What Has Crypto Done For You Lately?
An attempt to understand the current crypto ecosystem
Mea Culpa
I like to think of myself as somewhat tuned in to current events, but I admit that crypto doesn’t make much sense to me. It was fun and speculative in 2011, and it’s… still fun and speculative now. It sounds great in concept; but practically, it has no impact on my daily life. When’s the last time you bought a sweater with Ether, or sold your used iPhone for Litecoin? If engineers can copy Bitcoin’s code, rename it Dogecoin as a joke, then generate a market cap of $11 billion, what is the actual value of um, anything? Call me old school, but until I can pay my mortgage with it, I’ll focus my attention on things that actually pay the bills.
F The FTX
A lot happened in the business world over the last few weeks. Layoffs. Inflation. Twitter. But perhaps the most ostentatious display of tech’s nadir is the recent run on crypto exchange FTX that forced them to file for Chapter 11 bankruptcy.
Earlier this month, Changpeng Zhao, CEO of crypto exchange Binance, began selling off approximately $500 million of FTT coins, FTX’s native token. This sell-off spooked other FTT holders, triggering a collapse of the token. Quickly, FTX found themselves in a liquidity crunch and in need of $8 billion. That guardian angel came in the form of Zhao himself, announcing that Binance would acquire FTX basically immediately.
This is odd on a very basic level:
FTX was experiencing “significant liquidity” issues, which is deeply concerning. So their solution was to approach their largest competitor for help? This means either FTX had already explored other means of capital (and been denied), or they were completely caught flat-footed by their financial distress (also not great).
The expectation was that Binance would close the deal very quickly. Like next day. So FTX was hemorrhaging money and needed help immediately; Binance was not necessarily in a hurry if they discovered improprieties or if the deal was not significantly beneficial to them. Binance had all the time in the world; time was a luxury FTX didn’t have.
Binance could have bought FTX for a value very, very close to zero.
Shocker: Binance backed out of the deal. This means that given the option to buy their largest competitor for peanuts, they’d rather walk away. Functionally, there is a very short list of reasons that Binance would decline what is essentially a free deal:
The value of FTX’s portfolio and tech is less than worthless, or
There are skeletons in the closet that scared them away.
Binance’s stated reason for walking away:
As a result of corporate due diligence, as well as the latest news reports regarding mishandled customer funds and alleged U.S. agency investigations, we have decided that we will not pursue the potential acquisition of FTX.com
Binance may characterize their concern as “mishandled customer funds.” I would call it for what it is: fraud.
Where’s My Money?
Coinbase, perhaps the largest public crypto exchange, files their financials with the SEC in accordance with US accounting standards. This is great because once you develop the literacy to read GAAP financials, that skill ostensibly unlocks the secrets of every public company. Per Coinbase’s latest 10-Q, the company holds $95.113 billion in customer crypto assets. “Woot that’s a lot of assets,” one might think! But they also hold $95.113 billion in customer crypto liabilities. That means if their customers ever asked for their $95.113 billion in cash, Coinbase could theoretically pay it all back dollar for dollar. That’s not a bad thing!
Coinbase recently released their own statement reassuring their customers that what happened to FTX won’t happen at Coinbase:
There can’t be a “run on the bank” at Coinbase. As you can review in our publicly filed, audited financial statements, we hold customer assets 1:1. Any institutional lending activity at Coinbase is at the discretion of the customer and backed by collateral.
Additionally, Coinbase explains their financial mechanics as such:
We will never repurpose your funds: We do not lend or take any action with your assets, unless you specifically instruct us to. Many banks and financial institutions use customer funds for commercial purposes including lending and trading, meaning that they often hold only a fraction of their customer assets at any given time. Coinbase always holds customer assets 1:1. This means that funds are available to our customers 24 hours a day, 7 days a week, 365 days of the year.
This is a significant difference between a brokerage and a bank. Brokerages take a cut of each transaction on their platform - each time you buy, sell, etc. a tiny portion of that transactional balance goes to the platform. It’s a tax; and many businesses operate on this model, such as Coinbase. This allows them to make money off the volume of activity on the platform, and not the actual holdings of the customers.
Crucially, banks don’t operate like this; they operate by taking their customers’ money and repurposing it elsewhere. At any given time, a bank does not have your money dollar for dollar saved in a secret vault; your money only exists somewhere between the nebulous layers of legal documents that the bank and its lenders hold. If enough customers demanded their money - in cash - simultaneously, the bank would be unable to come up with all the cash immediately and could collapse.
