Leverage

(Originally published November 15, 2022)

The last week has been pretty chaotic. Personally, the economic slowdown has shown itself at my day job, second job, and freelance work. Money just isn't being spent the way that it was six months ago. Maybe that's for the best after what has happened this week in crypto. If you aren't familiar, the world's third largest exchange became insolvent after they got over-leveraged.

This terminology may not be something that you're familiar with or you may not see how this applies to crypto, so I'm going to take a little time to explain. Many people all around the world maintain a bank account. You open a consumer account, deposit your money, and the bank holds your money for you until you go back to get it again. That's the basic format of how banking works for the consumer. However, it doesn't explain what is happening behind the scenes.

The bank uses the money that is deposited to finance other operations that make money. For example, small business loans from a community bank are generally funded from the deposits that community members have made to the bank. The bank uses cash to generate returns and then pays a VERY small amount to account holders in interest.

The reason that it's possible to confidently put your money into a bank account is that there is typically some type of guarantee of deposit by an overlying entity. In the United States, the banking system is backed by FDIC insurance, which guarantees a deposit into an account up to $250,000. This means that if the bank is unable to pay out your account due to overextending the money they get from deposits into risky assets, the FDIC will help by guaranteeing your money and making sure that you get it back despite the individual risk of that bank going under. This was instituted after the major bank runs of the Great Depression and is what allows confidence to keep funds in the bank.

Banks typically carry responsible leverage; however, there have been historical exceptions that have created turbulence in the economy. The subprime mortgage crisis of 2007-08 comes to mind immediately. The checks and balances in the established banking system create a more stable economic force.

This is relevant because crypto is not FDIC insured, meaning that there is no guarantee of deposit of funds on an exchange or brokerage. Customers of FDX, the exchange that went under due to being leveraged too far (among other things), won't be able to claim FDIC insurance and will have to wait for bankruptcy courts to unwind the assets and hopefully get SOME of their money back.

Leverage at the scale of major financial institutions can create serious problems in the economy. Most people aren't heading one of these organizations and aren't going to be in this position. That doesn't mean that there aren't lessons to be learned though. For sake of beating a dead horse, I won't turn this into a rant on self custody of assets.

A big takeaway for individuals is that using leverage is very risky and that purchasing ANYTHING on credit comes with risk. Even something as simple and common as credit cards can really escalate and cause consumers to feel like they're fighting an uphill, if not impossible, battle. Debt can be a bear to overcome. Debt based on leveraging an asset, like a home equity line of credit (HELOC), can be risky if the asset that the loan is based upon (aka the leverage) starts to decrease in value.

Home prices can bottom out and cause serious liquidity crunches (2008 showed us that). It is more common, however, for this to happen with a more volatile asset. When it comes to volatile assets, crypto is at the top of the list. The use of fungible cryptocurrencies to be used as leverage for any type of loan is an extremely risky practice. We've seen enough blowups (Terra/Luna, Three Arrows, Celsius, Voyager, FTX) to know that this type of practice needs to stop AND mirrors what has happened in TradFi.

Moral of the story? Don't get greedy. If you want something, earn the money to pull it off. Be patient. Easier said than done, but that's my $0.02. Hopefully, the next post is a bit more cheery.