The Sky Is Falling
I will be honest, dear reader, that I had an entire 1300 word newsletter that I have mostly had to throw in the trash and set on fire. Since my last newsletter, more things have come to light about Sam Bankman-Fried, FTX, and the larger cryptocurrency industry that, while insane, were quickly overshadowed by the last few days' events.
Allow me to give as quick a rundown as I can:
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Ultra-fraud Sam Bankman-Fried has crumbled, with FTX and approximately 130 other affiliated companies (???) declaring bankruptcy. This includes FTX.US, the US-based counterpart that was, to quote Bankman-Fried, “not currently impacted by [his large amounts of fraud.” You will be shocked to hear that FTX.US has also halted withdrawals.
As I discussed previously, my concern around crypto lender BlockFi’s “savior” loan from Sam Bankman-Fried was well-founded - they have said that they can “no longer operate its business as usual” and have paused client withdrawals.
Crypto.com (the sponsors of the Los Angeles Lakers’ stadium) shared a preliminary audit of their assets, including one of the most incredible revelations of all - that they hold 20% of their assets in SHIB, a meme coin of a meme coin based on a meme of a dog. This holding accounts for just over 10% of the market capitalization of SHIB.
On Friday (November 11th), a mysterious update began appearing on the “FTX App” (it isn’t obvious if this was the native Android or iOS app) asking users to “update now.” It was quickly confirmed it was malicious, but it wasn’t obvious to what end.
As this happened, $600 million was ransacked from FTX’s holdings, split between two or three “hackers,” with a “white hat” hacker attempting to save money, and a black hat hacker messily breaking off pieces of a $300 million haul to sell. We still do not know who it is. General Counsel Ryne Miller said that there were “abnormalities with wallet movements related to [the] consolidation of FTF balances across exchanges,” which once again proves that saying lots of words often doesn’t help construe meaning.
FTX claimed that Thursday they were “facilitating withdrawals of Bahamian funds” based on Bahamian financial regulations, to which the Bahamian government responded two days later with a resounding “what? That isn’t true.”
At this point, it isn’t obvious how big the hack was - $338M, $447M? $663M? Who knows? I will tell you, though - if you had money in FTX, it is gone.
In what was somehow not the biggest story of the weekend, it turns out that there are $1bn to $2bn of missing user funds from FTX, and yes, Sam Bankman-Fried used that to do cryptocurrency speculation using his firm Alameda Research.
Please Explain This To Me In Plain English, Ed!
One of the critical issues with the cryptocurrency industry is its somewhat tenuous attachment to reality and good sense. I will get into a lot more detail here, but despite all of this chaos, it is important to remember that most of this isn’t real money.
The hacker attempting to split up the larger bag of different tokens from FTX to sell wasn’t just because they needed to find a way to slip under the radar. While you may be able to receive a transfer of $300,000,000 in cash to your bank, they would be hard-pressed to deliver you three hundred million physical dollars. However, if you attempted to transact them, you could spend them. Such a large amount of money likely has a few phone calls and perhaps a physical visit to a location, but it would not be moved if the bank receiving it could say, “okay, that’s real money.”
This is not the case in cryptocurrency. If you attempted to redeem your $300,000,000 for real money all at once, you would quickly find that most exchanges do not have that much money on hand. Not only are people concerned that attempting to withdraw their cryptocurrency might not work, they are also equally concerned that attempting to turn cryptocurrency into real money might not work because the companies in question do not have enough money.
Sidenote: My more annoying readers will now say “this is all a trust-based system!” and “this is just tokenized money!” You are correct that all of this resembles some sort of tokenization of money - the nature of globalization is such that remotely transacting money is the only sensible way to do things - but being part of the international banking system requires you to go through many, many hoops.
And you don’t care. If you are a person saying this, you know how broken and corrupt cryptocurrency is. Just say you like that you can break the rules a bit! I don’t care!
This is the concept of a bank run - when a bank is unable to keep up with the pace of withdrawals - and generally doesn’t happen to real banks because banks have laws that stop them from operating in careless ways with customer deposits. One specific rule is that customer funds are handled in a very, very specific way.
