Factual Descriptions of Crypto that Sound Like Hitpieces
The industry is in a bad place.
The promise of crypto was an open, low-cost financial system outside of the control of companies and governments. These days, it’s mostly a wild west of hacking, scams, fraud, pyramid schemes and unworkable ideas like ‘play-to-earn’ gaming. There are perfectly respectable people and projects working in the industry, but they’re badly outnumbered.
If you step back and simply describe some of the key infrastructure, processes and players in crypto, what you get is bleak. Here are a few lightly editorialized stories to illustrate that:
‘Fully Backed’ Stablecoins
With a market cap of over $73B, Tether or USDT is the largest stablecoin in crypto. As the ‘stable’ prefix suggests, each Tether is always meant to be worth a real US dollar. This is useful because investors can use USDT to park cash on blockchains without exposure to the extreme volatility of Bitcoin and other crypto assets. To maintain the peg, Tether promises to redeem its tokens 1:1 for real US dollars and purportedly keeps liquid assets on its balance sheet to do so.
But there are a few problems.
First, nobody really knows what’s backing Tether’s tokens. The company isn’t regulated by the Federal Reserve or the SEC. Instead, the public has to rely on quarterly disclosures about its assets to know what’s inside. The report for the quarter ending March 31st report (before $10B in recent withdrawals) looks like this:
Unfortunately, it could all be BS. Tether’s auditor isn’t KMPG or Deloitte. It’s a tiny firm in the Cayman Islands called MHA Cayman that has three employees on Linkedin. On google maps, their address looks like a P.O. box in a storage center. It could be legitimate, but I have some doubts.
Second, reserve reports apply to a single day, March 31st in this case. A week before, Tether could have had a cash injection or replaced risky assets with safe ones to look good for the end of the quarter, a practice known as ‘window dressing.’ Without a full audit by a reputable firm, we can’t be sure.
Third, Tether still has $5B of “other investments” including cryptocurrency on its balance sheet, likely volatile tokens like Bitcoin that crashed during the recent crypto meltdown. As Patrick McKenzie pointed out, this probably means Tether’s claim of always being fully backed became (once again) false in May.
None of this surprises industry insiders, who are well aware of Tether’s dubious past. The company shares common management and ownership with Bitfinex, a crypto exchange that is banned in the US and has had repeated run-ins with regulators and has settled legal proceedings related to various wrongdoings. Again, this is the main stablecoin in crypto.
Traditional capital markets are separated into different players and roles. Simplifying, these are:
Banks like Wells Fargo where people keep the cash they’re not investing.
Brokers like Fidelity and Charles Shwab that buy and sell assets on behalf of customers.
Market Makers like Jane Street Capital that quote prices to both buy or sell thousands of securities to earn a tiny spread.
Hedge Funds like Bridgewater and Pershing Square that make money with long/short positions over months and years.
Exchanges like the NYSE and NASDAQ where everyone transacts. And:
Public Companies like Google and Apple that sold their stock to the public.
Now take Binance, by far the largest crypto exchange that often does more trading volume than Coinbase, FTX, Kraken, Bitfinex and others combined. Binance is all six things on the list at the same time.
They’re a quasi-bank because they hold deposits in stablecoins (including their own BUSD) and offer passive yields on them; they’re brokers because they have a website and an app for mom and pop to trade; they’re market makers because they quote prices and take intraday long/short positions to earn trading spreads; an exchange, because they are the infrastructure on which market participants buy/sell; a hedge fund, because they take large long positions and have a VC arm; and a public company, because they have their own volatile cryptocurrency Binance Coin (BNB), a token ‘powers’ the BNB chain ecosystem.
You can imagine that when six different pieces of market infrastructure are all under the same roof, bad things can happen: trading against clients, dumping positions on retail investors, frontrunning, high entry barriers and costs for competitors, high fees, hidden fees, opaque pricing, opportunistic exchange outages (‘maintenance’) to bail out the company, etc. Nice.
Insider trading is a crime in most places. It consists of buying or selling securities while in possession of ‘material nonpublic information’ – information about a company that (a) isn’t public, (b) would move the security up or down, and (c) was acquired unlawfully.
For instance, if you hack Amazon’s monthly sales data, learn they will beat revenue expectations and buy some shares before the news gets out, you have committed insider trading and are liable to go to jail. That makes sense; trading on company secrets is unfair to other shareholders.
In theory, any transaction that is (1) an investment of money (2) in a common enterprise (3) with a reasonable expectation of profit from the efforts of others is an ‘investment contract’ and a security that should be subject to SEC regulation, which forbids insider trading, among other things.
These three criteria are known as the Howley test, and most crypto assets straightforwardly pass it. Your typical crypto token is basically equity – a direct or indirect claim on the cashflow or value of a project that will appreciate if the sponsors continue to build, maintain, publicize and scale the project.
