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Why the business model of crypto exchanges is now dead
We are about get a hard lesson about what crypto really is
Up front: If you judge my competence in finance by my retirement account’s recent performance, I am a certified idiot. Under no circumstances should you take what I say next as advice. I am just pointing out what I have done with respect to crypto over the past few weeks and why. Like me, you’re on your own.
I used to have GBTC and ETHE in my account. Both are Greyscale products. For GBTC, Greyscale buys and sells Bitcoin in a way that tracks with the buying and selling of GBTC shares. The Bitcoin is held in trust on behalf of those who own shares. ETHE is their Ether equivalent. If we step away from the news about FTX, and crypto exchanges in general, I really like the underlying idea as a way to own crypto.
A few weeks back I sold the GBTC and added to ETHE. I did this after the initial Ethereum Blockchain was merged into Ethereum v2.0. This means Ethereum is now a “Proof of Stake” Blockchain, as opposed to Bitcoin’s “Proof of Work.” I am not going to go into any depth on the two because this article is about what we are about to learn (I believe) about exchanges from the FTX fiasco. I am convinced Bitcoin will go down in history as a revolutionary proof of concept, but will eventually be rendered obsolete by Ether on the Ethereum v2.0 Blockchain. There are a number of reasons for this. But, again, this is about crypto exchanges, not crypto per se.
I just sold all of my ETHE. This is not because I have lost faith in the underlying idea of the Ethereum v2.0 blockchain and Ether. It is because the painful lessons that will follow from FTX are only starting to become evident. Here are a few:
Lesson 1) The crypto exchange business model is dead.
The bankruptcy court will have to decide exactly what a crypto currency unit is in the context of U.S. bankruptcy law. I predict that - as Coinbase recently speculated in a filing - the crypto currencies (not the tokens) held in FTX will be treated as an asset which the court can sell to satisfy FTX’s secured creditors. All crypto exchanges will thus be revealed as no different than a legacy bank. When you deposit your salary in a bank account, you surrender ownership of that money. That cash goes on the bank’s balance sheet as an asset. Your claim on that money lives on the liability side of that balance sheet. You are an unsecured creditor of the bank. (The FDIC insures your deposits up to $250,000, but only has about $0.01 on the dollar in assets compared to the total insured deposits.)
As for GBTC and ETHE, it has been pointed out that Greyscale owns its Bitcoin and Ether via Coinbase - an exchange like FTX. Greyscale recently claimed that it and it alone owns the Bitcoin and Ether held in trust on behalf of those who own GBTC and ETHE. In light of Coinbase’s recent filing noticing investors of the risks associated with bankruptcy, and FTX’s actual bankruptcy filing, this is a little too cute (if lawyerly language can be thought of as cute) for my comfort. If the bankruptcy court rules Bitcoin and Ether held in FTX can be sold to satisfy secured creditors, then Greyscales’ claim is false on its face and my shares are essentially worthless. Greyscale will be just another unsecured creditor to Coinbase. That is why I sold my ETHE.
But much more broadly, if crypto exchanges are no different than legacy banks as far as “counterparty risk” goes (this is specialty language for being an unsecured creditor to your bank - or possibly your crypto exchange), then the foundation of how the Blockchain/crypto-currency economy is currently structured is beginning to collapse. Does this mean the “end of crypto?” Not by a long shot; keep reading.
Lesson 2) If you value your crypto in USD, you do not understand crypto.
Every case for and against crypto can be charted: On the X axis is time; on the Y axis is USD (or % in USD). As for the X axis, the unit of measure is immutable. An hour, a day, a week, a month, a year... Once it has passed you cannot go back and fudge it. The problem with valuing crypto in USD is the Y axis (USD) is manifestly NOT immutable. You will not grasp the significance of this observation as long as you look at money from the academic/finance pro perspective (unit of measure/medium of exchange/store of value). Before money is any of these things, it is how you transmit your labor to your living. None of the academic properties of money mean anything until you and others accept it in return for your labor.
Money is how you transmit your labor to your living. None of the academic properties of money mean anything until you and others accept it in return for your labor.
It is extremely important, especially for the finance pro, to nurture the self-awareness needed to realize you are crowded into a narrow perspective - narrowed mainly by your credentials. Stop and think: You obtained your creds by passing tests written by other people like you; you all share the same academic/professional perspective. Just having to obtain a credential for a profession is one signal that you are introducing yourself to a world of group think. To appreciate the value of realizing this, and maybe even of having the stones to look at money and finance from a different perspective, listen to this speech by Steve Jobs. He tells the story of dropping into a calligraphy class. All of a sudden he saw the computer as something entirely different. The credentialed engineering class could not see what Jobs saw because they were buried by their own creds in group think.
