09 Jul Crypto Reality
“Crypto was devised to be a transparent, digitized, de-risked, de-centralized financial-technological invention that would overcome the inherent problems of traditional finance. It’s instead opaque, prone to fraud, over-leveraged, highly risky, and packed with unforeseen legal and financial bugs.” – The Lonely Realist
Did your history teachers ever devote time to the early 19th Century American financial system? Few did. It therefore should come as no surprise that the 1830s were a period in which America experienced a Bank War. Yup, a Bank War! This was before the Federal government took control of America’s financial system by adopting the US Dollar as the country’s fiat currency. Before then, virtually anyone could issue “money.” As a consequence, many so-called “banks” did just that, so that multiple currencies circulated. This created problems. Among other things, those non-bank banks promised their depositors/investors/lenders that their financial condition was sound … even though their balance sheets often had little or no hard asset reserves and actually were Ponzi schemes. The 1830s therefore were hardly the good old days! To the contrary, they were characterized by economic and political turmoil. Federalist supporters of the Second Bank of the United States (a structure that provided a level of economic stability) were challenged by candidate (and then President) Andrew Jackson, a populist who succeeded in devolving the authority to issue money to the States, a strategy that didn’t work out well. The good news is that Congress created the requisite stability via an independent U.S. Treasury system backed by the Dollar … although it took more than three decades for it to achieve that goal. The bad news is that the recent proliferation of crypto banks has returned America to a period of turbulent financial times.
The past few years have seen crypto banks engaging in the same practices that non-bank banks engaged in almost 200 years ago. Crypto banks not only have issued cryptocurrencies, they also have offered a range of financial services that include providing enormous leverage to crypto borrowers despite crypto banks’ relatively thin equity cushions. The sad fact is that they’re doing the same sorts of things that evil traditional banks did before the Global Financial Crisis of 2008. Both the GFC and the 1830s teach that loosely-regulated/unregulated so-called banks, especially those that can deal in their own alternative currencies, create a host of problems. That lesson apparently has been forgotten. Whether or not we’re currently experiencing a Crypto Crash, crypto investors most certainly have been given a wake-up call. It is past time to re-evaluate the risks and rewards of the crypto financial system. Among other things, it is now apparent that, instead of being transparent, the crypto world is opaque. It harbors excessive leverage and a small cadre of wealthy, interconnected crypto banks and their founders whose money is being used for discriminatory selective bailouts and price supports that enhance volatility. Like every other financial system, the crypto world too is riven by greed, fraud, outright theft, human error, and counterparty risk – human nature is not changed by blockchain technology or detachment from government oversight.
Crypto banking has no rules. It is subject to little regulation. It is a petri dish for fraud, hacking and outright theft. Its hazards have been apparent to a number of other nations that have banned cryptos, including China, India, Russia, Egypt, Turkey, and an increasing number of even less-wholesome countries. The U.S. government has (at least for the present) allowed crypto banking to flourish. The result is that crypto banks provide unregulated decentralized financial services (DeFi) based on peer-to-peer (that is, via bilateral contracts) leveraging and blockchain technology (which has been advertised as “digitizing the entire trade finance lifecycle with increased security and efficiency” [sic]). Crypto banks issue and host all sorts of digital assets that include currencies, DeFi loans, stablecoins and non fungible tokens (NFTs). These products represent the pinnacle of 21st Century financial-technology engineering, but bear a close resemblance to the soft currency banking products of the early 19th Century. Crypto banking owes much of its success to the fact that it looks, smells and tastes like pre-2008 banking (with proposed Federal legislation to increase the similarities). When the public reads about investors who have become crypto billionaires, it therefore wants in. Crypto products appear to be the same as those that traditional banks offer while possessing far greater upside, leading investors to believe that crypto investment must possess the same protections as regulated bank products. That’s not the reality.