In the case of Sam Bankman-Fried, he used customer deposits like a piggy bank, building a backdoor that hid the transactions from FTX’s internal systems. Imagine if, say, Bank of America CEO Brian Moynihan built a special backdoor into Bank of America and said “Merrill Lynch can use this.” To be clear, Merrill Lynch was hit with a $415 million fine in 2016 for holding customer funds in improperly-handled and accessed accounts, because a firm collapse would’ve exposed customers to massive risk - and this was without any actual customer losses. It is an extremely serious thing to play with customer funds. You do not do it, because if you lose those funds, the customers will too.
Have you ever considered why banks have not made their own cryptocurrency exchanges? This is why. While I am not saying that a bank has never done anything illegal or unethical, the sheer scale of this fraud - and that of the larger cryptocurrency industry - is so much bigger, uglier and dumber than you even know.
A Little About Wallets
Yes, I realize this is a lot to take in, and there is still so much more that you’ve yet to hear about, but I want to briefly explain something vital to understanding (and holding) cryptocurrency itself.
When you buy a cryptocurrency, you usually do so via a cryptocurrency exchange. There are centralized exchanges - websites you connect to and then buy cryptocurrency from, either from sending them real money, or through depositing cryptocurrency on their platform into one of the wallets that they hold. This is referred to a a “CEX.”
There are also decentralized exchanges that work in a similar way. Sometimes you still have to deposit money into them, but when you do so it’s held in a smart contract - meaning that somebody cannot dip into it unless those rules are in the smart contract. Or, of course, if the smart contract has code that can be exploited. These are known as a “DEX”.
Finally, you can store your crypto in “cold storage,” which is a wallet disconnected from the internet - meaning it cannot be transacted with in any way without you directly approving it. There are various different kinds (software wallets like MetaMask which can also operate as “hot wallets” connected to the Internet, or the Ledger Nano, a physical device).
In the case of a CEX, you are storing your crypto in their custody. In the case of a DEX, you are storing it in your custody. When you hear someone say “not your keys, not your crypto,” it refers to the fact that you are effectively storing your crypto in someone else’s wallet, and if they decided to do something bad, they have your wallet.
Sidenote: What is a “contagion”?
If you have not been reading every single thing I’ve written, to explain in short - Sam Bankman-Fried was using customer funds to speculate on the markets, while also lending money to other people (or simply storing it in FTX’s coffers in exchange for “guaranteed returns”, whcih would allow him to then lend it to other people).
The “contagion” people fear is the ramifications of said loans or funds being repayed, and big players in cryptocurrency not being able to make payments on other loans, or, say, if other exchanges chose to speculate with user funds by putting them in FTX.
Why Do I Need To Know That?
As we speak, the current anxieties in the cryptocurrency markets are that major exchanges may be insolvent. In a regular bank, you are expected to keep customer funds separate, and not do weird things with customer funds. In the case of Crypto.com, they accidentally sent $400 million to another exchange called Gate.io in some sort of accidental “cold storage transfer” issue that nobody can seem to elucidate the meaning of. It also isn’t obvious why (despite their claims that they were not severely exposed to FTX) Crypto.com may have sent over a $1 billion in stablecoins (cryptocurrencies pegged to the value of a US dollar) to FTX, and the explanation appears to be “exchanges do this all the time to trade cryptocurrency,” which is worrying in and of itself. Thankfully, Crypto.com’s CEO Kris Marszalek said that they had a “tremendously strong balance sheet.”
However, “insolvent” can have two specific meanings:
The exchange is insolvent because they do not have the cryptocurrency you invested.
The exchange is insolvent because they do not have the ability to pay every user in the event enough of them try to liquidate their holdings for real money.
The first problem is one that is being addressed by many exchanges, including Crypto.com and Binance. The second problem is one that you would not normally expect - your bank does not show you its reserves, nor does Robinhood or anyone else, because they are regulated in what they offer you and how they use your money (or securities). They have requirements about how they hold funds, how much they hold, and who they offer the service of banking or trading with, because they do not want to expose themselves (or the customer) to more risk than they are comfortable with.
The problem is that while the total market capitalization of the cryptocurrency industry is just under $1 trillion, yet the actual, real money in this industry may be quite a great deal less. Much of the volume on exchanges is faked, and even if it isn’t, the “market capitalization” of cryptocurrency tokens is total hogwash, as Molly White has explained extremely well.
