Dear patient readers, yes, your humble blogger should be writing more about crypto. But I regard the project as being as appetizing as having to dissect a turd. Let’s underscore some key issues: there’s no reason for regulators to have sat pat when crypto was starting out and at not much more than hobbyist stage. Banks and monetary authorities would not benefit from having currencies outside their purview, charitably assuming that crypto ever grew up. From the beginning, its mains uses have been and remain tax avoidance, money laundering/facilitation of crime, and speculation. Oh, and one can add exploitation of users. None of these are societally valuable. It may not have been possible to completely tamp out crypto, but it could have been subjected to enough prohibitions and/or regulations to render it a fringe activity.
Instead, the continuing rout is pulling down even more players. I have to confess that I have not heard of these firms despite their alleged significance. Today, the Financial Times has a new article on how three “decentralized finance” or DeFi platforms, Maker DAO, Bancor and Solend, have all had to break their own rules to save their businesses, customers and previous commitments be damned. Crypto maven David Gerard, in It’s Time for Regulators to Put Crypto Down in Foreign Policy, focuses on how the withdrawal halt imposed by “crypto investment” firm Celsius on June 12 triggered a further downdraft in the crypto market. The Guardian also has a fine, if a bit daunting for the newbie article on Celsius, What the crypto big freeze means for your money. TL;DR: Assume it’s gone poof.
The Wall Street Journal has also published a new trying-to-make-sense-of-it-all article, The Fire Burning Beneath Crypto’s Meltdown.
Before going into the particulars, let’s again look at why the crypto project was destined to go awry. First, it was always a technology in search of a market, which is generally not a sound idea, since customer needs are too often butchered to fit the Procrustean bed of the technology, or alternatively, as happened here, all too conventional and risky work-arounds were implemented. For instance, one of the big original selling points of Bitcoin was that it would be a “hard” currency, not at all like fiat currencies, because it had a limit on how many coins could be issued. Instead, Bitcoin was lent (rehypothecated1) and loaned against, creating leverage that appears to considerably exceed the original value of the Bitcoins. And the crazy proliferation of new coins was another way to massively expand “currency” supply.2
The result was the reverse of a prized inelastic and comparatively stable (in some sort of mythical real economy sense) marker. From the Journal:
The appeal of gold today is that it acts as a haven in bad times, and typically acts as a partial hedge against inflation. Bitcoin holders have discovered that not only is it not a hedge against inflation, it isn’t a haven either. Its price tends to move in line with risky assets, not safe ones. The gold price is up 4% in the past 12 months as inflation has soared, against a fall of 12% in the S&P 500 and a 43% loss for bitcoin. Digital, sure. Gold, not so much.
Another fundamentally misconceived notion was that crypto and blockchain would serve as foundations for a decentralized, as in fairer, as well as cheaper financial system. Instead, the promoters, whether out of ignorance or malign intent, have wound up looking like the itinerant cook of the Stone Soup story, where he tells the locals he’s making a terrific soup by boiling a stone….but if he only had an onion, then it would be even better. His list of soup enhancements keeps growing.
Similarly, crypto DeFi touts have found out that to have a proper financial system, you need custodial services, legal disclosures, record-keeping, payment services, tax reporting, investment products…the list goes on. And yes, current payments processors can overcharge due to their monopoly/oligopoly status, but that’s the sort of thing that can be addressed by regulation. Offering up alternatives that don’t deliver on their promise diverts energy from getting transaction and other charges down.3
And crypto isn’t very good for its supposed core use, payments. Bitcoin has huge and rising energy costs and has much slower processing speeds than the Visa/Mastercard network. Those problems are inherent to crypto. As the Journal explained:
[Bitcoin] failed to take off as a medium of exchange, as it is clunky and costly to use. Other cryptocurrencies are somewhat more practical for transactions, but all suffer from a core problem: The more they are used, the more expensive transactions become as a way to regulate capacity on the network. Like Uber, Bitcoin has surge pricing built in.
“In a way congestion is a feature, not a bug,” says Hyun Song Shin, economic adviser and head of research at the Bank for International Settlements in Basel. For normal currencies “network effects mean the more the merrier, but crypto achieves exactly the opposite, the more the sorrier.”
As I suspect most of you realize, it takes a special talent to be below what passes for standards in the likes of Alabama and New Jersey, both ranked among the most corrupt states in the US
Oh, and while we are talking financial services like custody (as opposed to keeping your crypto on your hard disk and being at risk of disk death, loss, theft, and forgetting your password, all of which have happened), and the perceived safety of gold, how about security? Fuggedaboudit. From Foreign Policy:
Bitcoin advocates have largely switched away from claiming that the cryptocurrency can function as an actual currency, mainly due to it still being largely unfeasible to pay for anything in it. Now the claim is that bitcoin is a “store of value”—that is, an asset that won’t lose its worth over time. This has been dramatically shown untrue. More than that, the storekeepers were shoveling the valuables into their own—U.S. dollar-denominated—vaults….
