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The crypto carnage is working its way up the chain
Even Eric Snowden is saying - we're in for an interesting week in crypto.
We are starting to really get to the heart of things: Cameron Winklevoss is accusing Barry Silbert of “bad faith stall tactics and the commingling of funds within [Digital Currency Group].” The Winklevoss twins run Gemini Trust, which converted its clients’ USD to an “investment token” known as EARN which it then lent out to Silbert’s Genesis Global Capital (GGC). Due to GGC’s exposure to the now bankrupt FTX, GGC halted redemptions - including to Winklevoss’ Gemini.
I am going to do my best to unwind this by drawing rough analogies to the Western legacy financial system. I am going to dispense with any desire to be exact or precise in favor of trying to make sense of this to a non-technical reader (in both the financial and technical senses).
Digital Currency Group (DCG) - which is roughly analogous to a venture capital firm - owns CoinDesk, Foundry, Genesis Global Capital, Greyscale Investments, and Luno. Let’s try to draw some analogies and then discuss what I believe lies at the heart of all of this dysfunction - the “stablecoin” and the difference between “yield” and “arbitrage”.
CoinDesk is roughly analogous to Bloomberg in that it is a media enterprise, but also supports the ability to track crypto currencies and tokens in real time (CoinDesk Indices might be thought of as the crypto world’s Bloomberg Terminal.) It also offers investment products like ETFs that are built around these indices.
Foundry offers financing for the purchase of Bitcoin mining equipment. For those those unfamiliar with the metaphor (mining) in the crypto space, each transaction on the Blockchain is presented for validation. This is done by solving a complex math problem (analogous to digging in a mining operation). The first node to solve the problem is the node which finalizes the transaction on the Blockchain. That node is awarded one Bitcoin for providing the computational power needed to solve the problem and support the ability of the network to prevent forgery. This fraud prevention is accomplished by virtue of the whole network of computer nodes all coming to the same computational conclusion as they compete to be first - known as the decentralized consensus mechanism. When a Bitcoin is awarded for being the first to complete the needed computational work, it embodies the “Proof of [computational] Work” model in crypto.
Genesis Global Capital appears to be (or aspires to be) a crypto equivalent of a Prime Dealer - or “market maker”. Both of these terms are specialty language, so in favor of being close enough for the non-technical reader, the easiest analogy is the Farmer’s Market. It is a very simple operation. The Farmer's Market organization (usually a non-profit) leases some space (or gets a permit to close off a street) and then sells stall space. The producers pay for their stall and the consumers then have one place to go to shop: A market is made. Banks like JP Morgan Chase are an example of Prime Dealers in the legacy banking space. A wide range of “consumers” seeking capital are served by “brokers” who originate loans to specs set by the Prime Dealers - who then buy these loans and package them up as investment products one can buy for their retirement account - known as the Secondary market.
Greyscale Investments operates trusts by which an investor can be exposed to crypto without actually owning it. A trust exists for each coin and buys/sells the coin in a way that tracks the buying and selling of shares in the trust. While there are 16 funds, GBTC and ETHE (for Bitcoin and Ether, respectively) are probably the best known. GBTC and ETHE are ticker symbols one can select for their investment or retirement accounts. They are similar to “Exchange Traded Funds” (ETFs), but tend to cost more to administer. Investors usually prefer ETFs over Unit Trusts because the fees are lower.
Luno is a consumer crypto exchange like FTX and Coinbase, but only offers Bitcoin and Ether.
A Parallel Financial System
As one can see, DCG is nothing short of an effort to create a parallel financial system for crypto. As long as the USD holds a monopoly on legal tender, this is simply a fools’ errand. Let’s unpack legal tender first. Then we’ll unpack the whole idea of a “stablecoin” - it lies at the heart of why crypto is reeling.
