Imagine someone comes up to you with a challenge: I’ll give you a life of fame and everything you want, so long as you can make $32b vanish.
My favorite Richard Pryor movie in 1985 was Brewsters Milllions. A minor league baseball player Brewster, who stood to inherit $300m if he successfully fulfils a condition to spend $30m within just 30 days.
How can you make $32b vanish over just 5 days?
Give it someone who wants to build a crypto exchange, who then runs it like a hedge fund until it blows up.
This just happened in the world of crypto recently, and it’s not the first time. Many, including myself, have lost funds through centralised crypto platforms of some sort in 2022, with the latest one being head up by the ‘guy a the fro’ known as ‘SBF’ (Sam Bankman-Fried).
The oil of mainstream finance, complete with the infinite backstop of a central bank, cannot mix with the water of decentralised finance.
You can’t operate a fractional reserve banking system where you take customer deposits and lend them out, without things breaking. Why? Because mathematics cannot accommodate the mistakes humans are good at making.
Some say the now world famous CZ (Changpeng Zhao), the CEO of Binance, was playing a game of chess over the checkers board of FTX’s Sam Bankman Fried (his friends (now enemies) call him SBF). Binance is the world’s largest crypto exchange (market place), and FTX was the up and comer. SBF was a donor to the democratic movement in the US and was said to be lobbying for regulation of the industry (some say it was as a strategy to collapse his competitor, who only just a few years ago, was one of the early stage investors in the FTX start-up).
Another dimension of this story is the token FTT, a crypto asset that was effectively created out of ‘thin-air’.
Where have you heard of the phrase, ‘created out of thin-air’? Oh yes, this is what happens when you obtain a loan from the bank – the bank has a ‘license’ to create currency out of nothing when you take out a mortgage. Within a long-established and well regulated ecosystem this can occur, and in fact is the backbone of how money makes the world go ’round’. It turns outs while holding cryptocurrency makes one ‘their own bank’, but that’s where the pavement of similarity ends and rocky roads of new technology commences. There’s no regulation, no oversight, and in some cases, limited accountability in the crypto-ecosystem.
In another movie but this time from the 90’s, Dumb And Dumber, was a story about two good-hearted but incredibly stupid friends who stumble upon a briefcase full of money. The movie centers around them trying to return the money to the owner but along the way, they end up blowing it all on all sorts of dumb stuff. Lambos’, fur coats – every time they ‘borrowed’ money, they just scribbled an IOY and dropped it in the suitcase. In the end they proudly return the suitcase full of IOY’s to the owner, but with no real money. That’s exactly what it feels like with FTX.
My simplified version of how the mechanics of this all works: SBF creates a token called FTT from his associated business Alameda Research, then lists on the FTX exchange. He then trades his special supply of FTT tokens in exchange for the digital assets which customers were leaving on the platform of FTX.
The key distinction to point between a bank and the FTX platform at this stage, is that customers had no knowledge their assets where being lent out.
Earlier this year I lost of some assets on the Celsius platform. Thankfully nothing that I couldn’t recover from. I wasn’t personally impacted by the collapse of FTX and Alameda Research but this scandal is rocking the crypto-community to the core. The shockwaves are crashing around the ecosystem and many fear it could be the tip of the iceberg and ultimately lead to a gigantic cascade the likes we haven’t seen since the Global Financial Crisis. That’s right, the GFC, or the banking crisis of 2007-8, or the reason why Satoshi Nakamoto invented Bitcoin in the first place. Derivatives up the wazoo all jacked up on Federal Reserve backstop.
Cheap and easy money, mixed with limitless opportunity, triggers greed in those who wear hoodies, just like it does in the white collar shirts.
This important to note as there’s often a slight of hand occurring in mainstream media – the implication is that crypto is dangerous. What they’re really saying is that the environment crypto occupies is dangerous. It’s almost entirely always about the hands that hold the assets (or try to hold them), rather than the assets themselves. In a way, regulation is the answer here, but for reasons beyond the scope of this article, some could say it’s not technically possible to create regulation from regulators who barely understand the ecosystem.
Getting back to the story – Shortly before the failure of FTX, a report surfaced with allegations that Alameda Research was technically insolvent. This didn’t seem to spook the market, well not until CZ decided to tweet that he’s dumping his FTT on their books due to these ‘recent revelations’. It should be noted at this stage that CZ was not entirely pleased with SBF’s lobbying behind his back to get regulators on the trail of Binance.
It’s very difficult to imagine a run on a bank these days – part of this is because money isn’t really anchored in anything absolute or finite. Fiat currency (like the NZD) is built on trust of institutions – so long as we trust the currency, commerce flows and banks are secure With crypto exchanges, while they can perform a function of a bank, there’s no central bank behind them who has a vested interest in the integrity of the system. Due to how blockchain works, digital assets are incredibly easy to watch moving around in the wild. On an exchange and in the custody of an actor not submitting to any defined regulation, what security do we have? Pretty much zero.
This why the phrase ‘not your keys, not your coins’ always applies – never leave your digital assets on an exchange or a platform where you don’t have direct ownership over it.
This is why I often make the distinction that Bitcoin was the first, it’s the best, and it’s the purest of the lot. Those looking to start with digital assets should:
– Start (and in some cases finish) with owning Bitcoin alone,
– Hold most your crypto on your own digital wallet,
– Limit exposure to digital assets to not more than 10% of an investible portfolio, and
– Never invest more than can be locked up for a very long period of time (infinite?).
So what about the account holders who lost funds on the FTX platform or those who held the token FTT? This will be devastating for many who had far too much locked up in this centralised honey-pot owned and operated by an incredibly un-trustworthy owner of a fro. How did this happen? If the platform performed some of the functions of a bank, it may have caused many to believe it was like a bank (I’m pretty sure they’ve never represented themselves as banks, it’s just that we see them as so), and perhaps some of the trust we have in mainstream institutes ‘bled over’ into this space. While users were told their funds were secure, they weren’t holding customers funds static. They were effectively using customer funds as collateral for other trading activity through a related entity, Alameda Research (in which SBF also operated).
The next chapter? Shortly after customers were given notice that withdrawals were paused, signalling something was seriously wrong, crypto-twitter blew up. CZ came flying to the rescue with a non-binding letter of intent to buy FTX to help cover the liquidity crunch. Fireman throws a kitty up a tree, then gets a ladder and brings it back down? Confused?
Doesn’t matter, he was to pull out the deal the very next day. Bankruptcy commences, and here comes cascades, contagion, and capitulation.
So here we are: Even if Binance swallowed FTX, we’d still be in the same position as we are today where there’s far too much centralisation within an ecosystem built on the ethos of decentralisation. While a low point for many in the industry, and trust is critically fractured, decentralised peer to peer money networks will not be inserted back into the lamp they popped out of. The ailment of traditional finance is still present, and apart from crypto, there is no alternative.
There are massive parallels within the current financial system and in a way, this whole drama shows us what’s been happening for decades in our ‘normal’ money world. A network of central banks acting as a safety web for the interconnected pathways between banks and everyone with access to accounts creates an environment where nobody wins if the system crashes.
To say it’s crypto that’s broken isn’t technically correct – WE are broken. We’re greedy, full of pride, and selfish – give us access to new realm where we can demonstrate that character and some of us will. Until this mess get’s sorted out, the main lesson (again!) for 2022, is this: ‘Not your keys, not your coins.’