The SEC prosecutes insider trading constantly, but insider trading in crypto is (de facto) legal because crypto assets are not (currently) treated as securities under US law. There are a few lawsuits making their way up the courts that might change that, but for now, crypto tokens are not subject to SEC regulation and so insider trading on them is simply allowed. Very nice.
Suppose you make an NFT profile picture project with 1,000 editions (‘mints’). Each mint could be worth $0 or $20,000 depending on the quality and hype, I suppose.
One way to make people believe each mint is worth $20,000 and not $0 is to have family and friends and do a lot of fake trades for $20,000 on public NFT exchanges like OpenSea and LooksRare. After enough fake trading activity, outsiders might believe the thing is really worth $20,000 and start buying mints from you and your buddies.
In traditional capital markets, doing fake trades to create the impression of high liquidity and high prices is called wash trading and is market manipulation, which is a crime. But like insider trading, wash trading is de facto legal in crypto, because crypto assets are (currently) not securities and aren’t regulated.
RobinHood constantly reminds you of how well you’ve done. You can see that if you put in $300 to buy the S&P 500 and your portfolio is worth $250, you are down $50 dollars or -16.7%. RobinHood remembers that your ‘cost basis’, your initial investment, was $300.
Amazingly, Coinbase and other crypto apps don’t have this basic feature. Want to know how much money you lost in the meltdown? Sorry, you’ll have to open an Excel spreadsheet, manually input all the USD you sent to your wallet and subtract out your current portfolio balance from it. Only then can you know how ‘rekt’ you are.
Every week or so, there’s a new cool thing in crypto. This week, it's StepN, “an app that lets users walk and run to earn tokens.” To get started, you need to spend around $600 on virtual sneakers (in NFT form). Then:
The usual return on investment requires about a month, upon which people can start generating income of up to several thousand dollars per day depending on their level, activeness and the current price of StepN tokens. In other words, the game can be quite lucrative.
Does this business have non-investment revenue in the hundreds or thousands of dollars per user per month to pay out to ‘walkers’? No. Does that mean payouts will come from other investors? Yes. Does that make this a pyramid scheme? Yes. Does that mean some ‘investors’ will lose money so other investors can make money? Yes. Does it matter? Not in crypto, apparently.
This month, an algorithmic stablecoin called Terra (UST) suddenly collapsed, wiping out $18B in market value (and erasing another $30B in market value for Terra’s sister token Luna). Unlike fully backed stablecoins, Terra did not have assets other than a little Bitcoin to back its UST stablecoin tokens.
Instead, an arbitrage mechanism with sister token Luna was meant to maintain the 1:1 peg with the US dollar. If UST dropped below $1, you could buy it at a ‘discount’ and convert the cheap UST into a full dollar worth of Luna tokens. Luna tokens are basically equity in the Terra/Luna ‘ecosystem.’ This algorithm was supposed to stop UST from falling under a dollar.
A general problem with the design is that Luna has an intrinsic value of near zero since nobody needs Luna for much other than speculation. A specific problem with the design is that in a market panic, if everyone is running for the exits and selling UST for less than a dollar, the arbitrage mechanism to support the peg kicks in. This floods the market with new Luna tokens, causing Luna’s price to crash, which causes more panic. With more panic, more people to sell UST for even steeper discounts, causing yet more Luna issuance, and on and on.
Both the ‘stable’coin Terra and sister token Luna can go POOF in what’s called a ‘death spiral.’ Matt Levine explained all this in detail, but the important point is that stablecoins backed by nothing or volatile quasi-equity tokens in dubious projects are extremely risky. They never have never worked. In 2020, a similar algorithmic stablecoin called Basis Cash by the same founder failed in the same way. That’s why the collapse of Terra was predictable and in fact, predicted.
Well, there’s a new token called USDD with a very similar design to Terra. Thankfully it still only has $500M in market capitalization, but it will also eventually collapse and burn people’s savings. Yet somehow, it still advertises itself as a ‘stable’coin. Cool.
The primary reason people bought the algorithmic stablecoin Terra (UST) in the first place was to put it in ‘Anchor,’ a DeFi protocol that offered 20% yields on UST. The 20% yields were mostly paid out of cash infusions from long-term Terra/Luna investors, not actual economic activity like lending. It was very expensive publicity to get people to ‘use’ Terra.
Of course, FinTech start-ups like giving their companies access to these high DeFi yields. For instance, Y-Combinator company StableGains offered an easy-to-use savings account that gave users 15% passive crypto interest, which is 15% higher than 0% at Bank of America or Citybank. What StableGains did was turn your money into UST, earn 20% from Anchor, pay you 15% and keep 5% for themselves. Then Terra (UST) collapsed from $1 to $0.06 and:
Stablegains said its 4,878 customers would likely lose most of the $47 million they had entrusted to the company.
StableGains’ tagline was “15% interest. No surprises.” Nice.
Honestly, what can you say about all this other than crypto needs regulation badly? It’s just bleak...
Note: This post was updated. It previously stated that Tether’s quarterly disclosures are voluntary.