Celsius said it could replace bank accounts and claimed a million customers. The company offered eye-popping interest rates—on the order of 18 percent annually. But Celsius’s interest rates were frankly implausible. You can’t get more than a few percent return anywhere in the current economy. If anyone offers 18 percent, your first thought should be: “What’s wrong here?”
Celsius had already been thrown out of Alabama, Texas, Kentucky, and New Jersey because its interest-bearing accounts were, functionally, unregistered offerings of securities. The U.S. Securities and Exchange Commission had been looking into Celsius since January 2022—but was yet to act against it.
The other problem was that Celsius was intertwined with many other crypto firms, including lending firms offering similarly implausible interest rates. This wasn’t a rogue operator; it was one part of a systemic risk—comparable to Lehman Brothers during the 2008 financial crisis.
Now let’s turn to the Celsius freeze and then to the Maker DAO, Bancor and Solend implosions. First to Celsius. From Foreign Policy:
On June 12, the crypto investment firm Celsius stopped all withdrawals, claiming “extreme market conditions.” The market went into panic. The price of bitcoin plummeted from $28,000 to $20,000. By June 14, reports emerged that Celsius was “restructuring.” Within a week, bitcoin crashed again…
Behind all this was a toxic waste dump of unregulated, dubiously sourced investments. Bitcoin’s price started rising in 2020 and launched into a new asset bubble in early 2021, peaking at $64,000 in April 2021 and again at $69,000 in November 2021. Both price pumps coincided with the injection of several billion tethers, a dubious dollar-equivalent stablecoin, via unregulated offshore exchanges. The real interest, and real dollars, came from ordinary investors when Elon Musk started talking up crypto in January 2021 and bought bitcoins for Tesla in February. When Tesla was reported to have sold the bitcoins in May, many of those investors exited the market. (Musk later claimed that he had sold only 10 percent of the holdings.) Without their actual dollars, the price of bitcoin crashed back to $31,000 by June 2021…
There were nowhere near enough outside dollars to pay out crypto holders’ paper wealth. The industry had to come up with more elaborate schemes to lure in fresh outside money. Venture capitalists frantically promoted NFTs and Web3—though it was never clear what “Web3” meant. Crypto companies even ran ads during the Super Bowl in February, marking the point at which an industry has reached nearly every American consumer, and there are no fresh customers left.
The Guardian gives more of a Matt Levine of Bloomberg level explanation, absent the trademarke Levine “You didn’t understand this was a casino and you were the mark?” chipperness:
It’s easy to treat money you can’t access right now as the same as money you can while the times are good, but when things get tricky, the difference becomes stark, and you have entered a liquidity crisis.
This problem isn’t affecting only depositors, it is also the main problem for Celsius itself. The crypto bank has a lot of money locked up in a convoluted crypto derivative called stETH, and can’t get it out.
It seemed like a great idea. Ethereum (ETH), is one of the most popular cryptocurrencies, but investment opportunities for the currency are slim. At the same time, there is a parallel project, ETH2, which is run as a test network for a new type of blockchain called “proof of stake”. In proof of stake, people “stake” their cryptocurrency – locking it up for a period of time – in order to generate raffle tickets from verifying transactions. The result is similar to earning interest at a bank, if doing so also gave you a vote on how the bank is operated.
So Celsius used an intermediary, called Lido, to take ETH invested by customers, and stake it on the ETH2 network, earning interest in turn. But there’s a problem: you can’t turn ETH2 back into ETH until the two networks merge at some point in the future. (Like self-driving cars, augmented reality and Linux on the desktop, the date of this merge is months away, and has been months away for about three years.) So Lido gives users a new token, called stETH or staked ETH, to represent their ETH2 claims.
Owning stETH should be great: it reflects not only the ETH you have locked up, but also the gains that ETH will have made by the time the merge happens. And, unlike deposits in a bank, if you need to get some ETH back, you can just sell the stETH to someone else. Until you can’t find buyers for your stETH, at which point bad things happen.
That seems to be the situation Celsius found itself in in early June. The not-bank had already taken a hit on the collapse of the Terra/Luna stablecoin, and as the crypto market fell, depositors began withdrawing their ETH. Each withdrawal required Celsius to sell a little more stETH to a rapidly declining pool of people who were willing to buy it, until, in early June, it ran out of buyers on the main exchange: you could not sell stETH at any price. The stETH still has value; the money is still there; but Celsius cannot access it.
The Guardian author continues to explain that this looks like a liquidity crisis, but it might just be a solvency crisis. Given that Celsius was offering an 18% interest rate, my bet is on solvency crisis.
The Financial Times explains how Celsius knocked over more dominoes, specifically Maker DAO, Bancor and Solend:
In the past week, three decentralised finance groups have stepped in with emergency plans to protect their projects and users from economic pain in the face of tumbling cryptocurrency prices.
