Individuals should strive to protect themselves at all costs, but you can only be lucky enough. Using a custodial wallet is risky, and crypto users should know that non-custodial wallets are better for storing funds.