Streetwise Professor

November 10, 2022

Another Blizzard in Crypto Winter, or, Tinker Bell Economics: To Call Crypto a “Trustless” System is a Joke

Filed under: Blockchain,Clearing,Cryptocurrency,Regulation — cpirrong @ 11:42 am

Another blizzard hit the winter-bound crypto industry, with the evisceration of crypto wonder boy Sam Bankman-Fried’s (SBF to crypto kiddies) FTX and its associated hedge fund Alameda Capital. (Which should be renamed Alameda No Capital.) The coup coup de grâce was delivered by SBF’s former frenemy (now full fledged enemy), Binance’s Changpeng Zhao (CZ, ditto). But it is now evident that FTX was a Rube Goldberg monstrosity and all CZ did was remove–call into question, really–one piece of the contraption which led to its failure.

The events bring out in sharp detail many crucial aspects of the crypto landscape. (I won’t say “ecosystem”–a nauseating word.).

One is crypto market structure. FTX (and Binance for that matter) are commonly referred to as “exchanges,” giving rise to thoughts of the CME or NYSE. But they are much more than that. FTX (and other crypto “exchanges”) are in fact highly integrated financial institutions that combine the functions of trade execution platform (an exchange qua exchange), a broker dealer/FCM, clearinghouse, and custodian. And in FTX’s case, it also was affiliated with a massive crypto-focused hedge fund, the aforementioned Alameda.

Crucially, as part of its broker dealer/FCM operation, FTX engaged in margin lending to customers. Indeed, it permitted very high leverage:

FTX offers high leverage products and tokens. The exchange currently offers 20x maximum leverage, down from its previous 101x leverage products. This is still one of the highest maximum leverage a crypto exchange offers when compared to FTX’s other competitors. Leveraged long and short tokens for BTC, ETH, MATIC, and others are also offered by the exchange; for example, the ETHBULL token allows investors to trade a 3x long position in Ethereum.

FTX also engaged in the equivalent of securities lending: it lent out the BTC, etc., that customers held in their accounts there.

These are traditional broker dealer functions, and historically they are functions that have led to the collapse of such firms–more on that below.

FTX supersized the risks of these activities through one of its funding mechanisms, the FTT token. Ostensibly the benefits of owning FTT were reduced trading fees on the exchange, “airdrops” (a distribution of “free” tokens to those holding sufficient quantities on account with FTX, a promise to return a certain fraction of trading revenues to token holders by repurchasing (“burning”), and some limited governance/voting rights. The burning also served the function of limiting supply. (I plan to write a separate post on the economics of valuation of these tokens, though I do touch on some issues below.)

So FTT is (or should I say “was”?) stock-not-stock. Not a listed security, but an instrument that paid dividends in various forms.

FTT was in some ways the snowman here. For one thing, FTX allowed customers to post margin in FTT.

Huh, whut?

Risky collateral is always problematic. (Look at the reluctance of counterparties to accept anything but cash as collateral even from pension funds as in the UK.) Allowing posting of your own liability as collateral is more than problematic–it is insane. Very Enron-y!

Why? A subject I’ve written on a lot in the past: wrong way risk.

If for any reason FTT goes down, the value of collateral posted by customers goes down. Which means that your assets (loans to customers) go down in value.

A doom machine, in other words.

The integrated structure of FTX exacerbated this risk, and bigly. If customers start to get nervous about its viability, they start to pull the assets (BTC, ETH, etc.) they have on account there. Which is a problem if you’ve lent them out! (Recall that AIG’s biggest problem wasn’t CDS, but securities lending.)

And this has happened, with customers attempting to pull billions from the firm, and FTX therefore being forced to stop withdrawals.

And things can get even worse. The travails of a big broker dealer can impact prices, not just of its liabilities like FTT but of assets generally (stocks and bonds in a traditional market, crypto here) and given the posting of risky assets of collateral that can make the collateral shortfalls even worse. Fire sale effects are one reason for these price movements. In the case of crypto, the failure of a major crypto firm calls into question the viability of the asset class generally, with some of them being affected particularly acutely.

The integrated structure of crypto firms is also a problem. Customer assets are held in omnibus accounts, not segregated ones. Yeah yeah crypto firms say your assets on account are yours, but that’s true in a bookkeeping sense only. They are held in a pool. This structure incentivizes customers to run when the firm looks shaky. Which can turn looks into reality. That’s what has happened to FTX.