The three platforms — Maker DAO, Bancor and Solend — are not household names. But they are prominent in the world of decentralised finance…
DeFi has also garnered a reputation for being the wildest of the “Wild West” in the largely unregulated crypto world, with regular thefts of tokens worth hundreds of millions of dollars as hackers exploited poorly designed systems…
Last weekend, users of Solend, a lending platform built on the Solana blockchain, proposed taking control of the wallet of its largest user. The operators feared the repercussions if the Solana coin, which dipped below $27, dropped to $22.30, a price that threatened the platform’s economics…
Bancor meanwhile cited “hostile market conditions” as justification for temporarily pausing a service that meant users were no longer protected if their deposited tokens were subject to big market swings….
And Maker DAO, a collective that runs the Dai stablecoin — a crypto token that is designed to be pegged to the dollar — voted to freeze a link to lending platform AAVE, because of the latter’s exposure to another struggling lending platform, Celsius.
Running a trading network through a consensus vote in theory means users have more say in the future of the project, according to Ingo Fiedler, co-founder of the Blockchain Research Lab and professor at Concordia University in Montreal, Canada. But this is not always the case, he noted.
“Governance is highly concentrated among a few players that can potentially co-ordinate to change the rules to their benefit and at the expense of other users,” Fiedler said.
This sounds an awful lot like, “All animals are equal but some animals are more equal than others.”
Mind you, these articles, because MSM, are pretty tame. For some real fun, have a gander through Bitcoin Is A Hideous Monstrosity Made Out Of Computers And Greed That Must Be Destroyed Before It Devours The World, Part I. Some choice bits:
The cryptocurrencies themselves (sometimes called “coins”) are just the mechanism the cryptocurrency cartel uses to extract capital from people who are gambling. The coins have no other purpose and are basically totally unimportant to this or any other story about cryptocurrencies. Coins come with names like Bitcoin, Ethereum, Avalanche, MagicalInternetMoney, Ripple, and Dogecoin. There are some 1,723 of these in circulation. Most of them are commonly known as “shitcoins.” There is sometimes truth in advertising.
I don’t think calling cryptocurrencies “demonic” is much of an overstatement. Cryptocurrencies are not currencies. There is some cryptography involved but there is also cryptography involved in sending your mother a text message on your iPhone. The places these cryptocurrencies are sold are not “markets”. They are gambling platforms that are preying on and destroying (mostly) young people’s lives financially and psychologically. Underhanded tactics are constantly deployed to get these young people to bet more in riskier ways. The businesses profit by financially and psychologically breaking the players. They cheat their customers with the numbers (as of last December, 90% (!) or more of listed trades are fake according to Nasdaq) and even more so they cheat them with psychological pressure tactics. And then there’s the billions of dollars lost to just outright theft…
Let me interject that I only really consume media about how humanity is a train wreck. Documentaries about wars, manias, the mentally ill, financial fraud, serial killers, non-serial killers, prisons — that’s my jam. Which is to say I have a pretty high tolerance for Darkness. And yet when I took a dive into the world of cryptocurrencies, I felt like I was looking at a kind of darkness humanity hasn’t encountered before… a kind of amoral cyborg monstrosity, made out of computers and greed, rising from the internet, that was already well on its way to taking over the world by the time I really noticed it.
Other experts on this beat have been regularly sounding alarms:
The specifics of any one crypto project don't interest me much. The entire space is just one giant scam that wraps itself in crackpot economics, technobabble, and phoney populism. Thus the distinctions between the scams don't matter all that much.
— Stephen Diehl (@smdiehl) June 21, 2022
Reputable people of all stripes are legitimately afraid to opine on crypto to the point where they self-censor. That's not normal for a technology, where usually everyone reputable has some future extrapolation to wax lyrical about.
— Stephen Diehl (@smdiehl) June 21, 2022
A lot of good analysis of why crypto is unsuitable for anything this BIS paper. But then it goes into fantasy land espousing the virtues of "permissioned DLT". Permissioned blockchains don't work period, they're a rubbish solution in search of a problem. https://t.co/1ElQsewZae
— Stephen Diehl (@smdiehl) June 22, 2022
Enough for today’s installment. I suspect we’ll be returning to this topic as the unwind progresses.
1 Those of you who remember the finer points of the global financial crisis will recall that how many times a security can be rehypothecated in the US is limited by the SEC, but the UK then had no limits. Lehman’s London office rehypothecated a lot of dodgy stuff more than would have been allowed in the US, and that rehypothecation played a factor in its unwind. I’m being bad by not scouring the archives for more detail, but the geekier commentators were all over this part of the unwind.
2 Remember crypto is not currency. Aside from the fact that the IRS does not regard crypto as a currency but as property, like trading baseball cards, it’s barely used in the real world (aside for criminal activities!), so users are forced to transact in and out of real world currencies and incur FX risk and transaction costs.
3 Don’t pretend this never happens. The SEC is about to end payment for order flow. And before you say no one was harmed, so how did Citadel get rich from it? Even if Citadel was only scraping micro-amounts across huge volumes, it was still a cost to retail. And that’s before getting to possible front-running, since the big brokers/fund complexes would at least send all their overnight orders before the trading day started…