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January 2023 | Finance

Finance Headlines, Explained

Controversial. Explosive. Confusing. Wharton finance professors provide deeper insights into the news stories making headlines, sharing their insider perspectives on the FTX collapse, political skirmishes over ESG investing, and blockchain technology.

The Collapse of FTX and the Future of Digital Assets

The quickly-evolving, shocking story of FTX’s collapse is bad enough — especially if some of the billions in lost assets were yours. But the hyperbole around the failure of one of the largest digital asset exchanges makes it difficult to discern what it might mean for blockchain, cryptocurrencies, and financial markets in general. It’s been called a “Lehman moment,” likened to Bernie Madoff’s ponzi scheme and Elizabeth Holmes’ Theranos fraud. Wharton professor of Legal Studies and Business Ethics Kevin Werbach says in reality it touches in some ways on all of those stories, but major differences are important to understand.

“The question of whether the collapse of FTX is analogous to Lehman implies that it could be the starting point of a broader collapse across the crypto market, and if that’s true, would that collapse spill over into the larger financial system,” says Werbach. “Regulators and central banks in particular have been looking at this for a while, and until recently have said that while they have worries about crypto, they don't see enough scale or interdependence that an unraveling of the crypto markets would lead to significant, systemic impacts on broader financial markets. But over the last year, there's been increasing alarm among financial policy makers about the growing scope and interdependence of crypto.”

The analogies to Lehman are questionable, says Werbach, because Lehman was an example of a larger problem, an “indication that the subprime mortgages and the systemic risk from credit default swaps were in fact systemic across the financial system. Lehman was not the worst actor. They were just the most poorly capitalized, and from a timing standpoint, they were allowed to go under.” The Theranos comparison is also problematic because it lacks broader implications: “no one looks at that fraud and says the medical device industry or the blood testing industry is a fraud.”

Werbach notes that other crypto-related business collapses pre-date FTX, including the Terra Luna stablecoin, Celsius, and Three Arrows Capital. “All of those events have raised fears about broader contagion within crypto, but we haven't seen any major impacts on financial markets. That's partly a result of the regulatory firewalls that are already in place in the United States. But there is still a question about what is going to come next, whether FTX is just one of a series of dominoes.”

What about the Madoff argument, which has been raised in large part by critics of bitcoin who see a much larger story in the FTX collapse? Werbach says it's clear that in many ways, FTX was a Ponzi scheme. “For example, FTX customers had deposited over 1 billion worth of Bitcoin that they were trading on FTX. At the time of its bankruptcy, FTX reported that they held zero Bitcoin. In fact, all of that Bitcoin that looked like it was in customer accounts had been transferred out to Alameda, FTX’s trading arm, and to other places. So that was a Ponzi scheme. They did not have the Bitcoin they claimed to have, and that's how it unraveled.”

However, says Werbach, that doesn’t mean Bitcoin itself is a Ponzi scheme. “The critics of crypto, including Paul Krugman, have argued for some time that the whole industry — the blockchain systems themselves, the digital assets — are fundamentally a Ponzi scheme, that they only have value because people talk up the value to sell it to someone else, that there's no underlying utility or functionality. And if that's the case, then it will eventually collapse. The FTX collapse doesn't show that, but it also doesn't disprove that.”

“I believe it to be the case that blockchain technology is fundamentally valuable, useful, and more than just financial speculation. But the industry as we know it is inseparable from the speculative activity we've seen in recent years, as people chase financial opportunities in this exploding market. It's going to need to eliminate that as a foundation in order to really reach its potential. And there's absolutely a need for new and greater regulation. The existing structure of financial regulation is poorly adapted to the nature of digital assets.”

The Future of Blockchain Technology

The collapse of FTX has shifted Congress into high gear, preparing to debate legislation that would better address the new challenges posed by digital finance. Informing them has been Managing Director of Wharton’s Stevens Center for Innovation in Finance Sarah Hammer. “I just got back from bipartisan briefings in the US Senate Financial lnnovation Caucus and House Financial Services staff on the Hill,” she says.”

“There’s a real sense that every conversation in financial services right now relates to FTX,” she says. “It seems to be what matters most at this time. But the real question is how to regulate effectively in the new world. Today we have laws that deal with securities and commodities, but there is a need for further clarity and likely also new regulations,” she explains. “And beyond that is the question of whether crypto will survive and what it will look like.”

Hammer says despite the controversies and conversations, “distributed ledger technology will likely be enduring. I have been interested in it for years, and I continue to believe in its potential to improve efficiency in financial infrastructure. Along these lines, there is recent news that Goldman Sachs is investing tens of millions of dollars in blockchain following the FTX bankruptcy.  In fact, David Solomon, the CEO of Goldman Sachs, recently authored an opinion piece in the Wall Street Journal on the strong potential for blockchain technology to improve trading, clearing and settlement, and investing.^[1]”

Through her role at the Stevens Center, Hammer sees both the scope and the potential for blockchain, working with companies that are using the technology to manage their supply chains, to analyze energy data to support clean energy, and to create digital financial identity.

The timing for portable digital identity in particular could not be better, as the Consumer Financial Protection Bureau (CFPB) is implementing a dormant rule from the Dodd Frank Act (Section 1033) requiring financial institutions to give consumers access to their own data. “Normally when you provide personal information to open an account,” says Hammer, “the bank manages your data. There has been a lot of discussion about banks selling that data. With the implementation of Section 1033 of the Dodd-Frank Act, the CFPB has made a great move forward for consumers — supporting open banking and greater transparency in the financial system.”