This is what happened to FTX in broad strokes. Instead of taking $1 from the customer to buy $1 worth of Bitcoin, they took $1 from the customer to buy $3 worth of Bitcoin by borrowing $2 from someone else - other customers (shorts), hedge funds, etc. - probably by putting up FTT as collateral. When the value of FTT is high, this strategy is great because FTX makes money by leveraging their customers’ money and their own home-made token. But if FTT’s price tanks, then the collateral becomes less valuable, then FTX’s value declines, then FTT’s value tanks more, etc. Once customers get spooked, they begin withdrawing their money, and with FTT’s price declining, FTX could no longer get the collateralized $2 from its lenders. And without an adequate cash balance on hand to cover the gap, FTX became insolvent. Boom goes the dynamite.
The Accountant
In 2016, Ben Affleck made one of the oddest movies in recent history, The Accountant. Ostensibly framed as a hitman action flick, Affleck plays a CPA whose mental ticks gift him… superhuman accounting skills? Feast your eyes on the modern superhero for bean counters:
Besides Ben Affleck, accountants just aren’t cool. We don’t build rockets, or save lives, or sell out concert venues. No six year old grows up wanting to file federal income tax returns for their entire adult life. So when accountants make headlines, it’s almost always for a failure to do our jobs. C’est la vie.
Enron 2.0
Just a few weeks ago, Sam Bankman-Fried, CEO of FTX, was known as the king of crypto with a net worth around $16 billion. Now with FTX officially bankrupt, his net worth has vanished overnight. Venture capital investors, such as Sequoia, have written down their investments to zero. There are allegations of secret “backdoor” programs used to transfer funds off the books. Bankman-Fried himself may have kinda sorta admitted this was a Ponzi scheme back in April. And worse, the company is now under criminal investigation by the Justice Department. And we thought Elon charging $8 for blue check marks was bad.
So the lingering question is how did this happen? On November 2, Coindesk ran a rather revealing report on Bankman-Fried’s crypto empire that basically boiled down to “Huh, there’s a lot of FTT coin on the balance sheet of Alameda Research, a sister company to FTX.” This by itself is not illegal; however, FTX secretly used their customers’ funds to buy their own tokens… in a different company… owned by Bankman-Fried… to invest in other vaguely illiquid assets like “TRUMPLOSE.” I believe the expression you're looking for is “What the actual fuck?”
This is where Bankman-Fried stepped in it. Theoretically, institutional banks invest their customers’ money elsewhere too; however, banks do not secretly buy their own home-made imaginary assets in another shell company owned by the same CEO to invest in more shady assets that may or may not even exist. Crucially, banks are also backed by the FDIC and various layers of deposit insurance, and are beholden to US regulatory bodies, such as the SEC and the Department of Treasury.
Four days after the Coindesk article, Changpeng Zhao, CEO of Binance, tweeted that they would be liquidating all FTT holdings “due to recent revelations that have come to light.” Is it conceivable that Zhao, the head of FTX’s largest competitor, spurred rumors of a sell-off in an attempt to torpedo FTX? Did he always know there were financial inconsistencies in FTX’s books and lunged at the chance to expose it? Did he subsequently offer to acquire FTX just to open their books and poke around for himself, but never actually intended to close? It’s possible. And frankly, I don’t think it’s that unreasonable.
Recently, Larry Summers, former Treasury Secretary and President of Harvard, likened the collapse of FTX to Enron, pegging the downfall as “less about the complexities of the nuances of the rules of crypto regulation” and more a case of classic financial fraud. I’m inclined to agree. The sad truth is nothing that FTX did here was especially unique to crypto; the financial exchange got greedy, over-leveraged, and when people got scared, couldn't pay out the money. This collapse was fundamentally no different from a run on an institutional bank. And I think that’s the point.
When a financial institution fails, the people who are most likely to get hurt are the customers. They trusted a system with their money that was inherently built to capitalize on that trust to encourage excess. Even with overt warnings - the FDIC explicitly stated that crypto stored or invested in FTX isn’t covered by the same protections granted to regular banks - people still put money in. For fun. For speculation. For a quick profit.
When crypto emerged, it was pegged as the anti-fiat currency. It was meant to reduce our reliance on government-backed bills, to remove barriers such as borders, exchange rates, processing fees, etc. In short, it was meant to democratize money. I would argue that aside from some pseudo-aspirational mumbo jumbo about blockchain and all the cool things crypto could do one day in the future, the dirty secret to the crypto ecosystem is that in its current state, it’s no different from our institutional capital markets. They all operate within a construct that trades in risk and is built to over-extend, over-leverage, over-expose. And as long as crypto is owned, operated, and exchanged by people, it will inherently contain all the flaws and hubris of those very same people.
Searching for my Coinbase password,
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