The connection with a hedge fund trading crypto is also a big problem. (The blow up of hedge funds operated by big banks was a harbinger of the GFC in August, 2008, recall.). And it is increasingly apparent that this was a major issue with FTX that interacted with the factors mentioned above. FTX evidently lent large amounts–$16 billion!–of customer assets to Alameda Research. Apparently to prop it up after huge losses in the first blizzards of Crypto Winter. (In retrospect, SBF’s buying binge earlier this year looks like gambling for resurrection.)

SBF described this as “a poor judgment call.”

You don’t say! I hear that’s what Napoleon said while trudging back from Russia in November 1812. Probably Custer’s last words, but we’ll never know!

Also probably an illegal judgment call.

But it gets better! Alameda held large quantities of FTT, also apparently emergency funding provided by FTX. And it used billions of FTT as collateral for its trades and borrowing.

And this was the string that CZ pulled that caused the whole thing to unravel. When he announced that he had learned of Alameda’s large FTT position, and that as a result he was selling FTT the doom machine kicked into operation, and at hyper speed: doom occurred within days.

Looking at this in the immediate aftermath, my thought was that FTX was basically MF Global with an exchange operation. A financially fragile broker dealer combined with an exchange.

And the analogy was even closer than I knew: FTX’s using customer assets to “fund risky bets” revealed this morning is also exactly what MF Global did. Except that Corzine was a piker by comparison. He filched almost exactly only 1/10th of what FTX did ($1.6 billion vs. $16 billion). (Maybe SBF should take comfort from the fact that Corzine walks free–though I don’t recommend that he walk free at LaSalle and Jackson or Wacker and Adams). (I further note that SBF is a huge Democrat donor. Like Corzine, his political connections may save him from the pokey, though by all appearances he should spend a very long stretch there.)

In sum, FTX’s implosion is just a crypto-flavored example of the collapse of an intermediary the likes of which has been seen multiple times over the (literally) centuries. As I’ve written before, there is nothing new under the financial sun.

The episode also throws a harsh light on the supposed novelty of crypto. Remember, the crypto narrative is that crypto is decentralized, and does not rely on trusted institutions: it is trustless in other words.

Wrong! As I’ve written before, economic forces lead to centralization and intermediation in crypto markets, just as in traditional financial markets. Market participants utilize the services of firms like FTX and Binance, and have to trust that those firms are acting prudently. If that trust is lost, disaster ensues.

In brief, crypto trading could be decentralized, but it isn’t. For reasons I wrote about years ago. (Also see here.)

Indeed, the issue is arguably even more acute in crypto markets, for a reason that SBF himself laid out in now infamous interview with Matt Levine on Odd Lots. Specifically, that token valuation relies on magic–belief, actually.

That is, tokens are valuable if people believe they are valuable–that is, if they have trust in their value. Furthermore, there is a sort of information cascade logic that can create market value: if people see that a token sells at a positive price–especially if it sells at a very large positive price–and they observe that supposedly smart people hold it, they conclude it must have some intrinsic value. So they pile in, increasing the value, validating beliefs, and extending the information cascade.

But this is Tinker Bell economics. If people stop believing, Tinker Bell dies.

And when someone very influential like CZ says “I don’t believe” death is rapid: the information cascade stops, then reverses. Especially given how FTT was the keystone of the FTX arch.

In brief, crypto theory is completely different than crypto reality. Crypto markets share all major features with the demonized traditional “trust-based” financial system. To the extent they differ, they are even more based on trust, given the ubiquity of Token Tinker Bell Economics.

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  1. Thanks for that. I’ve been too wise (or maybe too lazy) to pay any attention to the crypto schemozzle.

    When I was young I was a customer of my local Savings Bank. This was an institution invented in Scotland in the early 19th century to let the “small folk” (people of modest means) – who had negligible capacity to survive a bank run – store their money at minimal risk. The combined money in the savings accounts was invested in “gilts” i.e. government bonds. They paid interest and, after deduction of costs, the interest was added to the savings accounts. So, no lending to businesses or householders; only liquid, cautious investment. I suppose it was the inflation in the decades after WWII that killed them off.