[It is in this speech that Jobs says what I put at the bottom of every email: “Don’t be trapped by dogma, which is living with the results of other people’s thinking.”]
The problem with the current structure of the crypto economy is that the market pro perspective is an accounting perspective. The central knowledge question is: “Who owes what to whom.” This is understandable because the foundational case for the Blockchain (stop thinking about crypto currencies for a moment) is how the distributed consensus mechanism renders the Blockchain’s record of ownership immutable. But if we are going to measure who owes what to whom in a monetary unit that no longer reliably transmits our labor to our living... exactly what do we claim to know again?
Lesson 3) If you do not understand “legal tender”, you do not understand crypto.
In the FTX bankruptcy, it is hard to see how the court avoids treating BTC and ETH supposedly “owned” by others as an asset to be sold to pay secured creditors. This is because the USD has a monopoly on this thing called “legal tender.” The record of who owes what to whom is kept in USD as the unit by which assets and liabilities are measured. For this reason, there is only one “way” - by only one unit of measure - which a secured creditor can be paid back - the USD. As such, the BTC and ETH held on FTX simply has to be treated as an asset, has to be valued in USD, and will be sold out from under its “owners” (who are actually unsecured creditors as described above) to tender payment to the secured creditors.
To say, then, that the USD is “legal tender” is to say that when payment of a debt is tendered in USD, the obligation to make the payment is legally satisfied. If we are a creditor who has the right to collect a payment - and the payment is made by the debtor in USD - even if we don’t want to accept payment in that form, since the USD is “legal tender for all debts, public and private” courts will consider the obligation to pay as having been satisfied by the debtor tendering payment in USD.
So let’s go back to the question of wages and money as the means by which we transmit our labor to our living. In terms of a bankruptcy where the organization is being “liquidated” (as opposed to being “reorganized”), employees are treated as creditors. While they are not “secured” creditors, they are given higher priority than other unsecured creditors (like vendors). What matters, though, is that the unpaid wages are considered a debt and only payment in USD can legally satisfy the debt.
So if we imagine wanting to be paid our salary in a crypto currency like ETH, as long as the USD has a monopoly on recognition as legal tender, no company will agree to such an arrangement because tendering payment of wages in ETH - which is not legal tender - means the courts cannot recognize such payment as the legally required payment of wages. Even though you and your employer have agreed to exchange your time for ETH, as a matter of law, the wages remain unpaid.
No employee should accept such an arrangement for the same basic reason. In order to have a legally enforceable claim on a payment (i.e. wages) that claim has to be measured in some unit. Since the USD is the only form of legal tender, there is no way to even make a legally enforceable claim for unpaid wages in ETH (or any other crypto currency).
But let’s set this aside for a moment and imagine the USD is only legal tender for public debts. This means you cannot legally claim to have tendered payment of your taxes unless you have tendered that payment in USD. It means the U.S. Government can only borrow money and pay it back in USD. (If you worked for the U.S. Government you would likely be required to accept USD as payment of your salary.)
But the rest of us? It would mean we would be free to enter into an agreement with an employer to be paid in crypto. We would have recourse to the courts to enforce that agreement with respect to unpaid wages. And upon payment of those wages, that debt would be considered legally satisfied.
So, I’ll ask: Why, exactly, are you OK with receiving your salary in USD? Consider this: In 1964 - the last year the Quarter Dollar was minted in 90% silver - the federal minimum wage was $1.25. (That’s five Quarters for you jocks out there.) Prior to COVID, if you were to take five 1964 Quarter Dollars and melt them down, the silver would have been worth about $15. Post COVID? It’s now about $20. Does the fight over a $15 minimum wage look a little different now? But why is this? Can we at least come away understanding that the problem is not the wage, but the money in which it is paid?
So, I’ll ask again: Why do you continue to consent to being paid in USD for your labor? Is it not that you have uncritically accepted the group think assumption: “TINA” - There Is No Alternative?
But there is.
After the Revolutionary War, a group of Army vets who hadn’t even been properly paid for their service, and had borrowed money to leave their farms to fight, were being hounded by unscrupulous debt collectors. It came to a head in the Daniel Shays Rebellion. There were a number of problems with the Articles of Confederation, but the Daniel Shays Rebellion was the last straw. The Preamble to the U.S. Constitution speaks of ensuring “domestic tranquility” in answer to the civil upset of the Daniel Shays Rebellion. This is also why the Constitution authorized the U.S. Congress to pass uniform bankruptcy laws.
