“A deflating crypto bubble is now hemorrhaging from Ponzi punctures.” – The Lonely Realist
In July’s “Crypto Reality,” TLR noted that although crypto was devised to be a transparent, democratic, de-centralized financial technology that would overcome the burdens of traditional finance and allow investors to safely build wealth without the hassles of bureaucratically-regulated banks and brokers, that hasn’t worked out so well. Crypto businesses and their supporting cryptocurrencies instead have been part of a deflating financial bubble. That bubble characterization, however, has turned out to be charitable. Portions of the crypto industry have been exposed as frauds and Ponzis. Industry investors have been buried under piles of worthless stablecoins, crypto broker interests, crypto hedge fund investments and devalued cryptocurrencies. The crypto industry, valued only 12 short months ago at more than $3 trillion, now has a value of ~$870 billion … a value that continues to crumble.
The crypto industry indeed has been a bubble, it is continuing to deflate, and it has been a promoter of Ponzis, none of which should come as a surprise to investors. Anyone paying attention would have heard crypto leaders, notably Sam Bankman-Fried (SBF), at the time the industry’s leading statesman, as well as crypto commentators and financial industry experts saying exactly that (Charlie Munger labeled crypto “part fraud and part delusion”). Commentators referred to SBF as the John Pierpont Morgan of crypto because of his perceived success at preserving value for customers and providing stability to the industry. Yet it was SBF who in April described “crypto yield farming” (a strategy to create demand for new issues of crypto) as a Ponzi. His interviewer paraphrased his explanation as “Well, I’m in the Ponzi business and it’s pretty good.” It is precisely that “greater fool theory” that has characterized many crypto products. As TLR predicted in July, “the worst of the Crypto Crash is yet to come.” With the erosion of trust, expect more “worst.”
TLR previously provided examples of failing crypto businesses that the media had mis-characterized as part of a normal industry’s boom-and-bust cycle. TerraUSD, a stablecoin, saw its value dissolve in May and its crypto-billionaire founder go into hiding (he remains at large); Celsius Network LLC, a cryptocurrency lender, declared bankruptcy in July; Voyager Digital, another cryptocurrency broker, cratered in September; Coin Futures Lending Exchange was forced to restructure in September; Three Arrows Capital, a crypto hedge fund, had its assets frozen, saw its principals disappear, and watched as the regulators (finally) descended; etc., etc., etc. In addition, the leading cryptocurrency, Bitcoin, has seen its value slide … and slide … and slide from $67,000 in November 2021 to ~$16,700 today. In fact, the price of every major cryptocurrency has dropped in 2022. As a consequence, there are all-too-many crypto businesses … and their investors … facing economic ruin.
The problem is not that operating businesses failed when products lost market share, inventories became uncompetitive or factories or equipment became obsolete. Crypto businesses do not manufacture, they do not have inventories and they do not own hard assets. The problem has not been that crypto bankers and crypto brokers mismatched the duration of deposits with the duration of loans so that they were bankrupted by demands for the return of adequate, though illiquid, capital. The crypto industry has not been beset by liquidity problems (though many have tried to use “illiquidity” to explain away problems). The fact is that money – real money – has disappeared. Where has it gone?
What is perhaps the industry’s climactic event occurred in early November when FTX, one of the world’s largest crypto exchanges, filed for bankruptcy and its founder and CEO, former industry stateman SBF, resigned. FTX’s business model seemed straightforward: It was supposed to take in crypto loans and crypto deposits and invest them in comparable cryptos, earning profits on spreads and fees. Instead, it invested customer monies in unsecured pyramided crypto stuff and made loans to its sister crypto hedge fund, Alameda Research. When an investor buys stock in a regulated company, like McDonalds, he or she is investing in burgers and fries, the equipment necessary to make burgers and fries, and the hard assets needed to operate a burgers and fries business. When an investor invests in a crypto business, he or she is investing in the belief that other investors will invest in the crypto ecosystem so that increasing investor demand will push up prices – a classic pyramid. Should such belief collapse – as happens when a mania ends or a Ponzi is revealed –, there is no remaining value. That’s what happened to FTX. What remains is crypto debris the value of which depends on precisely those crypto assets that have vaporized. To date, known FTX contagion has infected digital broker Genesis Global Capital, crypto exchange Gemini and crypto hedge fund Galois Capital, with crypto lender BlockFi reportedly preparing a bankruptcy filing.
Media have reported that “the authorities” now are probing what happened at FTX. The crypto industry has no rules, no regulations, and no regulator. After all, it has been the absence of regulators and regulation that has been the crypto industry’s attraction. As the Wild West of finance, it’s been accepted wisdom that crypto companies can engage in Ponzis (through “yield farming” and similar practices). What says that it’s no longer OK? Doesn’t caveat emptor [let the buyer beware] continue to apply? What’s surprising is not that the crypto industry has included Ponzi schemes, fraud and mismanagement, but that anyone has been surprised.
How should the banking, securities and commodities regulators react to the crypto collapse? The simple answer is that they shouldn’t react (and it’s unfortunate that politics makes that impossible). They have more than enough on their plates overseeing regulated markets. Moreover, Congress should not enact new laws or create new regulators to oversee the crypto industry. Doing so would destroy the precise reason for the existence of a crypto ecosystem. The world already has a highly-regulated financial industry that will adopt the crypto industry’s best practices (including blockchain) without subjecting investors to the Wild West risks that have destroyed public trust in the crypto industry.
Having lost credibility and facing the investing public’s newfound understanding of the meaning of “Ponzi” and caveat emptor, many are questioning whether a “crypto industry,” as such, can survive. How much demand will there be for Bitcoin, Ether, etc., without products and services that rely on them? Can the crypto ecosystem regenerate or will it degenerate? Investors soon will find out.
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Finally (from a good friend)