    My father was a Director of our Savings Bank – he looked on it as a social duty and was determined that the bank be competently and cheaply run. As he said “my employees save there and I want their money safe for them”. Changed days, eh?

    And what, you may enquire, did I get out of my boyhood labours and consequent savings? My first motorbike, that’s what. Which was probably far more exciting than a bitcoin anyway. There should be a slogan in that – Enjoy your excitement from your purchases not your savings.

    Comment by dearieme — November 10, 2022 @ 4:43 pm

  2. Blaming the currency and not the criminal is always the first shot fired whenever some crypto scam is uncovered.
    I doubt that you’d blame the greenback itself for any given bank robbery or fraud committed by a dunce or criminal mastermind.

    While I do believe that you’re in a much better position to comment on all matters financial, I do believe your bias against all things crypto is blinding you to the potential that these stores of value will bring to the world.

    I understand that virtually every country in the world that doesn’t have a mud hut for a capital city is actively working on their own CBDCs. Crypto is coming to everyone’s wallet at some point. Pretending it isn’t, does your readers no favours. Perhaps your criticisms of crypto should be adjusted to point out the flaws in the system that allow the bad actors to work in this growing segment of the financial world instead of giving the impression that these currencies won’t eventually take over. At the very least, they will be forced upon all of us in the next 10 years, if not sooner. Are you prepared to refuse your tax refund because it’s only payable via your government approved crypto into the wallet they assign you?

    While there may have been a time that saw most Bitcoin being used to fund crimes, those days appear to be behind us now. At least your crypto is relatively safe in your wallet with only the most basic of measures taken by non-rocket doctors to secure it. Come to Canada where our government decided to freeze the bank accounts of people who gave money to a legal protest and then leak their names and addresses to the press so they could be harassed by hoards of outraged Karens.

    While we seem to be in the salad days of printing money, that music will stop at some point and while we’ll all be millionaires, we won’t have enough to buy a loaf of bread after draining our government approved bank accounts.

    Love reading your work.
    Keep up the great work and please post more often.

    Geoff H.

    Comment by Geoff H — November 10, 2022 @ 6:06 pm

  3. Just to be clear, is our esteemed SWP’s viewpoint that *all* crypto is fundamentally worthless, or just tokens issued by exchanges? I wouldn’t dispute the second: there isn’t much point in using a trustless transaction medium (blockchain/smart contract) when the management of the asset relies on custodial trust in the issuer. Even here, though, we may see a competitive winnowing that looks like the free-banking era, where banks may be tempted to overleverage, but if they do so a competitor can induce a run much like Binance did to FTX. For a counterpoint, we can look at Tether’s performance after the TerraUSD meltdown: a $9 billion dollar run did squeeze the price a few percent for a few days, but in the end, speculators arbitraging 90-cent tethers for bank-account-dollars (in $100k minimum orders, IIRC) kept a floor under the price, and Tether holds its peg even today.

    Bitcoin, however, requires no custodial trust in its base form. Its value is dependent on perception, of course, but that is true of gold, Picasso paintings, and so on. Its value is also dependent on a functioning markets to buy and sell them (since you can’t eat a Bitcoin), but when markets collapse people just build new ones, and Bitcoin has survived worse shocks than this. The collapse of Mt Gox took out 70% of all trading, but Bitcoin, after a gnarly price correction, continued on just fine, if anything more robust than before.

    Comment by M. Rad. — November 10, 2022 @ 6:23 pm

  4. good summary,
    you make it sound, as if SBF was trying to do serious business, but made bad calls, or was too inexperienced/stupid/greedy/naive (ignoring wrong way risk, the loan to Alameda, etc.) – this, of course, is one possibility.

    The way it looks to me:
    all these nonsensical features were there to induce customers to wire fiat into the ecosystem – sorry: landscape – in order to enable him (and his bro’s?) cash out his shitcoins, or bitcoins which he seems to have aquired early in the process (he is one of the few whales). this is why bailed out the scams over summer – the longer the game goes on (Bitcoin still at 16k). In other words, he did not lend the money to Alamede expecting it back – the org chart published in the FT suggests a classic delete your traces operation. Do not forget that SBF and CZ were business partners at some point which offers some interesting game-theoretic speculation on the latest episode.