Simply put, a debt is two things at once: It is a right to collect and an obligation to pay. When you see the term “counterparty” reading the financial blogs and media, the party with the right to collect from the party with the obligation to pay are the “counterparties”. When the party with the obligation to pay (the debtor) “tenders” payment in a monetary unit recognized by the courts as legal tender, the debt is extinguished. “Counterparty risk” is the risk assumed by the party with the right to collect that the party with the obligation to pay is not able to tender payment as scheduled. Even if both parties agree to measure their contract in a different unit (like BTC or ETH), that contract is not enforceable in a court of law unless the obligation can be converted to a corresponding amount in “legal tender” - the USD.
Public vs. Private Legal Tender
Today the USD has a monopoly on both private and public legal tender. Public legal tender can be thought of as the unit by which we must tender payment of taxes, and the unit in which the government borrows money and pays it back. Private legal tender is everything else. At its lowest level, private legal tender is what we agree to accept as payment for our labor. From that foundation it may be what a grocery store accepts as payment, what that store’s landlord accepts as payment on a lease, what that landlord’s bank accepts as a mortgage payment, etc., etc., on down the chain.
The reason I say “down” the chain and not “up” is to draw the analogy between what is called a “Layer 1” Blockchain and the Central Bank (the Federal Reserve in the U.S.) One might think of these settlements working their way up the chain to the Fed. If these settlements are in a crypto currency, they will work their way through a “Layer 2” proxy Blockchain (these are created to speed up the process of handling transactions) and end up on the Layer 1 Blockchain - the final, decentralized consensus as to who owns what and who owes what to whom.
Now let’s think about what DCG is trying to do. They look like they are trying to establish a hierarchical settlement system analogous to the legacy banking system. But since crypto currency units are not recognized by the courts as legal tender, there must be some way to intermediate between the crypto universe and the legacy USD banking universe.
Enter the stablecoin.
Stablecoins enable arbitrage - they have nothing to do with yield.
While there are other, marginal use cases for a stablecoin, let’s look at one notable case. You use USD to buy Bitcoin on a U.S. exchange like FTX. You then transfer that Bitcoin from your FTX exchange to an exchange in Japan. There you sell the Bitcoin for Yen, and then convert the Yen to USD. Amazingly enough, there was a time when you would end up with more USD than you started with.
The problem is with USD you encounter regulatory burdens which translate to what I will call “transactional friction”. This is my term for how easy/hard it is to execute a transaction. Think of when you once had to check the back of the Business Section of the local paper for yesterday's closing stock prices and then call your broker (using a rotary dial phone!!!) to send an order to the trading floor to buy a certain number of shares in a company. That is a lot of “informational friction” (depending on the newspaper for yesterday’s closing price) and “transactional friction” (sending a verbal buy order to the floor via a call to your broker). We (meaning people like me who write code) solved for much of this friction in the early 2000s.
Using the USD entails using the banking system, which entails the “transactional friction” of banking regulations. The stablecoin was devised by people like me to minimize this friction.
Stablecoins are a proxy for the USD
So consider my Yen strategy... I convert USD to a stablecoin like Tether (USDT). (USDT, USD Coin [USDC], and Binance USD [BUSD] are the top three in circulating supply as of this writing). So let’s say I then buy Bitcoin with Tether, transfer the Bitcoin to my Japanese account, sell it for Yen and then buy back Tether with that Yen. In theory I end up with more Tether than I started with. I am using Tether as a proxy for the USD to solve for the regulatory friction inherent in using USD. This allows me to repeat trades strategies like this much more frequently.
There are two assumptions here: 1) The value of Bitcoin vs. the Yen is higher than Bitcoin vs. the USD; and 2) The stablecoin I am using can retain its “peg” to the USD.
Before we unpack this, the market pro (especially the foreign exchange - or FOREX - professional) should recognize this play immediately. This is just another flavor of FOREX arbitrage. What it manifestly is NOT is “yield”. But certain players in the crypto crowd will sell you on this as “yield farming”.
Cough-cough... BULLSHIT... cough-cough. But I digress....