Take the example of the TerraUSD blockchain, a stablecoin the value of which evaporated in May when its native token, Luna, plunged. The per-token value of the $18 billion TerraUSD fell from its peg of $1 on May 7 to less than $0.03 on May 28. (Stablecoins are intended to emulate traditional money market funds that have a per-unit value of $1 with greater upside.)
Or take Celsius Network LLC, a cryptocurrency lender that became a crypto behemoth based on its founder’s claims that Celsius’ investment strategy was less risky and had greater upside than strategies pursued by traditional banks. When challenged on this assertion, Celsius’ founder said that “Somebody is lying. Either the bank is lying or Celsius is lying.” We now know who the liar was: Celsius has frozen customer withdrawals and engaged restructuring attorneys to advise it with respect to its mounting financial problems, while the Federal Reserve recently assured investors that traditional banks are in sound financial condition. The result is that, even though Celsius was relatively well-funded – at least for a crypto bank (having a capital ratio of over 5%) –, both investors and lenders are likely to suffer significant losses. The interconnectivity between Celsius and other crypto banks also is cause for concern given the expanding ripple-effects of Celsius’ problems, as a recent Wall Street Journal article makes clear. Moreover, it’s notable that Celsius’ capital ratio was greater than those of other crypto giants like Tether (~0.2%) and Voyager Digital (~4.3%) (which recently filed for bankruptcy protection despite having promised its investors “a straightforward, low-risk approach to lending and asset management [that makes] crypto as simple and safe as possible”), though it compares unfavorably with the capital ratios of traditional banks (that operate with a floor of 8%) … and that have asset bases that are far less volatile than those of crypto banks.
Or take the fact that the Coin Futures Lending Exchange (CoinFLEX) (which offers physically-delivered futures for cryptocurrencies and stablecoins) has suspended withdrawals because one of its borrowers has failed to pay $47 million of stablecoin USDC as part of a margin call …, or the Non-Fungible Token (NFT) “insider trading” scandal at OpenSea, an NFT marketplace where an employee traded NFTs based on confidential information …, or the liquidation of Singapore-based Three Arrows Capital, a hedge fund that defaulted on a loan of 15,250 Bitcoin (worth ~$324 million) and $350 million worth of stablecoin USDC …, or the corporate governance and legal convolutions at Merit Circle, a decentralized autonomous gaming organization (DAO), in which Merit Circle accused a significant investor of not adding sufficient value and, on that basis, canceled its tokens (although the parties ultimately entered into a settlement agreement) …, or the fact that the cryptocurrency of choice, Bitcoin, has gone from a value of $67,000 on November 8, 2021 to $20,000 today …, etc., etc., etc.
Crypto banks, lenders, brokers, and investment entities operate in a new and exciting Wild West where there are no rules – there really are none –, few laws, no regulations, and little oversight. Crypto products may resemble traditional deposit accounts, lending facilities, and investment businesses …, but they’re not. Too many are Ponzi schemes. Sam Bankman-Fried, a crypto billionaire and the founder of FTX, a huge crypto exchange, explained a crypto product called “yield farming,” a crypto alternative to traditional bank lending, describing it in terms that are the very definition of “Ponzi” (which was how interviewer Matt Levine characterized Bankman-Fried’s description … and Bankman-Fried didn’t disagree): You start with a company that builds a box; you put cryptocurrencies into the box in return for an IOU (the result being that the box therefore has no value); owners of the box then issue a token which is either given away or sold to those who receive some sort of governance rights, causing the marketplace to perceive the token as actually having a value; and the increase in the perceived value of the box then brings in more investors which causes others to believe it has a value and must be legitimate, so they put in more money … ad infinitum (all as reported here and here).
Although a time-worn saying, it nevertheless is true that “those who fail to learn from history are doomed to repeat it.” Crypto products may look new, but they retain the flaws of 1830s and 2007 “bank” products. Regulated banking services and government-issued currencies are the standard today for a reason. History therefore suggests that the worst of the Crypto Crash is yet to come. If so, the cost to Americans and America is likely to be significant.
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Finally (from a good friend)