From bank vaults to the crypt

The Coppola column

Crypto currencies are dead. Long live the crypto currency?

The crypto industry has had a terrible year. The prices of cryptocurrencies have crashed and major crypto companies such as FTX and Celsius have collapsed into bankruptcy. And people have lost enormous sums of money. An economic crisis in the real world has triggered a financial crisis in crypto and once again, we are witnessing the failure of things thought to be safe.

The tsunami of money that floated all crypto boats during the pandemic years is now receding fast, leaving a trail of devastation in its wake. “Only when the tide goes out do you discover who is swimming naked”, said the veteran investor, Warren Buffett. Now the tide is going out on crypto, we are discovering that nude swimming was the crypto world’s entire business model.

The memory of the 2008 financial crisis made people distrustful of banks, and a very long period of very low interest rates also made it impossible for them to earn any significant money from their savings. So crypto platforms like FTX and Celsius promised two things: a safe place for people to put their money, and exceptionally high returns. They have turned out to be anything but safe, and the money they promised has evaporated like fairy dust.

In desperation to attract new depositors, many crypto companies resorted to lying.

The crypto industry creates tokens by the million out of thin air. But all the tokens it creates are valued in real money, and most are supposedly exchangeable for real money. It has no central bank or commercial banks creating real money such as dollars and pounds, so to honour these promises it needs a constant inflow of real money. Some of this comes from investors – venture capitalists, particularly, have provided crypto companies such as FTX with eye-watering amounts of money on the basis of very little due diligence. But the biggest and most reliable source of real money is deposits. If it is to honour the promises it has made to itself, the crypto industry urgently needs new depositors; thousands of them.

To attract people who otherwise might not have considered investing in crypto – and in many cases could ill afford the risks – crypto companies embarked on aggressive and misleading marketing campaigns.  Some regulators, such as the UK’s FCA, closed down the most overt mis-selling but most of it went unchallenged. And in desperation to attract new depositors, many crypto companies resorted to lying.

FTX, for example, told customers it did not lend out their deposits, but was actually sending customer deposits to its sister company, Alameda Research, to fund risky, leveraged bets, acquisitions and lavish personal spending by executives. Several platforms, including FTX, Celsius and Voyager, falsely claimed that deposits on their platforms were backed by government deposit insurance.

With such an onslaught of mis-selling and outright lies, it is hardly surprising that people not only put money into crypto, but kept their money in hot wallets on exchanges like FTX. They genuinely thought that FTX was safe, just as they thought the lenders Celsius, Voyager and BlockFi were safe. They have been systematically deceived and intentionally defrauded of their money. The greedy, corrupt bankers of 2008 have given way to the greedy, corrupt chiefs of crypto lenders and exchanges.

Crypto has only been in existence for 14 years, but in that time has earned a reputation for lies and deceit, fraud and theft, and the financing of crime. Bitcoin was used as “money” on the criminal online marketplace, Silk Road, which was closed down by the FBI in 2013 and its founder Ross Ulbricht, arrested. In 2014, the exchange Mt. Gox collapsed after a major hack in which thousands of bitcoins were stolen. Its chief executive, Mark Karpeles, was subsequently found guilty of false accounting. In 2018, Tether, the crypto world’s biggest stablecoin, was found guilty by the New York Attorney General of lying about the composition of its reserves. Canada’s largest exchange, QuadrigaCX, collapsed into insolvency in 2019 after its chief’s mysterious death in India: funds worth a Can$250,000  had apparently been embezzled from the exchange.

The greedy, corrupt bankers of 2008 have given way to the greedy, corrupt chiefs of crypto lenders and exchanges.

Whatever lessons were learned from these disasters were quickly forgotten. Frauds, scams, ponzis and rug-pulls have become a near daily occurrence in the crypto world. We’ve reached the point now where it is wise to assume that any scheme that offers high returns and/or promises safety either is, or will be fraudulent, whether it is offered by an existing player or a startup.