    I found this guy particularily interesting to read:

    Comment by viennacapitalist — November 11, 2022 @ 6:14 am

  5. I have no feeling for the scale of all this. It couldn’t be a Creditanstalt moment, could it?

    Comment by dearieme — November 11, 2022 @ 6:59 am

  6. Crypto = tokenized religion: belief it or not…

    Its adepts all only can think in its dogma and speak in its jargon.

    But some were lucky bastards and made a big pile of money (as you could have done at the times of the Dutch tulip bubble)…

    …but the ones I’ve met are buying ‘old world’ toys and assets with it, an appartement, an expensive brand SUV etc…

    …yeah but ya’know…it’s not old speculation and so, not going for status symbols, ’cause it’s ‘decentral’…ha ha ha…

    Comment by Mikey — November 11, 2022 @ 9:12 am

  7. Blame the SEC, the democrats, the politicians… The Ontario Teacher’s Fund is on the hook for 95 million with these guys… Heads should roll but where are the regulators… Bitcoin, Crypto is a spreadsheet, not a currency.

    Comment by Patrick Loria — November 11, 2022 @ 9:50 am

  8. @deari: They’re talking billions, so small change. That said, the FT are getting a tad animated, so it could be seismic (or a slow news day in the finance universe).

    Comment by David Mercer — November 11, 2022 @ 10:12 am

  9. Gee!! Maybe SBF can walk free like Corzine by claiming he was just “early to the trade” not really a f*%king crook.

    Comment by Donald Wolfe — November 11, 2022 @ 11:00 am


    The comments of the True Believers under your 2018 piece are hilarious in the current context. Swallowed all the hype, with a total focus on the technical “solution” to everything without bothering to think what the economic problem was in the first place. When they watch basic economics taking over with the rise of the centralized exchanges, they’re too busy declaring that crypto is just “losing its soul” rather than wondering why homogeneous assets that lots of people want to buy/sell might not end up primarily trading bilaterally. Wonder what they’ll blame the current problems on? Will there be a “stabbed in the back” narrative: frauds and corporate sell-outs hijacked crypto, but the basic technology was good and crypto could have saved the world if only it had been left to the little guy?

    Comment by Anon — November 11, 2022 @ 5:37 pm

  11. @dearieme. It’s big, but crypto is still hived off enough from the broader financial system that it’s unlikely to spillover. Moreover, unlike most financial crises, where those exposed to a failure are themselves highly leveraged, here the losers in FTX are “real money” investors including pension funds and firms like Black Rock. Equity meltdowns that hit real money investors tend to be less systemically threatening than meltdowns that hit leveraged entities. Think the dot com crash of 2000 vs. GFC of 2008.

    Comment by cpirrong — November 13, 2022 @ 9:07 am

  12. @viennacapitalist. Our views are not inconsistent. The Tinker Bell Economics point is quite similar to your explanation for his actions. He was exploiting belief–as he pretty much admitted in various interviews.

    Further, I agree re the motivation for his bailouts. It wasn’t vulture investing. It was as I said in the post gambling for resurrection to keep the game going.

    Comment by cpirrong — November 13, 2022 @ 9:11 am

  13. @M.Rad. Just to be clear, I said nothing of the sort.

    To the broader issues. All forms of “money” are essentially social conventions, as has been recognized for eons (cf., Carl Menger). Some theoretical models of money, notably those of Rob Townsend, specifically model money as “tokens” and use that exact word, and model the process by which certain tokens become valuable and are used as media of exchange. Expectations/beliefs are an important part of the equilibrium. So belief–I believe money is valuable because I believe other people believe it is valuable and hence will accept it in exchange for goods and services–is pivotal in all models of non-government issued money. (Government fiat is somewhat different because it can be used to pay taxes.)

    To be sure, the belief supported equilibrium is more fragile for some things than others. Belief supported tokens are far more fragile than BTC or ether, so as you note the latter are more likely to endure.

    Comment by cpirrong — November 13, 2022 @ 9:21 am

  14. @Geoff H. You seem to be one of the crypto advocates who misinterpret my critiques. (See @Anon’s comment below–he’s noted the same.). My basic critique is that crypto market structure reality is totally different from crypto market structure narrative, and that crypto market structure as it exists is not really different from traditional financial market structure, and is thus subject to the same problems.