“Arbitrage” is just one more example of specialty language. It rests on understanding that all prices combine two units of measure. Here BTC/USD (Bitcoin in US Dollars), BTC/YEN, and USD/YEN. This depends on the reliability of these units of measure. So let's back up even more - to what I have called the “Labor to Living” perspective. Does the Yen - for the Japanese - transmit their labor to their living better than the USD for the American? There are a lot of variables that go into answering that question. But for my purposes, just asking the question should reveal to the reader what really matters. If, between the USD and the YEN, the USD has more “street cred” than the YEN, the opportunity to play the YEN against the USD for speculative profit - by way of BTC - drives the decisions of market players.
This is manifestly NOT “yield”. Let’s use the energy sector as an example. One company might find and lift oil from the ground. (Or to put it differently, the earth “yields” its oil.) They are obtaining the raw materials of the earth and selling them to others who will turn them into useful things. A refiner buys the crude oil and refines it into consumer fuels. A transportation company trucks the fuels to the point of sale. A gas station chain sells the fuel to motorists. And for all of these, there are the companies who make the “nuts and bolts” that make it all possible. Each of these steps creates what I like to call the “wealth-value chain”. Wealth is created by taking the raw materials of the earth and making useful things. Various forms of value then emerge. The auto mechanic does not create wealth. But he does provide value. Yet the value he provides depends entirely on the prior creation of wealth - whether it be the raw materials to manufacture the car or the refining of crude oil into gasoline to fuel it.
A much more simple example: The farmer grows the coffee and the potter forms the coffee mug... and now a barista has a job.
Wealth is created by taking the raw materials of the earth and making useful things. Various forms of value then emerge.
If I invest in any of these companies, they might distribute their profits to shareholders by paying a certain amount of money per share in dividends on a quarterly basis. I can take those four dividend payments and divide that by the average price of the stock and come up with an annualized dividend “yield” as a percentage. I can then compare that to what I might otherwise get from a savings account. (This is why ultra low interest rates goose the stock market.)
From the 1990’s until today, we have seen an ever increasing share of what appears to be economic growth coming from “financialization”. It is not a coincidence that the deregulation of the financial markets corresponded with the emergence of the digital age. The kind of information technology used to predict the path of a hurricane is EXACTLY the same technology used to identify future price-pair arbitrage opportunities. This really all boils down to card-counting at the Blackjack table - and people like me are the ones writing the code to count the cards. There is nothing new in the crypto space right now; this is just another form of FOREX arbitrage - only a more efficient form which uses a stablecoin as a proxy for the USD to avoid regulatory friction.
So, for my purposes, yield is the percentage increase realized by owning a position on a legitimate wealth-value chain where wealth is created by the earth yielding raw materials which are then used to make useful things. Arbitrage is a percentage increase realized by betting on the difference in the price of one thing on different markets. Old school arb might be the difference between the price of a stock on the NASDAQ and the NYSE, which is exploited by high frequency trading. Crypto arb is no different. A stablecoin serves as a proxy for the USD and is used to arbitrage price differences of a crypto unit like BTC against different fiat units like the USD and the Yen.
Stablecoins and their “peg” to the USD
So now let’s look at how a stablecoin is “pegged” to the USD. There are two approaches. The first is naked arbitrage and requires the issuer of the stablecoin to also issue its own crypto currency. The biggest example is the Terra (UST) stablecoin its crypto unit partner LUNA. If there is high demand for UST, its price can notionally rise above 1 USD. That, though, creates an arbitrage opportunity which the Terra/LUNA Blockchain is coded to incentivize and allow. When the arb opportunity is exploited, it results in the “burning” of 1 UST and “minting” of 1 LUNA, which the trader can sell for dollars at a very slight profit. That selling activity is what pushes the UST price back down to $1. (Or further down below $1... but that’s an entirely separate essay.)
This is an “algorithmic” stablecoin. The problem is its algorithm assumes orderly and rational price discovery. It is the ultimate in “normalcy bias” - it works great when market conditions are normal, but is highly fragile during market disruptions.
