Shock Shock

Part I in a series coming to grips with Crypto, DeFi, and Shenanigans

“What’s shocking is the fall from grace, it was so rapid… we’re learning that value can evaporate within minutes in crypto, that’s the most shocking thing.” When I read this statement from a Mizuho analyst for the crypto “asset”[1] class my first reaction was shock—shock that someone could be shocked at this realization or that it was even a realization at all. I will admit as a long-time skeptic of the crypto phenomenon I am currently experiencing one of der besten Freuden there is, Schadenfreude, at the massive implosion of FTX and the general tanking of the crypto world. I have long believed the whole space is an absurdity that can largely be explained by the Austrian Business Cycle Theory of malinvestment—wherein an artificially low cost of credit and increased money supply lead to investment in shit of suspect value. In this case the post Global Financial Crisis world of ZIRP,[2] near ZIRP, and Quantitative Easing has created so much excess liquidity that, beyond flowing into and driving up every asset class under the sun, has spurred the creation of new highly suspect “asset” classes. [3]

As the TikTokers and celebrities rushed for the door in—I remained skeptical and confident that the music would stop and there would be no chairs to sit on if we ever inched closer to realistic pricing of risk. Well here we are—rates are up and crypto is down. Now that the hysteria is starting to wear off—the flaws that were always there are easier to see. Our current monetary system is the product of nearly one millennium of development, much of which has been characterized by extreme growing pains—to say the least. As Winston Churchill is purported to have observed of democracy—the monetary system we have is the worst system imaginable, except for all the others. The crypto and DeFi people were ok at identifying problems with the current system but it seems that building a monetary system de novo was harder than they thought.[4]

Let us begin with my base case argument on cryptocurrencies—for this discussion we will focus on the least insane of them, Bitcoin. I recall being subjected to lectures by people I know and people in the media writ-large about the virtues of Bitcoin. I was told that actually, Charles, money has three characteristics. It functions as a medium of exchange, a unit of account, and as a store of value! The implication being that if I understood this about money itself—I would get Bitcoin and cryptocurrency.[5] Twist: I did in-fact know this ECON100 level pseudo-insight about the nature of money—and that knowledge[6] was one of the underpinnings of my wariness. Now all these things could be true about cryptocurrencies—but they were not in practice true. Bitcoin was and is highly volatile and it is this constant change in its value that makes it highly, highly unsuitable for any of these core functions. Money allows people to transact across time—and if the value is constantly changing through time it is very hard to use it as a medium of exchange. Simply put if I charge you 1 Charlescoin for a Key Lime Pie[7] in the morning and the fluctuation in the value of Charlescoin means that my ingredients cost 1.5 Charlescoins in the afternoon—well that sucks for me doesn’t it? Furthermore if I have a full vault of limes and condensed milk that I have to keep track of, I am going to have to remark the value of that inventory ALL THE TIME and those records will be pretty useless. I could obviate these stresses by transacting and denominating my hoard in limes and cans of milk—but then why have money? Furthermore, I have very little certainty about how many new limes and cans of milk I will be able to buy with all my Charlescoins that I have socked away in my “wallet”—so it’s probably better to store that value more directly in actual goods, as limes[8] are more predictable.

But here is the kicker, this waffle about the three qualities of money, which Bitcoin allegedly demonstrated, was cited to me as the bull case for its rapid appreciation. Lets sum up this ouroboros of nonsense. The monetary qualities of Bitcoin were why it was appreciating so much; the extreme appreciation and concomitant speculation was why it was so volatile; the volatility was why Bitcoin didn’t actually live up to its alleged monetary qualities. So, it was appreciating so much for reasons that couldn’t be true because it was appreciating so much—circular logic that doesn’t actually close as a circle and forms more of a lower-case “e” shape. Now if Bitcoin, et al, had a stable value—all of these things could be true, but both could not be true at the same time, let alone could one be the reason for the other. This fundamentally leaves us with Buffet’s Iron Law of Speculation, Greater Idiot Theory. Momentum was the name of the game—not value.