And, on top of all that, we have no idea of how much actual money each exchange has, along with its assets and liabilities. While CoinDesk’s Nic Carter has said that crypto should “actually commit to proof of reserves,” specifically “merkelized” proof of reserves where users can verify that they are included in the exchange's outstanding liabilities. Carter explains that an audited proof-of-reserves is great.
The other problem is that none of this is remotely enough.
What about the bank accounts? What about the assets and liabilities that cannot be rendered on the blockchain, or cannot be live-updated on the blockchain, because the blockchain can’t do that? Or perhaps you think I’m deeply unfair for saying that every single cryptocurrency exchange should have to operate with complete transparency of what they have, what they owe, and to whom they owe it to?
Because why, at this point, should anyone trust any cryptocurrency company that doesn’t do this? If FTX can do what FTX did, there is absolutely nothing stopping any other privately-held non-US-headquartered exchange to keep doing the same thing in perpetuity. The signals that people used to trust FTX - a CEO that would visit America, a company with US holdings, a nice website that actually worked, celebrities, and so on - were worthless, because there was the assumption that nobody would actually do this. Though there were signs, what possible way was there to truly know that Bankman-Fried had stapled 400 loans together in a trenchcoat and called $24 billion? My suspicions only grew because I read a CNBC article and said “I wonder if he’s actually worth that much money. Could he have any other loans?”
Then again, if you step back and look at it objectively - how was Sam Bankman-Fried worth $24bn? How is anyone in cryptocurrency worth that much, other than the values derived from the various tokens they hold that are nakedly manipulated? We used the same definitions we used for billionaires holding stock or real estate and acted as if tokenized “assets” that held no real value and stood for nothing. FTT was always a token created and owned by FTX, and yet Forbes used it as the underpinning value of Bankman-Fried’s billionaire status.
What I am saying is that there is no way to trust any cryptocurrency exchange that is not burdened with reporting to the government their exact holdings in completion, including their literal assets (cash, real estate, et. al) and literal liabilities (loans to real companies that are not on the blockchain). The reason that “big government” doesn’t let regular companies do this is because human beings, when given free rein to experiment with their greed, will tend to exploit with efficiency and disregard.
I took this extremely scenic route because I see a sentiment throughout the cryptocurrency industry to pull money from centralized exchanges. If this happens at scale, it will fundamentally test whether any of these companies actually have the assets on hand, and if they do, whether they have the fiscal liquidity to exchange them for money. If all of these people decide to yank their crypto from the exchanges, that’s less money being traded, which means less volume and less transaction fees. It’s all quite bad.
Binance’s CEO CZ has said that he is creating an “industy recovery fund to help projects who are otherwise strong, but in a liquidity crisis.” Let me be clear: such a concept does not exist. This is not like a regular company running out of money - in the event that a company that agrees to store, buy or sell something cannot provide all three of those services at the request of the user, it is because they have engaged in fraud or ignorance at such a scale that they are not “strong” in any sense. They are scammers.
I do not know what happens from here, but I do know that CZ would not be vaguely offering bailouts to an industry that he believed to be solvent, or stable, or reliable, or (let’s be honest) operating ethically. I believe a major exchange will fall. I do not know which one. But if you are reading this and still investing in cryptocurrency, knowing that I fundamentally do not believe that 95% of exchanges have enough money to handle user deposits.
If one major exchange dies in the next 2 weeks, this industry may be about to implode. If too many people want to cash out, one of the exchanges will fail to do so, and people will begin trying to liquidate their assets on other exchanges, which will also fail to do so. It will be grim.
One final note: It’s also important to realize that the entire cryptocurrency industry 100% knew that Sam Bankman-Fried was promising loans with “no downside”, along with returns of 15%.
Ironically, the person who warned everybody was Zhu Su of Three Arrows Capital, but he neglected to name who was offering the terms at the time, I assume because he was busy working on his own massive scam. He claims he was “pressured via his business partner” to delete the tweet (he never did) and then added that “nobody calls out scams…[because of] risk of exclusion higher than return from exposing.”
To be clear; the “risk of exclusion” here refers to “him being excluded” and the “return” he refers to exchanging that for is “millions of people losing billions of dollars.”
