How magical thinking enabled the rise of FTX – and led to its fall

A few months ago, at a raucous tech conference in Toronto, I struck up a conversation with some crypto evangelists eager to extol the joys of decentralized finance, or as they like to call it, “DeFi.”

With reverent fervor, they explained that they love digital assets because there are no hierarchies: anyone can trade Bitcoin, for example, without having to rely on central gatekeepers like banks.

What about the exchanges, I asked, pointing out that a lot of crypto activity takes place on these centralized hubs. Economic sociologist Koray Çalışkan notes that more than 90 percent of Bitcoins traded in 2021 were stored in crypto exchanges.

It seemed to me that this created more, not less, concentrations of power than in mainstream finance. The collapsed cryptocurrency exchange FTX, for example, was not only a broker, but also issued its own currency, offered custody of customer assets and was affiliated with a trading company called Alameda.

Wasn’t this centralization a contradiction to the DeFi faith? Not for the crypto kids in Toronto who brushed my question aside.

I smiled at the irony at the time, but the situation is no laughing matter. Since FTX imploded this month, it has become clear that the concentration of power, coupled with a lack of oversight, has resulted in massive customer losses as funds were passed around without accountability.

As British central banker Sir Jon Cunliffe noted in a speech this week: “The crypto institutions at the center of much of the system exist in a largely unregulated space and are highly vulnerable to the risks that regulation in the conventional financial sector is designed to avoid.”

As we look at the wreckage, we must ask not only how FTX created an $8 billion hole in its balance sheet, but also why these dangerous contradictions were ignored for so long. Why did so many have a blind spot?

One answer is that, as anthropologists often point out, humans are predisposed to adopt magical thinking or mystical explanations for things we do not understand; We need hope in a scary world. Digitalization has not changed this. The way cyberspace works is as confusing to most of us as anything we encounter in the real world.

Technology's creation mythology was full of contradictions that were largely ignored

We are also quite adept at ignoring things that might undermine the beliefs we use to shape our world. “It is difficult to get a man to understand something when his salary depends on his not understanding it,” noted US writer Upton Sinclair. The same applies to social status, religion or other parts of our identity.

Decades ago, I witnessed this while working as a reporter in capital markets, where financiers had invented a new way to repackage debts like mortgages into complex new instruments known as collateralized debt obligations (CDOs). When I asked why bankers were doing this, they told me they were creating a more "liquid" (tradable) free market that would make the financial system safer by diversifying risk.

It sounded seductive. And they probably partly believed it. But as in cryptoland, there were some major contradictions. On the one hand, the CDOs were so complex that they could not easily be traded on a “free” (liquid) market. And the CDO sector was so opaque that it actually increased risk in the name of financial security. Magical thinking reigned.

So to Silicon Valley. On my first visit in 2010, despite the recent global financial crisis, I encountered an evangelism with echoes of the CDO sphere. There were people like Facebook founder Mark Zuckerberg who insisted that making the world more connected was good because it would promote equality, democracy and freedom. Never mind that the sector appeared ripe for exploitation, with only a tiny minority understanding the core algorithms used by groups like Facebook. Technology's creation mythology, like finance, was full of contradictions that were largely ignored.

I'm not suggesting that technology or finance has been unusually bad in this regard. Conflicting creation myths can be found in most professions, including in the media. Nor am I suggesting that the mere existence of self-deception makes all of these innovations wrong. Far from it. The Internet is an amazing invention, even with its flaws. And some forms of debt restructuring are useful if supervised. Innovations in digital assets can also be valuable: decentralized ledgers could improve the retention of real estate records, for example.

But the FTX saga shows how doublethink, when taken to the extreme, can have extremely damaging effects.

Follow Gillian on Twitter @gilliantettand email hergillian.tett@ft.com

Follow @FTMagon Twitter to be the first to hear about our latest stories