    Further, the appeal of the narrative makes crypto more vulnerable to scams. The very idea that crypto is somehow different lures the unsuspecting into the same traps that have snared suckers for centuries. (EG., Mississippi Bubble, Law’s Bubble). People get poisoned by old wine in new bottles.

    The safety of crypto that you mention is a case in point. Yes, you can secure BTC or whatever in your own wallet–although as experience has shown that has its risks. But for those who want to trade or invest in crypto, that is extremely cumbersome. So–not surprisingly–the actual market structure has moved to an omnibus model just like that in stocks where people deposit their crypto (and their fiat) on an exchange where it is commingled, and often can be used by the exchange/broker dealer (lending, for instance). And that is vulnerable. (I note that you could hold stock certificates in your safe deposit box too, but very few do because it is too cumbersome to trade and invest that way.)

    This is an example of how technological possibility (truly decentralized, trustless trading) is trumped by other economic forces that lead to centralized trading relying on trust-based institutions. That’s been my basic point for years. Please don’t extrapolate and read into it what isn’t there.

    And don’t get me started on CBDC. In my more cynical moments, I think that BTC is a form of bait and switch to get people excited about digital currency and therefore susceptible to the lure of CBDC–which are utterly antithetical to the raison d’être of BTC. I dread CBDC, not least because they greatly empower governments to do things like what Canada did last winter, and worse. But I fear that the popularity of crypto, and the perception that it frees one from government control, will be used to condition people into accepting and indeed welcoming CBDC. Not all digital is created equal.

    Glad you like my work–thanks. I will try to post more often. Competing demands on my time have reduced my output here. But my writing thrives on disasters (I refer to myself as the “master of disaster” :P) so maybe the current environment will be conducive to more posts.

    Comment by cpirrong — November 13, 2022 @ 9:43 am

  15. When we were children we had a bag of cowrie shells that we used as currency for board games and card games.

    ‘All forms of “money” are essentially social conventions’ was accordingly explained to me at my father’s knee.

    Ditto for the foreign coins around the house.

    “That’s not money, Dad, it’s got a hole in the middle.” “It is in Kenya.”

    Another story: I was asked for a bus fare in Wales and it turned out I only had Scottish pound notes. The bus conductor refused to accept them. The other passengers were outraged by his behaviour and had a whip-round to pay my fare.

    Comment by dearieme — November 13, 2022 @ 10:43 am

  16. The South Seas Company and the Mississippi Company and the Sword Bank and now this. In one sense it is reassuring to see that nothing has changed in 310 +- years.

    But god damnit, where are the Hegelian dialectics when we need them?

    Comment by Sotosy1 — November 14, 2022 @ 7:48 am

  17. The comedy is pure Shakspeare. Yours and FTX. Well your humor was much more intentional. Great stuff sir!

    Comment by Carl — November 14, 2022 @ 9:53 am

  18. O/T
    Prof, can you explain this?
    After months of incompetence the Russian military, under a new commander with no experience of the tactic (his previous career being devoted to long range bombing of civilian) achieves one of the most difficult manoeuvres an army can perform, i.e. a tactical retreat with limited loss of materiel and personnel.
    Can it be true? It seems very unlikely to me, unless there was some kind of local collusion between the opposing armies.

    Comment by philip — November 14, 2022 @ 12:17 pm

  19. @Carl. Thanks! I try 😉

    Comment by cpirrong — November 14, 2022 @ 12:37 pm

  20. @philip–I think the reason they were able to do this is that the Ukrainians were not pressing them hard. The Ukrainian attack culminated weeks ago, and they had made no real progress down the right bank of the Dneiper/Dnipro during that time. The lines were also fairly static to the north and west of the city. As a result, the Kherson pocket was pretty big, and the Ukrainians basically limited themselves to interdicting Russian communications with long range fires. Those were fairly effective, and made it harder for the Russians to withdraw, but the Russians really didn’t have to stage a fighting retreat to the river. The Ukrainians pretty much let them go which probably reflects the need to reorganize after their pretty rapid advances, and their unwillingness to incur more casualties to take ground the Russians were willing to abandon. The Russians weren’t fleeing before a hell-for-leather pursuit.

    Comment by cpirrong — November 14, 2022 @ 5:01 pm

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