In the midst of the FTX fallout, Binance CEO Changpeng “CZ” Zhao’s proposal to create an “industry recovery fund” has been the focus of significant attention. According to an announcement, the $2 billion Industry Recovery Initiative (or IRI) will support projects that “through no fault of their own, are facing significant, short-term, financial difficulties.” Some $50 million has been committed by venture capital firms, while Binance will ostensibly provide the rest, as well as general administration.
This announcement is the latest step in the crypto industry’s attempts to establish a mechanism for bailing out firms facing liquidity issues and heading off the systemic risk from their collapse. Bloomberg columnist Matt Levine observed that establishing the IRI would solidify Binance’s role as a de facto central bank for the crypto industry by establishing it as the industry’s lender of last resort.
Stephanie Hurder is a founding economist at Prysm Group and an academic contributor to the World Economic Forum. This piece is part of "Crypto 2023"
Designing a system to bail out firms in financial crises and to mitigate systemic risk is not a new problem. Domestically in the United States, a combination of government organizations, such as the central banks and the Federal Deposit Insurance Corporation (FDIC), frequently play this role for banking systems via emergency lending programs and deposit insurance. This year’s Nobel Prize-winning research detailed how such programs can help avoid widespread financial crises.
But the crypto industry is far more like the hedge fund industry than a system of retail banks: token-denominated liabilities and assets are in a variety of currencies whose relative values are volatile. How can a backstop be designed in light of this additional complexity?
Read more: Crypto Needs an FDIC-Like Protocol to Prevent Liquidity Crises | Opinion
The International Monetary Fund (IMF) has spent decades serving as the lender of last resort in a global economy where countries must grapple with a wide variety of unique currencies and financial circumstances. And while the experience of countries bailed out by the IMF is not exactly idyllic, and fierce debate among economists continues about how the fund can improve, it provides a reference point for the crypto industry. Crypto today is taking its first steps toward establishing institutions to promote systemic stability.
What can the crypto industry learn from the IMF when it comes to bailouts?
First, no single entity should supply or control the use of funds in the context of bailouts. It must be a consortium endeavor. The IMF is composed of 190 countries, who contribute funds and participate in different ways, such as through voting and in various sub-committees. At a high level, the IMF governance structure is composed of the Board of Governors and the Executive Board. Each country has one seat on the Board of Governors and a specified voting power based on their pro-rata funds contribution in a quota system. The single-highest voting power – the United States – is only ~16% of total voting power. Moreover, the Executive Board is composed of 24 executive directors, with a portion of seats rotating and representing multiple nations while seven countries have permanent seats.
Overall, no single country controls any of the IMF’s plethora of economic support vehicles and facilities.
Positioning any single entity – including Binance – as the crypto industry’s lender of last resort fails to reduce systemic risk and creates a host of new problems. The recent collapse of FTX and its widespread impacts on other players have begun to reveal the full nature of the complex interdependencies that existed between the exchange and other entities in the crypto industry.
These relationships, as currently publicly known, have been summarized by publications like CoinDesk. If an entity functioning as the lender of last resort in the crypto industry were a participant in such a complex interdependent network, a myriad of conflicts of interest would arise. For example, they could wield funds as anticompetitive weapons or use access to proprietary information to their own private benefit. A lender of last resort isn’t actually a lender of last resort when its own solvency and institutional trust is fragile and highly correlated to the same players it is meant to backstop.
Just as the IMF distributes power and responsibility across many entities, crypto should aim for a similarly distributed structure.
Second, bailout provisions must depend on systemic risk, not on the allocation of blame. Binance’s IRI announcement said the IRI will support projects that “through no fault of their own, are facing significant, short-term, financial difficulties.” This confuses the primary function and economic logic that creates a defensible scope for bailouts.
Read more: The Role Regulators Played in the FTX Fiasco
The purpose of a bailout is to both make whole the firm’s lenders and customers, and to the greatest extent possible to prevent widespread liquidity crises from spreading and developing into broader financial crises. Whether an emergency financial scenario arises from prior malicious risk-taking activity or blameless behavior is inconsequential at the point when swift action is required to ensure market stability.
For example, after the 2008 global financial crisis, the IMF helped bail out Greece even though the Greek government had partially caused the scenario by incorrectly reporting debt levels. Ultimately, the IMF gave relief funds and even violated some of its own internal rules in the name of preventing a widespread crisis.
In crypto, a similar dynamic may develop if a structurally significant player becomes hacked or compromised. Sure, the protocol should have done all it could to avoid the scenario in the first place, but at the point in time that it has a spillover impact on the entire crypto industry, the priority is to guarantee stability, not attempt to assign ultimate responsibility or make funds conditional upon the court of public opinion.
This brings up a third point – how to avoid moral hazard? The obvious problem with a bailout fund that bails out each entity with sufficient systemic risk is that it’s too easy for firms to be careless with risk management and then turn to the fund for ex post relief. While bailouts can’t be conditioned on whether management behaved badly, ex post punishments and economic restrictions certainly can.
The IMF is known for imposing onerous debt service and other structural conditions on bailout recipients, even when these restrictions might prevent the country from rebounding quickly. Indeed, these are so unpleasant that countries will do almost anything to avoid using the IMF’s resources. There are typically ~20 structural conditions imposed by the IMF when a country accepts a bail-out package, though in 2012 Greece had as many as 97 structural conditions imposed by the IMF. The message is that while the lender of last resort won’t let a country collapse, it won’t be easy or pleasant for the country in the following years.
This brings us to the crux of the matter: In order for crypto to have any hope of solving this same problem, the cost to individual project teams of needing bailouts must be severe. Importantly, these punishments will need to be imposed by other members of the crypto industry. With an industry as globally distributed and borderless as crypto, agencies of individual governments will forever be playing whack-a-mole.
Schemes for such punishments haven’t yet been developed, but could include a subset of the consortium members assuming immediate control over the project or taking board seats. Key members of the management staff may experience sanctions, penalties or difficulty raising funding for ongoing or new projects.
Overall, the messaging from the lender(s) of last resort to the management of failed crypto firms must be swift and severe: We’ll help save your creditors and ensure you avoid collapse, but you are not going to enjoy it and your reputation will be severely damaged.
In light of the fallout from FTX’s collapse and this year’s insolvencies, bailouts and recovery funds have become a hot topic. Although it is much easier said than done, an independent IMF-style organization is the crypto industry’s best chance at implementing a financial backstop to mitigate systemic risk and protect consumers. Letting any single entity, especially a crypto industry competitor, assume this role will ultimately increase crypto’s systemic risk and leave the industry vulnerable to yet another FTX-style collapse that hampers the industry’s growth and adoption.
Prysm Group Senior Associate Johnny Antos and Prysm Group Associate Kajol Char contributed to this article.