by Thomas Kirchner, CFA
Crypto fails to live up to its promises of peer-to-peer disintermediation.
Abysmal safety and soundness.
Reboot and return to its roots are needed.
The FTX debacle puts a hard stop to the dream of alternative digital currencies. A peer-to-peer cash system without banks or central banks was the promise of Satoshi Nakamoto's original Bitcoin white paper [i]. What we ended up with is a carbon copy of the fiat monetary system, but without its protections and safeguards. The result is that crypto investors lose billions, most recently from the suspected fraud at FTX.
Crypto copies fiat
The path crypto currencies have taken over the last 15 years has no connection to the ideals its early prophets had in mind. They were looking to establish alternatives to what many consider an errant monetary fiat system. However, if we look at the state of the crypto industry today, we find an industry structure that resembles the conventional fiat banking and brokerage system surprisingly closely. Little is left of the original peer-to-peer concept. Instead, crypto has become completely intermediated.
Few crypto users have the technical skills to hold their coins in a real wallet, much less transact on the blockchain. Therefore, service providers help users out by letting them open an account, in which they can store their coins and make transactions. This is no different than traditional banking and brokerage, except that, as we will discuss later, these intermediaries also run an order book to match buyers and sellers like a traditional securities exchange. In fact, that's what they are called – exchanges.
The parallels go even further. Exchanges extend credit to their customers, like a traditional broker in a margin or prime brokerage account. A wide range of derivatives is also available. Clearly, none of this is peer-to-peer, but fully intermediated like in the fiat banking and brokerage system. And with that come the same counterparty and fraud risks as in the fiat system, except that the crypto world is severely underdeveloped in its safety and soundness.
Prevalence of pump-and-dump schemes
That something was amiss in crypto land became apparent when the Terra-Luna pair of stablecoins collapsed in a rather unstable descent in October. Two interlinked tokens raise red flags. It appears that one token props up the other, while the second props up the first. It is a circular pump-and-dump scheme. It is now known that Sam Bankman-Fried admitted as much in a Bloomberg “Odd Lots” podcast with Matt Levine as early as April 2022. Of course, using one token to prop up the other has nothing to do with the original disintermediated peer-to-peer concept underlying cryptocurrencies, but when everyone makes money, such details didn't seem to bother anyone.
Similarly, nobody seemed to question the double-digit yields offered by some crypto schemes. If we were running a crypto project that were producing legitimately high yields in the double digits, we would not pay out that much to investors. Instead, we would pay them a generous high single digit yield, while fattening our own bottom line with the extra spread. A legitimate single digit yield would still be enough to attract plenty of yield starved investors. Clearly, double digit yields are offered by those who cannot actually generate a return in order to part the gullible and clueless from their money.
Exchanges are the weak link
For most people, the only practical way to access crypto currencies is to invest through an exchange. Exchanges are very different from other securities markets in that they act as brokers who hold the funds, while simultaneously running the order book. And they are not particularly efficient at running order books. While high frequency trading has generated lots of headlines on traditional stock exchanges with microsecond execution, known as latency in industry parlance, crypto exchanges are notorious for their slow speed. The fastest exchange we found at a recent check was Coinbase with a lame 180 milliseconds, while the exchange at the 95th percentile ranking had an astonishingly poor 1.8 second latency[ii]. This compares with as little as 26 microseconds for the NYSE [iii], faster by a factor of almost 7,000 than best-in-class Coinbase. That's a terrible verdict for the crypto bros, who are often technology geniuses, yet cannot beat the incumbents in technology. Latency measured in seconds is what we had three decades ago in open outcry futures pits.
As an alternative technology to traditional stock exchanges, crypto exchanges clearly are unsuitable. But the technical challenges of exchanges don't end there. If you want your crypto assets to be safe, you can withdraw them and place them in an offline wallet. However, we venture the guess that most clients of crypto exchange have no idea how to get their cryptocurrencies out of the exchange and into cold storage. With a bank account, it's easy: you go to an ATM and withdraw fiat currency. For most exchange customers, the only option to recover their investment is to transfer fiat currency from their exchange to a bank account. This, in turn, makes exchanges particularly vulnerable to bank runs. We would argue that in the absence of exchanges, with the current state of crypto technology, it would be more practical to use gold coins than crypto to make payments.
Exchanges are the critical infrastructure of the current crypto industry structure, and they are the weak link. At the same time, the need for an exchange to make crypto currencies usable negates the entire appeal of peer-to-peer digital currencies. In fact, much of crypto today resembles traditional finance, with crypto lurking somewhere in the background. Claiming crypto exchanges have something to do with crypto currencies is a bit like claiming that the dollar is gold backed just because the Fed holds a lot of gold in Fort Knox. In reality, crypto exchanges are leveraged balance sheets indexed on Bitcoin and other crypto currencies.
Crypto 2.0 versus the government
Just like the dot-com bust of 2000 was not the end of the internet, crypto will reboot from its current crisis. Somebody will figure out actual use cases and solutions to the shortcomings of the current crypto infrastructure. We doubt that the world needs 100s of cryptocurrencies, and thousands of VC-funded solutions for crypto-specific problems for which there is no actual business case.
The question is how the government will react to the scandals. We suspect that regulation will accelerate the reboot of the sector as crypto 2.0: exchanges will be regulated out of business, more or less. This, in turn, will give innovators the opportunity to return to the original concept and create a genuine peer-to-peer infrastructure that does not rely on intermediaries.
[i] Satoshi Nakamoto: “Bitcoin: A Peer-to-Peer Electronic Cash System” Available at bitcoin.org/en/bitcoin-paper
[ii] https://www.api.expert/collection/crypto-currency-exchanges retrieved on November 20, 2022.
[iii] https://www.nyse.com/data-insights/nyse-pillar-migration-adding-efficiency-to-the-marketplaceretrieved on November 21, 2022.
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Thomas Kirchner, CFA,
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Fund (EVDIX, EVDAX)
since its 2003
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was the founder of
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Fund. He is the author
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How To Profit From
Global Event Driven
Arbitrage.' (Wiley
Finance, 2nd ed 2016)
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