To be clear: it is not possible to “guarantee” returns in that volume. Doing so suggests that you have created a fiscal perpetual energy machine.
The Stock Market At The End Of The World
Back in June, I wrote a paragraph that I’d like you to consider again:
As I’ve remarked before, so much of this industry is built on conning people into believing it’s the future, then extracting something from them - or convincing them to join the con and trick people into joining too. And instead of creating something real, something with meaning and structure, the cryptocurrency industry - even at the biggest companies - seems utterly incapable or unwilling to act in a way that isn’t usurious. There is no other way to describe an industry that seems blindsided by the volatility of cryptocurrency at every turn, having either too many people or not enough people to run the business properly.
On a personal level - as bizarre as it sounds - I do not believe the people you see on Twitter - the average cryptocurrency enjoyers - are morally bankrupt, but a victim of an extremely long, messy and unintentional con. Bitcoin grew out of the Great Recession, and was a libertarian-driven way of transacting money as a means to “take financial control back from the elites.” The community, while bordering on fanatical, grew from the immediate shock that came post-2008 that society would not be getting better in the way it previously had.
The dream of simply going to a job and owning a house and retiring in said house was dead. Getting a mortgage wasn’t happening. College (and student loans) were increasing, and thanks to the Great Recession, a college degree became a requirement rather than a speciality, meaning that going into mountains of debt to go to college was borderline essential.
This has coincided with a massive decline in Church membership in U.S. adults. While it feels weird to bring faith into a situation like this (I’m agnostic, I do not go to any kind of church), I believe there is a degree of worship to empower this interest. The fervent cries of “#WAGMI” and the damnation of non-believers as “having fun staying poor,” the deified of Vitalik Buterin and Satoshi Nakamoto, the televangelist con-artists like Anthony Pompliano who pretend that there is meaning to be derived from the chaotic, untraceable yet manipulated markets.
At the core, however, are people that want meaning in their lives. While many of them have buffed off moral edges - things that might say “hmm, this is incredibly risky, I’m not sure this is safe to introduce people to or hype” - I also believe that they are desperate for community, purpose and a path to thrive. At a time when we are more disconnected from those around us (and I mean even before the pandemic), when the general rat race conveyer belt hasn’t really worked, a community exists (or existed) that said “sure, come on in. We’re all going to make it. Anyone saying otherwise is going to be poor.”
It is easy to forget - despite how silly this is - how close to their line of thinking most people are. Most people cannot buy a house. Most people have no hope of a decent retirement. If you lose your job you lose your health insurance, and if you lose your health insurance, you cannot afford to go sick, and if you do, you will either get sicker from not visiting the doctor or go broke from doing so.
It’s no shock that a global generation that has felt tricked by society - that feels disconnected from its leaders, conned by their parents’ promises of working hard and being rewarded - would fall into a form of desperate iniquity as a means of trying to build something with their lives. Yes, many of them are aware of how crooked all of this is, but many more I argue believe this to be legal and just and fair. And if they know it’s crooked, they believe it to be crooked in the same way that everything is - rules are there to be bent, and it’s fine if they’re not broken, and hey, maybe you’ll get rich?
The real criminals are the people that willingly led people into this industry - evangelists like Anthony Pompliano and Ian Ballina - and the figureheads that continually failed to push against regulation like Brian Armstrong and CZ. Celebrities like Steph Curry, Tom Brady, Matt Damon, Jimmy Fallon and Mila Kunis should be held accountable for the financial pain they have caused real people. They have willingly led people to the slaughter, pushing products they didn’t understand that caused real harm, playing on the desperation that a lot of young people have felt that they’re being left behind by an increasingly difficult and more expensive society. And yes, this counts for those that took money for the commercials too.
The disgust I feel for the players involved with this is palpable, because this was all avoidable. I want to know every single person who knew about FTX/Alameda’s “guaranteed returns,” because anybody who knew that and did not publicly disclose it is partly responsible for this situation.
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I keep going back to Folding Ideas and his closing line from Line Goes Up: these are people who think the problem with the 2008 recession, and capitalism in general, is that there aren't enough opportunities to be the boot.
What do you think of the repeal of the Glass-Steagall Act? I was under the impression that gave banks somewhat carte blanche to gamble with customer money again.