Now Bitcoin, et al have shed a huge amount of value[9] in the past year—Bitcoin is down 70% TTM. But Bitcoin represents the end of the spectrum that is closer to reasonable and acting in good faith. The real problem is the world of Decentralized Finance or DeFi. I will admit I am not great expert in this field but as I understand it the idea is to create a new financial system, free from intermediation by financial institutions. And sure, I get it banks are bad, we hate banks, lets get rid of the banks.[10] But the rub is that the world of DeFi seems to be rife with institutions and people who function as intermediaries,[11] many of whom appear to be involved in behaviours banks are barred from by “a shitload of really good laws” to paraphrase Tom Hanks as Representative Charles Wilson (D-TX). The bank-like activities these folks engage in involve schemes[12] like the creation of taking deposits, making loans, acting as exchanges and clearing-houses, making markets, or issuing securities that are backed by other assets. But unlike banks, these institutions face no regulation on reserve requirements, leverage, or really anything at all. So the stablecoin you have that’s backed by honest-to-God, take-it-to-the-bank USD… maybe they don’t actually have those dollars to back that up. Maybe their risk management process is, or maybe it simply isn’t. The balance sheet they are lending against, maybe it is made up of complete horseshit low-liquidity assets whose value is easily manipulated. The Bahamian domiciled fund that is the biggest market-maker on an exchange? Maybe it is run by the same 29 year old freaks as the exchange itself and that exchange largely exists to lure marks for their scheme.

Maybe it’s not “maybe” at all.

So when I read so-called experts who are shocked that this could all fall apart so easily. I think about this stuff and am shocked that they are shocked. Nobody could have predicted the exact details of what is unfolding—but the broad shape of it was highly foreseeable.

Stay tuned for the next instalment when I take a deeper dive into the Nightmare in Nassau AKA the FTX Fuckery featuring SBF and his merry band of incompetents / fraudsters.

[1] The OECD defines asset as “entities functioning as stores of value and over which ownership rights are enforced by institutional units, individually or collectively, and from which economic benefits may be derived by their owners by holding them, or using them, over a period of time (the economic benefits consist of primary incomes derived from the use of the asset and the value, including possible holding gains/losses, that could be realised by disposing of the asset or terminating it).” I am not 100% sold cryptocurrencies fit this definition—the strongest case for in on the “holding gains/losses” point.

[2] Zero Interest Rate Policy

[3] I imagine FA Hayek, et al were probably originally thinking about an extra widget line a factory didn’t need and not equity in companies that never will make money, JPEGs of monkeys that you can buy but not own, or fake internet money that exists almost exclusively as a medium of speculation and has less underlying value than a Princess Diana endorsed purple bear plush toy.

[4] Here, I am ascribing to everyone in the space the presumption of good faith—this is a stylized scenario to say the least. I am pretty sure that this assumption does not hold.

[5] Question Begging in the extreme.

[6] I feel stupid calling this knowledge—it’s much like saying that knowing that there are 50 states is knowledge. Yes, one knows it—but it’s not that interesting. It barely rises to the level of a fact.

[7] Objectively, the best dessert. It combines richness and acidity in a way that few other desserts do as well—and it takes only marginally more effort to make than a bowl of ice cream.

[8] Which will quite literally decompose

[9] As ascribed by the market

[10] Blah blah blah—having a banking system is one of the major reasons I get to write this on a computer, sit on an ok chair in a warm house, buy things without having to carry around a bunch of shiny metal or engage in barter, not die from cutting my hand or a toothache… the list goes on. But if you think the banks are robbing you or enslaving you—try living somewhere or sometime that didn’t have them. I hope you like warlords. This is a simplification—but not much.

[11] Because financial intermediaries are useful. Do you like buying stuff or getting paid with relative ease? Thank a financial intermediary.  

[12] Take this in the value neutral, descriptive British sense, e.g. a “parking scheme” or the normative North American sense, e.g. a “Ponzi scheme.” Either works for me.