The other approach is to “collateralize” the stablecoin. Tether (USDT) holds a mix of assets, 82% of which can be cashed out either immediately or very quickly. Tether (USDT) survived the collapse of Terra/LUNA because its claim to a 1:1 value against the USD is backed by a wide array of easily cashed out assets.
Part of its backing include loans to other entities, none of which are affiliated with Tether. This sets it apart from FTX/Alameda, which listed loans to itself (basically) as assets. In other words, FTX/Alameda turned out to be a circular firing squad. The degree to which other crypto businesses are engaging in the same shell game runs to the heart of why crypto is reeling. There is speculation that SBF used $1B in UST lent to FTX by Genesis (see above) to flood the Terra (UST) market with sell orders, creating an opportunity for others to short-sell UST, as part of what SBF himself called a “Second Great Stablecoin War” possibly to create demand for a new stablecoin issued by FTX.
And therein lies the problem...
Let’s walk this step by step:
1) As long as the USD has a monopoly on legal tender, crypto can never be anything other than an arbitrage opportunity. This means crypto can never provide an honest yield. Ethereum v2.0 comes the closest because of its “Proof of Stake” design, but even then the ETH “yield” is “nominal” and needs to be converted to USD to be realized. So if ETH nominally yields 5%, but the USD loses 5% or more in real-term purchasing power, that ETH “yield” is a mirage.
2) As long as crypto is only an arbitrage opportunity, transactional friction creates the demand for which stablecoins are issued. Do not be fooled by other marginal use cases or the idea that a stablecoin is an asset class; it isn't and never will be. “Yield farming” is bullshit; the stablecoin is simply a means by which transactional friction is reduced in what is essentially a FOREX arbitrage play.
3) The proliferation of stablecoins to meet this demand then creates an incentive for one issuer to deploy resources to undermine other issuers. This is what some suspect happened to Terra/LUNA. Some believe the pace of selling outstripped the network’s processing capacity to execute the algorithm’s instructions so as to maintain the 1:1 peg. Yet even if this is true, it shows how easily market confidence in an otherwise “unbacked” stablecoin can be shaken.
4) An over-collateralized stablecoin like Tether functions well for crypto arbitrage... but only if the issuer manages the collateral well. Do not mistake Tether for an “asset” - it isn’t one, but rather a proxy for the real assets held in reserve to maintain the 1:1 peg. The “winner” of the “stablecoin wars” will only end up being the crypto analog to the Federal Reserve. The whole thesis of decentralization is turned on its head, and the crypto crowd becomes the new Ruling Class. History teaches us what comes next.
So, how should we move forward?
1) There is no alternative to amending the U.S. Constitution to allow for competitive monetary systems and to separate public and private legal tender. Congress can establish its monetary unit (the USD) for payment of taxes and incurring/redeeming public debt. And that’s it! We should be free to enter into legally enforceable contracts requiring payment be tendered in whatever monetary unit we deem best fits our needs.
2) Understand that Blockchain technology permits any number of monetary systems to operate simultaneously. This is what I mean by “competitive monetary systems”. One person’s interests may indicate engaging in commerce in a very “tight” monetary system like Bitcoin. Another person’s interests might align better with a more accommodative system where credit is more easily obtained. (This will certainly be the case for the technology sector and their “early adopter” customer base. This is also why I believe Ethereum v2.0 is vastly superior to Bitcoin’s Blockchain.)
3) Revoking the government's authority with respect to private legal tender will then permit us to reject the USD for our labor in favor of a crypto currency. Then - and only then - can the earth’s “yield” of its raw materials, and our labor making them useful, be valued in crypto. Because of the immutable nature of the Blockchain, this will return us to an “immutable pair” (a crypto unit received in return for our time) by which our labor retains its value regardless of what the Ruling Class decides to do with the USD.
And only then will crypto offer an honest yield and genuinely be an investment which can, over time, replace our labor for the needs of our living.