To be sure, we’ve long known that unregulated financial systems attract crooks. In traditional finance, regulation limits the tendency of financial systems to degenerate into snakepits, though there is a cost: over-tight regulation of banks and financial markets can seriously dampen economic growth. The UK is now considering relaxing the post-2008 regulatory regime so its dominant financial industry can get its stagnant economy growing again.

But it is not strictly true that crypto is unregulated. There is regulation, but it is patchy, inconsistent and inadequate. More importantly, it is specific to nation states. Crypto is a global, borderless industry. It isn’t possible for national regulators to regulate a global, borderless industry effectively. And when there is no global oversight, fraud can proliferate.

FTX’s complex global structure was impossible to regulate: no regulator had jurisdiction over all the network, and there were conflicts of law and standing – and there still are now. Interestingly, earlier this year the Swiss regulator, FINMA, refused to allow FTX to buy a Swiss bank because it was concerned about FTX’s lack of global regulation. How right it was.

But again, there’s nothing new about complex global financial empires falling through regulatory nets. Examples from traditional finance include the Bank of Credit and Commerce International (BCCI), which failed in 1991, and Espirito Santo (BES), which collapsed in 2014. But cryptocurrency promised a new and better financial paradigm, not a re-enactment of the failures of the past. It has clearly failed to deliver on that promise

When that industry’s reputation for honesty has been shot to pieces, self-regulation and voluntary disclosure are not remotely credible.

Another problem is opacity. Crypto exchanges and platforms are notoriously opaque: there are no real audits and few companies produce financial accounts. Attestations and “proof of reserves” are merely marketing devices to fool people into thinking their funds are safe. Opacity on this scale is always a red flag, especially in an industry that claims to improve transparency (which it manifestly does not). And when that industry’s reputation for honesty has been shot to pieces, self-regulation and voluntary disclosure are not remotely credible. Right now, there is no hard evidence that any of the prominent platforms in the crypto space are either honest or solvent, and some evidence that several are not. Until regulators force crypto companies to reveal the true state of their finances, none of them can be regarded as safe places for ordinary people to put their money.

Because of the risk that it poses to retail depositors and, increasingly, to the global financial system, there are calls for the crypto industry to be brought fully within traditional finance regulatory frameworks. But there are also calls for it to be cut off completely from mainstream finance. Some argue that centralised platforms that mainly deal with retail investors should be regulated, but “decentralised” platforms should be left to their own devices. The problem with this is that centralised platforms are the gateways to decentralised ones: if centralised ones are regulated but decentralised ones are not, someone will inevitably find a way round the regulation.

The valuations that crypto was enjoying only a year ago are gone, possibly for ever – indeed crypto prices probably have further to fall.

In its 14-year lifetime, crypto has failed to generate any significant real-world use cases apart from the financing of crime. And it is now facing a paradigm change. It has never known anything but easy money – low interest rates and quantitative easing (QE). But now central banks around the world are rapidly raising interest rates and unwinding QE. There’s a brutal liquidity squeeze going on in global markets, and money is being sucked out of risky asset classes such as crypto. The valuations that crypto was enjoying only a year ago are gone, possibly for ever – indeed crypto prices probably have further to fall. And the gravy train of new depositors attracted by false promises of high returns and safety has hit the buffers, hard.

We may be witnessing the death of crypto. There are already widespread platform failures: it may be that the vast majority of cryptocurrencies and stablecoins currently in circulation will die out,  including Bitcoin, which might find it hard to survive global tight money and very high energy costs. But man-made ecosystems like crypto tend to reflect what happens in nature. So if nature is any guide, whatever will replace crypto already exists. There’ll be some small weird beasts hiding away in a forgotten corner of the financial system that will emerge from the extinction of their order.

But an alternative future for crypto is that it will be absorbed into the existing financial system so completely that in 20 years’ time people will have forgotten that it ever existed separately. After all,  we’ve only recently discovered that dinosaurs still exist in the form of birds, and that Neanderthals live on in the DNA of modern humans. Similarly, crypto could, by disappearing from view, fundamentally change the future of finance.