FTX is about to teach us a very disruptive lesson about these laws.
Also found in the Constitution - in Article I, Section 8, Clause 5 - is where We the People delegated to Congress the authority to “coin money and regulate the value thereof.”
The only reason it seems there is no alternative is that we have forgotten that the USD exists only by the consent of We the People. The last battle of the Daniel Shays Rebellion was fought in 1787. The U.S. Constitution was ratified in 1788. Four years later the Coinage Act of 1792 was passed which created the USD in its various denominations - all defined in weights of silver or gold (or copper for the penny). It is not my intention to relitigate old arguments about gold/silver as money. Rather, this ought to teach us a crucial lesson about why we are forced, in a sense, to accept the USD as “legal tender” for what is owed to us as a result of our labor.
Lesson 4) If you do not understand the “immutable pair” by which we once valued our labor, you do not understand crypto.
Let’s go back to our charts. Recall the X axis is time, and therefore is immutable as a unit of measure. Now consider that in its original form, the USD was defined by its weights in silver or gold. The reason why gold (and even more so, historically) silver has been used as money is because of the chemical properties of the Nobel Metals. Neither gold nor silver rust, which means their weight does not dissipate over time. This means our labor was once priced in an “immutable pair.” We were paid a certain weight in gold or silver for a certain amount of our time (and effort).
Over the past year we have learned the hard way that today’s USD is not an immutable unit of measure like time. But in its original form, the USD was immutable as a unit of measure in either gold or silver. Let’s go back to our observation about the minimum wage in 1964. Why does it take - at a minimum - $15 to buy what once cost $1.25? The answer is not so much gold or silver as money but whether the money in which wages are paid to us for our time make an immutable pair.
Once again: Why are we willing to accept USD for our labor? If you do not appreciate the question, you do not understand crypto.
Conclusion: The Digital Liberties Amendment
I’ll end with a statement which will likely earn the derision of the credentialed class... That’s quite OK. The engineers laughed at Steve Jobs and we all know who got the last of those laughs.
If you look at all of this from the “who owes what to whom” (accounting) perspective of the credentialed class, you probably think crypto is an asset. From the accounting perspective, an asset is something that (notionally) can be sold to satisfy a liability. The problem with this is how the “selling” of the asset means you convert it to cash in another monetary unit (the USD). That unit is also the unit by which you are measuring liabilities to be satisfied from the proceeds of the sale.
If you think crypto in its current form is an asset (or an investment), you do not understand crypto. As long as the USD is shielded from competition by legal tender laws, crypto might as well be a tulip.
But this ought not be read as a dismissal of crypto currencies, but as an indictment of our willingness to “live with the results of other people’s thinking” - our mindless consent to accept what has become of the USD in return for our labor - therefore allowing it to remain the unit by which we account for who owes what to whom. This is the analog to Steve Jobs looking at the computer from the perspective of calligraphy and typography. For you market pro jocks out there: If you can grow a pair and leave the crowded group think of the credentialed classes and see crypto as a means to return to the immutable pair by which we might insist on valuing our labor (let’s just call this the “Labor to Living” perspective) you’ll then understand what has to come next.
I have stood up a website to make the case for what I call the Digital Liberties Amendment. Here is a quick outline (highlighting the part most pertinent to the brewing FTX scandal):
Section 1 repeals the above discussed Article I, Section 8, Clause 5 of the U.S. Constitution;
Section 2 establishes the use of Blockchain technology for competitive monetary systems as a “right fundamental to ordered liberty”;
Section 3 forbids Congress or the Executive from making laws of private legal tender. It limits Congress to public legal tender - determining how taxes will be paid and public debt issued and redeemed;
Section 4 prohibits Congress or the Executive from shielding either Blockchain data or data about public gold and silver holdings from public scrutiny;
Section 5 protects the right to private custody (e.g. cold wallet storage) of crypto and places privately owned crypto custodied on public exchanges outside of the reach of bankruptcy courts;
Section 6 prohibits Congress or the Executive from banning private ownership of gold or silver and from confiscating it for public purposes;
Section 7 secures to us an intellectual property right interest in all data which is created as we conduct our lives in the digital age.
Section 8 secures our right to know whether such data belonging to us is in the possession of any agency of government.
A separate effort I support but am not otherwise formally associated with is working to call an Article V Convention of the States to “to [propose] amendments that will impose fiscal restraints on the federal government, limit its power and jurisdiction, and impose term limits on its officials and members of Congress.”
There is no better way to impose these fiscal restraints and limit the power of the federal government than to take back the monetary authorities that have always belonged to We the People.