Digital financial IDs are more secure and efficient than the current system of providing information and going through a verification process every time you open a new account. “Banks, credit unions, and financial services companies should be looking at these IDs as an efficient way to comply with the new rule,” say Hammer. “They give individuals their own credentials that they can use across institutions, controlling who can see it and whether it is sold.”

One digital identity company that Professor Hammer refers to is Portabl, a blockchain-based startup that successfully completed the Cypher Accelerator program at the Stevens Center for Innovation in Finance.  Portabl was founded by Wharton alum Nate Soffio. “Banks and credit unions need tools to comply with Section 1033. It would be a ‘hefty lift’ for them to solve for it on their own.” he says, “Using a plug-and-play solution like ours means they can be ready quickly to enter customer records into our architecture, and when the customer asks for it, or needs to change or update it, you can deliver. It can aggregate and manage data, synch from one account to others, update, and be used for new originations and applications.”

An important benefit of this blockchain technology application is allowing for greater financial inclusion, which Soffio calls “very challenging. A primary hurdle for most people is the origination process, which requires a number of documents and is often poorly designed and confusing. This problem can be remediated by providing a safe mechanism to store trusted data about themselves and share it with others. From a financial application standpoint, we want to be the last data form you have to fill out. Once that record is created and verified, you can take it with you and share it in a few seconds with two or three clicks. If someone is comfortable paying through a cash app or signing up for Google, they should have no problem establishing a digital financial ID.”

Hammer adds, “As someone who cares deeply about financial inclusion, I believe having a way to manage your financial data and gain access to financial services is really important. People need that access to pay bills, take out small loans, finance their education, and save for retirement. Blockchain technology is making that possible — and it is just one of the many important uses that are currently being developed. It is an exciting time to be working in this space.”

Individual Investors Take the Reigns

When it comes to investing your retirement funds, who gets to choose? That question is gaining traction — and controversy. A notable example is in the ESG space. “A lot of press in recent weeks has had to do with ERISA (Employee Retirement Income Security Act), which dictates the fiduciary duties of those who structure retirement investing,” says finance professor and director of Wharton’s Stevens Center for Innovation in Finance David Musto. Specifically, ERISA fiduciaries will not be penalized for “appropriately considering” ESG-type factors when weighing investment alternatives, where those factors are material to the risk-return analysis.

The controversy stems not so much from retirement plans that offer investors a range of funds to choose from, but from plans in which fiduciaries invest on behalf of employees, who have no choice in those investments. “Public school teachers, for example,” says Musto, “have a defined benefit plan that they’re stuck with. The question is, in that situation, what is the fiduciaries’ latitude to consider ESG principles in their investment decisions? It’s when you don't have that choice that the tensions grow.”

Those tensions set the stage for actions like governor Ron DeSantis’s forbidding Florida fiduciaries from investing any part of their state’s funds with Blackrock because of their commitment to ESG investing. “It’s not about ESG funds’ performance,” says Musto. “It sounds more like it was about ideology. Larry Fink [Blackrock’s CEO] is a very vocal proponent of certain views about what companies should do, and DeSantis has other views. I think that's all there was to it. Because Blackrock, Vanguard, and State Street hold about 18 percent of the shares of the typical S&P 500 company, the question becomes whether they are using their huge voting power to influence the companies they hold in a way that their funds’ shareholders would want them to be influenced.”

DeSantis and the state’s Chief Financial Officer seem to think that’s what’s happening. “Using our cash to fund BlackRock's social-engineering project isn't something Florida ever signed up for,” CFO Jimmy Patronis said. But a recent rule by the Department of Labor, which oversees ERISA, allows retirement fund fiduciaries to add funds that invest in accordance with ESG principles. “My guess is individual investors in Florida would like to have that choice,” says Musto. “They wouldn't want to be forced into it, but they would like to have it.”

“A lot of pressure can be resolved by just offering people that choice,” he continues. “I think we’re going to see more of that coming from investment firms and politicians for their own sense of preservation. I think we're moving in that direction. Instead of leaving it up to a governor or a fund manager, the individual investor will have the power to decide.”

What would that look like? Musto says firms like BlackRock and Vanguard are looking for ways to allow the ultimate shareholders—those whose money is in their funds — to vote if they want to. “That could release a lot of pressure, showing that although Larry Fink has authority over a lot of votes, he lets everybody who wants to wield the voting power that arises from their own investment. That could be where we're headed, and the question it engenders for fintech is, how do you do that?”

One option, according to Musto, is getting ballots to individual investors, which would be “harder than it sounds. Building a new secure system to allow the right people to vote, and having them cast their ballots on time is not a simple thing. But allowing people to wield the votes that arise from their own investments, not making them captive to somebody else, would calm a lot of people down. It would eliminate much of the grounds for complaint. The whole question of whether you're captive or not is important.”

Another option is a middle ground, in which fund managers could ask how investors want them to vote their shares. “They could offer choices,” says Musto, “including perhaps an ESG paradigm, and investors would check a box that that reasonably encapsulates their ethos. That could be a way to get around some of the ‘integrity of the vote’ issues that could arise if you try to bring the vote all the way back to individual investors.”

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