Understanding Cryptocurrency's Ponzi-nomics [Finance Fridays]
How Multiple Crypto Firms built a multi-billion dollar house of cards.
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To those of you that have been asking me to cover the FTX collapse,
It’s coming. There is a lot about that situation I want to cover, so I’m waiting. Don’t worry, we will go very in-depth with that. As some background to that, I thought I’d cover this important topic.
In my article about Blitzscaling, I covered how unsustainable Tech and Crypto Companies reach obscene valuations and attract VC investment. That contributed a lot to the crypto crash. However, there is another aspect of the way Cryptocurrency firms conducted business that is unique to the field. This technique is what allowed Crypto Currency firms to report billions of dollars of assets on their balance sheets. It is also the reason that the collapse of one major player kick-started the collapse of an entire industry.
Important Highlights
Crypto’s Infinite Money Hack- Crypto firms like FTX were selling their tokens as collateral for loans. Since they controlled the production of these tokens, they could hypothetically have infinite money.
The problem with this- The problem with this is this makes the system very inter-connected. If the token loses value, then these collaterals become worthless. Thus the one holding the collateral loses a lot of money. If you have an entire ecosystem built on this, it will collapse.
Comparison with normal businesses- The practice of using tokens as collateral is similar to a normal company using their shares as collateral. If the business is doing well, this seems fine. But if the business collapse, then the shares of that company also become worthless.
Understanding this practice is key to understanding the FTX collapse. Let’s get right into it.
How Cryptocurrency firms have Infinite Money
Let’s say I created a Crypto Trading Platform tomorrow. Along with all the usual suspects like Bitcoin, Etherium, Dogecoin, etc I also list my own coin- Wokecoin-Inu. I create a billion of them. I sell one coin for 1 USD. This makes the valuation of my coins 1 Billion USD (yes this is actually valuations work). Notice that I don’t have to sell all the coins to show that they are actually worth 1 Billion. Selling one is enough.
As a crypto bro, I now need to make a few key investments. I need a yacht, need to make videos of me screaming on TikTok, and other business expenses. For this, I need normie money. How do I get this?
I go to a lender and ask them to loan me 1 Million Coins. In return, they ask for something to secure the loan. Normal people would use things like houses, cars, etc. But I don’t own any of these things. So I give them 1 Million Wokecoins. On paper, this is an equal trade. I also throw in a speech using phrases like Blockchain, Web3, and the Moon and we have 1 Million USD of actual money. Time to stimulate the economy by funding some key business expenses.
Anyone that has some experience with investing and finance might think I’m making this up. Here is a quote from CoinDesk’s investigation into FTX and their sister firm Alameda-
The financials make concrete what industry watchers already suspect: Alameda is big. As of June 30, the company’s assets amounted to $14.6 billion. Its single biggest asset: $3.66 billion of “unlocked FTT.” The third-largest entry on the assets side of the accounting ledger? A $2.16 billion pile of “FTT collateral.”
-Source, Divisions in Sam Bankman-Fried’s Crypto Empire Blur on His Trading Titan Alameda’s Balance Sheet
Notice how the FTT coin (the coin by FTX) is used as Billions of Dollars of collateral.
Now let’s cover why this is a huge problem.
Building a House of Cards
The problem with this approach is clear when you think about it- my Wokecoin-Inu is only valuable if my Crypto firm is valuable. The way these coins are designed, they have no other intrinsic value. You can’t use them for anything but trading.
“If the exchange issues a huge number of tokens and holds them on their balance sheet, only offers a small number of those tokens for trading—restricting the ‘free float,’ which can create an artificially high valuation—and uses the locked tokens on its balance sheet as collateral for loans, this creates a systemic risk because the collateral’s paper value isn’t real,” Matt Hougan, CIO at Bitwise Asset Management, told Fortune via email. “If the loans get called, the exchange may be insolvent.”
If a whole bunch of people in the industry does something similar, then the whole kingdom is built on quicksand. On paper, it seems like there is a lot of liquidity because everyone has billion-dollar assets and coins loaned out. But if one person collapses, then everyone loses money. If people start pulling out, then everyone will take the hit.
Imagine if instead of 1 coin, I gave you one cookie. You can use that cookie if something happened to my operations and I was unable to pay. You can’t do that with the coin.
A whole while back, when FTX, 3Arrows, and the other big names were still fine, I had written the following in my article on the crypto prices falling (read that here). At that time, we hadn’t seen all the bankruptcies we have now. But I had warned about how the economic system was primed for collapse. I’ll let the results speak for themselves-
I’m going to end this piece here. This article should give you an understanding of how Crypto companies were able to show billions of dollars on their balance sheets, and why a little bit of a bank-run caused a major collapse.
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Stay Woke,
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Devansh <3
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