Solvency is not liquidity and liquidity is not solvency

If you want to understand what happened with FTX, learn the difference between solvency and liquidity.

I see a lot of people claim that FTX had a liquidity crisis. I don’t think that’s correct. I think it had a solvency crisis. These are different things, though insolvency can often cause a liquidity crisis. In any event, Matt Levine seems to agree with me:

Still the distinction matters. Roughly it comes down to: If someone gave you enough time to sell all your assets—whatever that means exactly—would you be able to sell them for enough money to cover your debts?

If the answer is yes, then you have a liquidity crisis, and someone can probably fix it. You call up someone with a lot of money—J.P. Morgan, Jamie Dimon, Warren Buffett, the Federal Reserve, etc.—and say “hey we need some money to pay our current debts, which we were hoping you would lend to us, but we have plenty of good assets, which we will sell at a leisurely pace over the next few months to raise enough money to pay you back.” And then your potential rescuer looks at your financial statements and evaluates your assets to see if it agrees that you are solvent, and if it does it gives you the money to solve your liquidity problem, and then you pay it back in good time.

And—SBF apparently tried to raise that capital. He tried to solve for a liquidity crisis, but no one was willing to fund him. This suggests, as Matt Levine alludes to, somewhat obliquely, a solvency crisis, not a liquidity crisis.

So, what does “solvency” mean? Simple: it means that your assets can be sold to cover your debts. If you have $100 in assets and $50 in debt, you are solvent ($100 > $50). Now, you may not be able to sell those assets in a timely manner, in which case you have a liquidity crisis. But you are still solvent, and, if you can’t sell those assets because they’re illiquid, then, as Matt Levine suggests, someone will step up to the plate and give you an emergency infusion of cash to pay down those debts. Now, that emergency infusion of cash will be expensive: it will have a high interest rate, it may have warrants or options attached to it as a condition of financing, etc. But you will get your money, you will be able to pay off your debts, and everything will work out.

But insolvency is different. Assume you had $50 in assets and $100 in debt, and assume you need to pay off your debt, fast. You’re fucked. Your assets can’t cover your debt, and no one will lend to you because, even when you are able to sell your assets, you won’t be able to pay the loan back! You’re insolvent.

And that’s what seems to have happened with FTX. Its assets were worth less than its liabilities. So no one was willing to lend it money. And it collapsed.